xvEPA
United States
Environmental Protection
Agency
      Tools of the Trade
        A Guide to Designing and
        Operating a Cap and Trade
      Program for Pollution Control
*W
               U.S. EPA Headquarters Library
                 Mail Code 3404T
               1200 Pennsylvania Avenue,
                Washington DC 20460
                  202-566-0556

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Tools of the Trade
   A Guide To Designing and
   Operating a Cap and Trade
 Program For Pollution Contro
       United States Environmental Protection Agency
           Office of Air and Radiation

            EPA430-B-03-G02

           www.epa.gov/airmarkets
              June 2003

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Table of Contents
Acknowlegments.
Chapter 1: Introduction	.....1-1
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   Introduction	1-1
   Purpose	.	1-1
   Structure	1-1
   Cap and  Trade	1-2

Chapter 2: Is Cap and Trade the Right Tool?		2-1
   Introduction	2-1
   General Assessment Issues	2-1
   Comparison of Cap and Trade and Other Policy Options	,	2-5

Chapter 3: Developing a Cap and Trade Program		.	3-1
   Introduction	3-1
   Guiding  Principles	3-1
   Establishing Legal Authority	3-2
   Creating an Emission Inventory	3-3
   Program  Design Elements 	3-4
   Other Design Considerations	3-25

Chapter 4: How to Implement and Operate a Cap and Trade Program 	4-1
   Introduction	4-1
   Integrated Information Systems	4-1
   Auditing and Verification 	4-4
   Technical Support for Regulated Sources	4-5
   Administrative Costs Associated with Cap and Trade 	4-6

Chapter 5:Assessment and Communications	5-1
   Introduction	5-1
   Communicating Status and  Results	5-1
   Communication Issues Unique to Emission Trading Programs 	......5-2
   Modes of Communication	1	5-5
   Continued Assessment	5-5

Glossary of Terms	.Glossary-1

Acronvms......	  Acronvms-1
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References		References-1

Appendix A:The Optimal Level of Pollution	A-l
   The Economics of Emission Trading 	A-2

Appendix B: Example Assessment of the Potential For Cap and Trade	B-1
                                            Table of Contents

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Acknowledgments
    The U.S. Environmental Protection Agency (EPA) would like to acknowledge the many individual contribu-
    tors to this document, without whose efforts this guidebook would not be complete. Although the com-
    plete list of experts who have provided technical and editorial support is too long to list here, we would like
to thank some key contributors and reviewers who have played a significant role in developing this guidebook.
  In particular, we wish to acknowledge the efforts of the staff of the Clean Air Markets Division (CAMD) of
the U.S. EPA - the division responsible for operating the U.S. SOz Allowance and Ozone Transport Commission
(OTC) NOx Budget Trading Programs. Many staff contributed to this guidebook, including Rona Birnbaum,
Kevin Culligan, Katia Karousakis, Stephanie Grumet, Richard Haeuber, Melanie LaCount, Sasha Mackler,
Brian McLean, Beth Murray, Sam NapoJitano, and Sharon Saile. Special mention is due to Jennifer Macedonia
and Mary Shellabarger who did much of the planning and development of this guidebook. Joe Kruger and
Jeremy Schreifels compiled and edited the completed document.
  This guidebook benefited immensely  from the comments and suggestions of a panel of external reviewers,
including Dallas Burtraw, Resources for the Future; Andrzej Blachowicz, Center for Clean Air Policy; Tomas
Chmelik, Czech Ministry of Environment; A. Denny Ellerman, Massachusetts Institute of Technology; Erik
Haites, Margaree Consultants; Bias P6rez Henriquez, University of California-Berkeley; Stan Kolar, Center for Clean
Air Policy; Nancy Seidman, Massachusetts Department of Environmental Protection; Jintian Yang, Chinese
Research Academy of Environmental Sciences; and Peter Zapfel, European Commission. We would like to
thank each of them for their insightful comments and suggestions.
  We would also like to thank the staff at ERG for graphics and production support.
                                                                                                      I
iii
Acknowledgements

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                               Introduction
Introduction
"o ensure a cleaner, healthier environment, gov-
  I  ernments are increasingly using market-based
  I  pollution control approaches, such as emission
trading, to reduce harmful emissions. The theory of
emission trading and the potential benefits of market-
based incentives relative to more traditional environ-
mental policy approaches are well established in
economic and policy literature. Until recently, however,
practical applications of emission trading programs
have been relatively limited. In 1990, the United States
enacted legislation to implement a comprehensive
national sulfur dioxide (SOz) program using a form of
emissions trading called "cap and trade." The U.S.
SOz cap and trade program has proven to be highly
effective from both an environmental and an economic
standpoint. The success of this program and others
that followed has spurred interest from policymakers,
regulating authorities, and business and environmental
organizations. Today, emission trading mechanisms are
increasingly considered and used worldwide for the
cost-effective management of national, regional, and
global environmental problems, including acid rain,
ground-level ozone, and climate change.
Purpose
This guidebook is intended as a reference for policy-
makers and regulators considering cap and trade as a
policy tool to control pollution. It is intended to be
sufficiently generic to apply to various pollutants and
environmental concerns; however, it emphasizes cap
and trade to control emissions produced from station-
ary source combustion. In the United States, SOz and
NOx are controlled with cap and trade programs.
These programs provide many illustrative examples
that are  described within this text.
Structure
This guidebook is organized as follows:
   The introduction explains the policy tool known
    as cap and trade.
   Chapter 2 provides guidance on how to deter-
    mine if cap and trade is the right solution for a
    particular problem and describes how it varies
    from other policy options, including other forms
    of emission trading.
1-1
                                        Introduction

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    Chapter 3 explains the process for developing a
     cap and trade program.
    Chapter 4 explains how to implement and oper-
     ate a cap and trade program.
    Chapter 5 discusses how to assess the results of a
     cap and trade program and communicate them  to
     the public.
  *  Glossary of Terms and Acronyms contains defi-
     nitions of the terms and abbreviations used
     throughout this guidebook.
    References contains a list of articles and papers
     cited in this guidebook.
    The Appendices contain additional technical
     and reference information.
  Specific examples are provided throughout the text.
These examples draw on the experience from cap and
trade programs,  including the U.S. SOz Allowance
Trading Program (also known as the Acid Rain
Program), the Regional Clean Air Incentives Market
(RECLAIM) in  Southern California, the Ozone
Transport Commission (OTC) Regional NOx Trading
Program in the Northeastern United States, and the
United Kingdom's emission trading program for car-
bon dioxide (COz). These examples were selected to
illustrate various aspects of cap and trade and are not
intended to endorse controls on a specific pollutant.
Cap and  Trade
Cap and trade is a market-based policy tool for environ-
mental protection. A cap and trade program establishes
an aggregate emission cap that specifies the maximum
quantity of emissions authorized from sources included
in the program. The regulating authority of a cap and
trade program creates individual authorizations
("allowances") to emit a specific quantity (e.g., 1 ton)
of a pollutant. The total number of allowances equals
the level of the cap. To be in compliance, each emis-
sion source must surrender allowances equal to its actu-
al emissions. It may buy or sell (trade) them with other
emissions sources or market participants. Each emission
source can design its own compliance strategy - emis-
sion reductions and allowance purchases or sales - to
minimize its compliance cost. And it can adjust its
compliance strategy in response to changes in technol-
ogy or market conditions without requiring government
review and approval.


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Environmental Certainty
Cap and trade programs offer a number of advantages
over more traditional approaches to environmentai reg-
ulation. First and foremost, cap and trade programs can
provide a greater level of environmental certainty than
other environmentai policy options. The cap, which is
set by policymakers, the regulating authority, or anoth-
er governing body, represents a maximum amount of
allowable emissions that sources can emit. Penalties
that exceed the costs of compliance and consistent,
effective enforcement deter sources from emitting
beyond the cap level. In contrast, traditional policy
approaches such as command-and-control regulation
generally do not establish absolute limits on allowable
emissions but rather rely on emission rates that can
allow emissions to rise as utilization rises.
  With cap and trade  programs, even new emission
sources may not increase the limits on emissions. The
regulating authority may require new entrants to pur-
chase or receive allocated allowances from the total
allowable emissions set by the cap (see Chapter 3 for a
description of different ways that new entrants may be
treated). Thus, the emissions target is maintained  and
the price of an allowance can adjust to reflect the
increased demand for allowances.
  A cap and trade program may also encourage
sources to pursue earlier reductions of emissions than
would have otherwise  occurred, which can result in
1-2
                                            Introduction

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the earlier achievement of environmental and human
health benefits. This is a result of two primary drivers:
first, the cap and associated allowance market creates
a monetary value for allowances, providing sources
with a tangible incentive to decrease emissions.
Second, a cap and trade program can incorporate the
flexibility of banking (see Chapter 4) to provide
sources with an additional incentive to reduce emis-
sions earlier than required. Banking allows sources to
carry over unused allowances for use in a later compli-
ance period when there might be more restrictive
requirements or higher expected costs to reduce emis-
sions. Essentially,  banking gives sources some flexibil-
ity in the timing of emission reductions (i.e., temporal
flexibility). This is in addition to flexibility given to
sources in the location at which they make emission
reductions (i.e., spatial flexibility).
  Another environmental advantage of cap and trade
is improved accountability. Participating sources  must
fully account for every ton of emissions by following
protocols to ensure completeness,  accuracy, and con-
sistency of emission measurement. This system  con-
trasts with  most environmental programs that base
compliance on periodic inspections and assumptions
that equipment is functioning and the source is  in
compliance between inspections.
  Accurate measurement of emissions and timely
reporting are critical to the success of a cap and trade
program and the integrity of the cap. After emissions
data and allowance transaction information are reported,
  Figure 1. Cost Minimization With Trading
                       Potential transfer of 2 allowances for $80-3120 each
the regulating authority can provide detailed or summa-
ry information to the public (e.g., on the Internet). This
transparency, or access to information, can provide con-
fidence in the effectiveness of the program.

Minimizing Control Costs
In addition to the environmental benefits of adopting
a cap and trade program, significant economic benefits
also support the use of such a mechanism. Cap and
trade programs provide sources with flexibility in how
they achieve their emission target, which is uncommon
under traditional environmental policy approaches.
The cap establishes the emission level for emission
sources; the sources, however, are provided with the
flexibility of choosing how they want to abate their
emissions. Each source can choose to invest in abate-
ment equipment or energy efficiency measures, to
switch to fuel sources with no or reduced emissions, or
to shutdown or reduce output from higher emitting
sources. The regulating authority does not need to
approve each source's compliance choices  because the
cap,  accompanied by emission measurement and
reporting requirements, enable the regulating authori-
ty to focus on assessing compliance results (i.e., ensur-
ing that each source has at least one allowance for each
unit of pollution emitted). Cap and trade programs
also  allow sources to trade allowances, providing an
additional option for complying with the emissions tar-
get.  Sources that have high marginal abatement costs
(i.e., the cost of reducing the next unit of emissions)
                     can purchase additional
                     allowances from sources that
                     have low marginal abatement
                     costs. In this way, both buyers
                     and sellers of allowances can
                     benefit. Sources with low costs
                     can reduce their emissions
                     below their allowance holdings
                     and earn revenues from selling
                     their excess allowances - a
                     reward for better environmental
                     performance. Sources with high
                     costs can purchase additional
                     allowances at a price that is
                     lower than the cost to reduce a
                     unit of pollution at their facility
                     (see Figure 1), This outcome is
                     consistent with the "polluter
                     pays" principle.
                                                             Initial Emissions
1-3
                                                   Introduction

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  A well designed cap and trade program can afso
provide continuous incentives for innovation in emis-.
sion abatement. Because of the value attached to
allowances. The value creates an economic incentive
to invest in research and development for emission
abatement options that can further reduce the costs of
attaining compliance.
  Finally, the cost-minimizing feature of cap and trade
has long-term environmental benefits. Driving down
the cost of reducing a unit of pollution means that poli-
cymakers and regulating authorities can set targets that
reduce more pollution at the same cost to society. This
system makes it economically and politically feasible to
achieve greater environmental improvement.
1-4
                                             Introduction

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                Is  Cap  and  Trade
                    the  Right Tool?
Introduction
    Cap and trade can be an effective tool to address
    air pollution. However, it is not appropriate in all
    situations or for all environmental problems.
Policymakers should consider a number of important
issues before deciding whether cap and trade is appro-
priate. Prior to developing a cap and trade program,
policymakers.and other experts should determine
whether the nature of the environmental problem, as
well as the institutional capacity and political situation,
is conducive to the successful establishment of such a
program (Benkovic and Kruger, 2001).
  This section begins with a brief discussion of some
of the general issues that must be assessed for any
type of emission reduction program. Next, the section
examines whether cap and trade can address a particu-
lar environmental problem. Finally, it compares cap
and trade to other types of policies including different
forms of emission trading.
           General Assessment

           Issues
           Before making a decision about an emission reduction
           program, policymakers should assess a number of sci-
           ence, technology, and other issues. For example, regard-
           less of the type of program chosen, policymakers must
           understand the nature of the environmental or health
           problem of concern, the pathways of exposure, the loca-
           tion and magnitude of the sources that contribute to the
           problem, and the emission reductions necessary to
           address the problem. Similarly, policymakers should
           have answers to technical and economic questions such
           as the cost, availability, and performance of control tech-
           nologies. Although a full discussion of these questions
           is beyond the scope of this manual, Appendix B sum-
           marizes how some of these questions were addressed
           under the U.S. SO2 Allowance Trading Program.
             Once policymakers have a thorough understanding
           of these issues and questions, they can determine
           whether cap and trade is an appropriate tool to address
           the problem. The following sections outline some of
           the key considerations used to determine whether cap
           and trade will be an effective program for a particular
           situation.
2-1
Is Cap and Trade the Right Tool?

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Is  Flexibility Appropriate?
Cap and trade is premised on the notion that regula-
tors do not need to direct the type or location of spe-
cific emission reductions within a region. Instead,
these programs set an overall target and let "the mar-
ket" determine where to make the most cost-effective
reductions. In some cases, however, it does matter
where an emission reduction is made. For example,
some toxic emissions may have primarily local health
impacts in the area immediately surrounding a facility.
Allowing such a facility to buy allowances from other
similar facilities in the area may not fully address the
risks caused by its emissions.  It may make a situation
worse by causing a "hotspot"  if the cap does not
require sufficient reductions to minimize or  prevent
local impacts. In such a case, it may be necessary, from
a public health standpoint, to impose source-specific
controls and limit the flexibility inherent in  an emis-
sion trading program.
  In general, the more a pollutant is uniformly dis-
persed  over a larger geographic area, the more appro-
priate it is for the use of cap and trade.
  Even when the location of emissions does matter,
cap and trade may be effective if the environmental
goal can be met through emission reductions in a gen-
eral region. For example, a cap and trade program can
reduce  total loadings of a pollutant into the atmos-
phere, particularly if these pollutants are emitted by
many sources and  transported over a large geographic
region.  This was the case in the United States with
the SOz Allowance Trading Program, which  is intended
to reduce acid deposition in the Eastern United States
and Canada. Similarly, cap and trade-programs can
address ambient air quality problems by reducing
background levels of pollution that contribute to
adverse air quality. For example, if there are  prevailing
winds,  it  may be necessary to include emission sources
upwind of the polluted area that could prevent down-
wind areas from meeting their ambient air quality
standards. The NOx cap and  trade programs in the
Northeastern United States were designed to reduce
long-range transport of N0x emissions  that  lead to the
formation of ground-level ozone.
  Before designing cap and trade programs to address
emissions that are not uniformly mixed, it is necessary
to conduct an assessment of the  possibility  of
hotspots. Chapter 3 contains  a discussion about ways
to assess the potential for hotspots and how to develop
policies to avoid them if necessary. In such  cases regu-
               lating authorities may need to limit emissions at spe-
               cific sources or limit trading to ensure that the pro-
               gram does not create hotspots and that it achieves the
               environmental objectives. It should be noted, howev-
               er, that if a program requires too many trading restric-
               tions to avoid hotspots, a more conventional regulatory
               approach to address the problem might be preferable.

               Do Sources Have Different
               Control Costs?
               Cap and trade programs make the most sense when
               emission sources have different costs for reducing
               emissions (Newell and Stavins, 1997). These cost dif-
               ferences may result from the age of the facilities, avail-
               ability of technology, location, fuel use, and other
               factors. In the US. SOz Allowance Trading Program,
               there was considerable diversity in emission reduction
               costs because of differences in the age of power plants
               and the proximity to low sulfur coal supplies (Stavins,
               1998). Where costs are different, there is "room for a
               deal,"  because sources with high marginal abatement
               costs have an incentive to buy allowances from sources
               with low marginal abatement costs. Conversely, if
               affected sources tend to be relatively homogenous,
               their marginal abatement costs may be approximately
               equal and there is little incentive for trading. In  this
               case, a cap and trade program is not likely to yield a
               significantly more cost-effective outcome than more
               traditional types of regulation. Table 1 is a compilation
               of SOz marginal control costs for sources in Taiyuan,
               China. The data were used to assess the feasibility of
               using cap and trade  to reduce SOz emissions. This
               type of analysis is critical to determining the merits of
               using cap and trade as a policy instrument.

               Are There Sufficient Sources?
               In general,  cap and trade programs should include
               enough sources to create an active market for
               allowances. If there are too few sources, there may be
               few opportunities for trading. In addition, even if there
               are cost-effective trading opportunities in a program
               with few sources, a market with few transactions could
               make potential sellers reluctant to part with their
               excess allowances. These potential sellers could be
               concerned that if business conditions change and they
               need more  allowances in the future, they will have dif-
               ficulty purchasing them. They may instead hoard
               excess allowances even though it might not appear to
2-2
Is Cap and Trade the Right Tool?

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be in their economic interest to do so. Additionally,
with fewer sources, there may be a concern that larger
sources may exert market power and withhold
allowances from the market to drive up prices of
allowances.
  There is a tradeoff, however, in that the more numer-
ous the sources, the more complex and costly the cap
and trade program may be to establish and operate. For
example, a cap and trade program for vehicles could be
administratively costly if there was a need to measure
and report emissions and enforce compliance at the
vehicle level.1 Technological advances, however, are
making it possible to cost-effectively expand participa-
tion in cap and trade programs (e.g., computerized data
tracking systems, improved emission measurement tech-
nology (Kruger, et al., 2000)).

Is there Adequate Authority?
Another important question government officials must
consider is whether the relevant government entity has
sufficient jurisdiction over the geographic area where
they would implement the cap and trade program. In
many countries, regional or local authorities are respon-
sible for implementing environmental programs. Often,
                     they must follow national poli-
                     cies but are given considerable
                     autonomy in implementation.2
                     To the extent that the region of
                     a cap and trade program covers
                     more than one jurisdiction, the
                     authorities should maintain
                     some consistency in key design
                     elements of the program. To
                     ensure that the allowances are
                     consistent and fungible across
                     jurisdictions, cap and trade pro-
                     grams require common design
                     elements, including standards
                     for determining applicability,
                     emissions measurement and
                     reporting, recordkeeping,
                     enforcement, and penalties for
                     non-compliance (Kinner, 2002).
Thus, program designers should answer the following
questions:
     Will provinces and municipalities be responsive
     to directives, such as monitoring requirements,
     imposed by the national government or would
     they cooperate to form a collective effort to
     develop such requirements?
     Does  the central government, or coalition of
     local governments, have the capacity to enforce
     compliance provisions and penalties throughout
     the entire trading region?
Other design elements,  such as allocation methodolo-
gies for assigning the initial distribution for
allowances, might be left to the provinces or munici-
palities since the allocation methods have little envi-
ronmental  impact.3

Are there Adequate Political
and Market Institutions?
For the trading component of a cap and trade program
to work, a country must have some of the same institu-
tions and incentives in place as those required for any
type of market to function. These include:
   Other environmental policy tools, or alternatively, the compliance obligation and allowance allocation at the vehicle manufacturer, fuel refiner or
   distributor level, may be more appropriate in this case.
   For example, China's provincial Environmental Protection Boards have the main responsibility for running air quality and other environmental
   programs. Similarly, in Slovakia there are 79 local districts that implement environmental and other programs.
   Allowing different provinces or municipalities to have different allocation schemes may have distributional economic impacts, such as favoring
   firms within an industrial sector in one region of a country over another. This result could have economic efficiency effects if product markets
   are not perfectly competitive.
2-3
                                          Is Cap and Trade the Right Tool?

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     A developed system of private contracts and
     property rights (see Chapter 3 for discussion of
     property rights issues associated with emission
     trading).
     A private sector that makes business decisions
     based on the desire to lower costs and raise profits.
     A government culture that will allow private busi-
     nesses to make decisions about "how" to achieve
     objectives with a minimum  of intervention.
   As with all environmental programs, a cap and trade
program requires adequate enforcement to ensure that
emission objectives are met. In addition, for an
allowance market to develop, market participants must
be confident that sources will measure and report
emissions correctly, the regulating authority will verify
compliance, and, if there is non-compliance, the regu-
lating authority will assess sufficient financial  penal-
ties.  Thus, cap and trade programs will  have greatest
success in  countries where rule of law is respected and
enforcement is consistent, impartial, transparent, and
independent of political considerations  {EDf and
RSHE, 2000). In addition, once regulations are imple-
mented, they should be changed only through trans-
parent and fair procedures. Participants should clearly
understand from the beginning how the program
works and how regulating authorities will measure and
enforce compliance. Interest in a trading program will
diminish significantly if firms believe that rules are
unfair, arbitrary,  or unpredictable.
   Even if a country does not yet have all of the attrib-
utes  described above, it may still be beneficial to
develop the infrastructure necessary for a cap and
trade program in advance of more comprehensive eco-
nomic changes (Ellerman, 2002). As  centrally planned
economies make the transition to become more mar-
ket oriented, they may also transform their environ-
mental programs to become more efficient. Even if
conditions are not yet ripe for trading, the structure of
a cap and trade program may improve environmental
performance. In particular, the emphasis on careful
mass-based emission measurement and accounting
may  improve environmental accountability of sources.
For example, recent experiments in Slovakia (CCAP,
2001) and Chile  (Montero, et al.,  2000) have indicated
              that the allocation process associated with cap and
              trade has served as an incentive for more complete
              and accurate emission inventories.

              Are Measurement Capabilities
              Sufficiently Accurate and
              Consistent?
              In considering whether cap and trade is an appropriate
              tool to address an environmental problem, policymak-
              ers should consider whether sources covered by the
              program can measure  emissions with sufficient accura-
              cy and consistency to support the cap and trade policy
              tool. (For a discussion of emission measurement priori-
              ties and issues for a cap and  trade program, see
              Chapter 3.)
                 Unlike many types of environmental regulation
              where regulating, authorities judge compliance by
              adherence to detailed technology or process specifica-
              tions, cap and trade programs require a purely perform-
              ance-based test for compliance. Ultimately, measured
              emissions dictate how many allowances a source must
              surrender at the end of the compliance period. Thus,
              the measured emissions dictate how many extra
              allowances a source may be able to sell or how many
              additional allowances  a source may need to buy. If one
              source uses a less accurate emission  measurement
              method than another, and consequently underesti-
              mates its actual emissions, it could surrender  fewer
              allowances than necessary to offset its emissions. If
              this scenario occurred, the emission  goal (or cap)
              would not be met. In  addition, facilities with  opportu-
              nities to reduce emissions beyond required levels
              would lose some of the economic incentive, because
              the underreporting sources need fewer allowances for
              compliance and will therefore either increase the sup-
              ply or decrease demand for allowances.
2-4
Is Cap and Trade the Right Tool?

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Comparison of Cap

and Trade and Other

Policy Options
A number of different policy tools can be used to
address environmental concerns. These include:
    Economic-incentive approaches, such as environ-
     mental taxes and emission trading.
    Command-and-control approaches, such as tech-
     nology mandates or emissions rate standards.
    Non-regulatory approaches, such as voluntary
     agreements and eco-labeling.
  Ultimately, the policymaker's objective should be
to achieve the optimal level of pollution control to
adequately protect human health and the environ-
ment at a minimum cost to society.

Market-Based Approaches vs.
Command-and-Control
Regulation
For many air pollution problems, command-and-con-
trol (or direct regulation) may be the best course. For
example, where regulating authorities can identify a
specific facility as the source of a public health prob-
lem, limiting its emissions may be the simplest and
most effective solution. Also, in the transportation sec-
tor where fuel characteristics can have a direct impact
on the effectiveness of engine technology, it may be
best  to directly specify fuel parameters, such as sulfur
content, to permit firms to design engines in the most
cost-effective way to reduce harmful emissions of par-
ticulates or other pollutants such as NOx, hydrocar-
bons, and carbon monoxide.
  Command-and-control regulations often work best
when: ,
    Emission reduction experience is limited and
     expertise is concentrated among regulators.
    Solutions are clear or there are few options for
     reducing emissions.
    Monitoring total mass emissions is not feasible.
    Emissions have serious local health impacts, and
     trading might make such hotspots worse.
  *  Emissions are toxic, and the desired emissions
     level might be zero.
          With command-and-control, the regulating authori-
        ty typically establishes a requirement to install a spe-
        cific type of emission reduction technology. Although
        sources may achieve a certain level of emissions per
        unit of heat input or product output using the tech-
        nology, increased utilization and new emissions
        sources can threaten the ability to achieve and main-
        tain an emissions target. Older sources that have been
        exempted or "grandfathered" from strict emissions
        controls might also threaten the ability to achieve and
        maintain an emission  target.  This threat can affect the
        ability to  achieve an environmental and/or human
        health goal.
          For some environmental problems, however, specif-
        ic requirements may cost more than flexible policy
        approaches and inhibit innovation. These types of
        environmental problems may work well for a transi-
        tional application of incentive-based approaches or
        economic instruments, such  as taxes or a cap and
        trade  program. Such programs may be preferred to
        encourage more economically efficient solutions. If
        properly designed, economic incentives can harness
        market forces to work toward environmental improve-
        ment. By internalizing pollution control costs they can
        make pollution reduction in  the economic interest of
        the firm and promote innovation.
          It is also possible and, in some instances, beneficial
        to use a hybrid approach where command-and-control
        policies are implemented side-by-side with a cap and
        trade  program. Command-and-control policies, if not
        overly restrictive, can  establish a backstop or safety net
        to adequately protect human health and the environ-
        ment (see Chapter 3).4


        Cap and Trade vs.
        Environmental Taxes
        Environmental taxes are another significant market-
        based instrument for reducing pollution. The major
        difference between cap and trade and environmental
        taxes is that cap and trade imposes an absolute restric-
        tion on the quantity of emissions allowed (i.e., the cap)
        and allows the price of emissions to adjust to the mar-
        ginal  abatement cost (i.e., the cost of controlling a unit
        of emissions). An environmental tax sets a price for a
        ton of emissions and allows the quantity of emissions
4  For a discussion of integrating cap and trade with other instruments, see Schreifels, 2000 and Ellerman, 2002.
2-5
Is Cap and Trade the Right Tool?

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I  Figure 2. Economically Efficient Control of Poiiution
                         CAPAND TRADE
                                                TAX
                        Actual Marginal
                        Abatement Cost
     OP*
    8
    .*:
    3

     I
Expected Marginal
Abatement Cost
                             Q trade
                  Quantity of Pollution Reduced
_
**-
o
4-t
'c
IP*
                                         Actual Marginal
                                         Abatement Cost
Marginal
Social Benefit
Expected Marginal
Abatement Cost
                                    Qtax
                                     Quantity of Pollution Reduced
    Theoretically, environmental taxes or cap and trade will provide the same level of environmental protection. However, if policymakers have
    incomplete or imperfect information about costs and benefits, researchers create new control technologies,or unforeseen developments arise,
    cap and trade provides certainty that the level of emissions will not increase beyond the emission cap. However, there are no assurances about
    the cost of the program. An environmental tax does not provide certainty about emissions, but it does establish a limit on the cost of the pro-
    gram to ensure that the price of emitting a unit of pollution does not exceed the tax level. In the second graph, the actual marginal abatement
    cost is higher than expected leading to fewer emission reductions (i.e., higher emissions) for the tax program. If the actual marginal abatement
    cost were lower than anticipated, the emission reductions for the environmental tax program would be greater than for the cap and trade pro-
    gram (and costs would be higher.)
to adjust to the level at which marginal abatement cost
is equal to the level of the tax (See Figure 2).

Environmental Certainty
There is extensive discussion in economics literature
about the relative merits of cap and trade and environ-
mental taxes.5 In situations where greater environmental
certainty is needed, cap and trade programs are prefer-
able because the cap sets an emission goal that sources
must meet. With taxes, the regulating authority must
establish a tax per unit of emissions. However, due to
imperfect information (e.g., regarding marginal abate-
ment costs and price sensitivities) and technological
changes, setting the tax at (he level required to attain the
emission target becomes difficult and uncertain.*
Moreover, under a regime of environmental taxes, new
entrants into the polluting activity will lead to increased
                   emissions. With cap and trade, regulating authorities can
                   require new entrants to purchase allowances directly
                   from the market or the regulating authority can provide
                   allowances from set-asides that are within the cap. Thus,
                   the emission goal can  be maintained.

                   Price Certainty
                   In situations where price certainty is needed, tax pro-
                   grams are preferable because the tax per unit of emis-
                   sions limits the cost to firms. For example, where the
                   costs of achieving a level of emission reductions are
                   uncertain, policymakers may decide to set an emis- -
                   sions tax rather than taking a chance that an allowance
                   price will rise to a level that is economically or politi-
                   cally unsustainable.7
   For a discussion of the economic considerations for choosing between taxes versus emissions trading, see Baurnol and Oates, 1988.
   A recent study of environmental taxes in Europe showed that these programs have failed to achieve the expected level of emission reductions
   (OECD, 2001).
   A third type of economic instrument is essentially a hybrid of a tax and a cap and trade program. This mechanism, sometimes known as a "safety
   valve" or a "price cap" is a cap and trade program with a maximum price per ton. If the market price per ton rises above the maximum price,
   regulated sources can buy additional tons at the maximum price. In such a situation, the emission cap is exceeded, but the price per ton does
   not rise above the maximum level (Pizer,  1997).
 2-6
  Is Cap and Trade the Right Tool?

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Administrative Costs
Administrative costs are similar for both environmental
taxes and cap and trade. Each approach requires
sources to keep records of fuel consumption or emis-
sions and to report this information to the regulating
authority. The regulating authority's administrative
costs include  processing this information, reviewing it
for completeness and accuracy,  and recording it. The
regulating authority could also conduct detailed audits
of selected submissions.
   With both  instruments the regulating authority
must decide the rigor of emission measurement and
reporting requirements. For example, Sweden's NOx
tax and the U.S. SOz Allowance Trading Program
require the use of continuous emission monitors
(Blackman and Harrington, 1999). Similarly, the regu-
latory authority's review of data can be more or less
rigorous depending on the level of review necessary.
Under the U.S. SOz Allowance Trading Program, emis-
sion data review is rigorous. Although it is highly auto-
mated, more  than 75 percent of staff resources at the
federal and state level are associated with the meas-
urement, processing, and tracking of emissions data
(see Chapter  4 for a more detailed discussion of
administrative costs).
   Under a cap and trade program, a small amount of
additional resources are necessary to process
allowance transfers and reconcile emissions and
allowances at the end of a compliance period. A tax
program will  require resources to collect and manage
tax receipts. Some fiscal institutions, however, may
already have the resources in place to collect and man-
age receipts from other tax schemes.

Political Considerations
Some regions have a history of implementing environ-
mental tax programs. In these regions environmental
taxes may be  easier to implement because they are
already understood and accepted and much of the
infrastructure may already exist. In other regions, there
may be political reasons to opt for a cap and trade pro-
gram. Emission sources may prefer a system in which
allowances are allocated without charge rather than a
system of environmental taxes  in which a source has to
pay for emissions. The initial allocation of allowances
reflects a transfer to sources of an asset that is scarce
and therefore has economic value. Recognizing this,
sources are often more supportive of this market-based
         incentive program than they are of environmental
         taxes. In some circumstances, policymakers might use
         both policies, environmental taxes and cap and trade.8
         A low tax can generate revenue for the regulating
         authority while still offering emission sources the ben-
         efits of a cap and trade program. Alternatively, the reg-
         ulating authority could generate revenue with a cap
         and trade program by distributing some or all
         allowances through an auction.

         Other Forms of  Emission
         Trading
         This section examines two additional forms of emis-
         sion trading - project-based  trading and rate-based
         trading - and compares them to the cap and  trade
         approach in terms of potential to limit total emissions,
         ability to achieve cost minimization, administrative
         overhead, and transaction costs.

         Cap and Trade vs. Project-Based Trading

         Potential to Limit Total Emissions
         Project-based trading, otherwise known as credit trad-
         ing or offset trading, is generally not used as a stand-
         alone program. It can be used to offer emission sources
         the flexibility to seek lower cost emission offsets from
         sectors outside a regulatory program. Historically in the
         United States, these types of credits or offsets have
         been used to meet rate-based emissions limits for con-
         ventional pollutants. More recently, there has been con-
         siderable international interest in using project-based
         trading as a complement to cap and trade to meet vol-
         untary or mandatory greenhouse gas emission targets.
            Emission offsets, or credits, are typically calculated
         by comparing actual emissions against a baseline. The
         baseline is an estimate of what emissions would be in
         a hypothetical situation (e.g., if the project had not
         been created). Determining the baseline is often the
         biggest challenge with project-based trading.
         Designing effective protocols to verify offsets is diffi-
         cult because it requires making a determination about
         whether the emission reductions  from an offset proj-
         ect would have occurred anyway.  This type of test  is
         known as "additionality." If emission reductions from
         a project are not "additional," there is a risk that these
         reductions could dilute an emissions goal and  lead to
*  For a discussion of integrating cap and trade and environmental taxes, see Ellerman, 2002.
 2-7
Is Cap and Trade the Right Tool?

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increased emissions compared to a case in which no
offsets are allowed.
   A similar concern in some situations is "paper cred-
its." These are created when a source uses its legal
allowable level of emissions (e.g., its maximum poten-
tial to emit) as its baseline rather than what emissions
would have been in the absence of the project. These
paper credits are the difference between what a source
is allowed to emit and what a source actually emits.
These credits increase allowable emissions without
generating any real emission reductions.'
   Two issues must be addressed for project-based
trading-the effect on total emissions from "non-addi-
tional" offsets and  "leakage," which is an increase in
emissions or decrease in sequestration caused by the
project but not accounted for in the emission baseline
for that project activity.10 The underlying concept is
that a particular project can produce offsetting effects
that fully or partially negate the benefits of the proj-
ect. For example, a project that protects a forest tract
slated for deforestation may simply accelerate logging
of the next most suitable location.
   Projects that temporarily sequester emissions {e.g.,
forestry projects  that sequester carbon dioxide) also
raise issues of "permanence." If the emission reductions
from the project are used to offset other emissions, and
the project subsequently releases the sequestered emis-
sions, not only is the environmental benefit lost, but the
credits may allow emissions to increase.

Cost Minimization
As with cap and trade, project-based trading can
reduce the economic costs of achieving an emission
goal by adding flexibility for sources to develop appro-
priate compliance strategies. For example, a polluting
facility may invest in an offsite emission abatement
project to earn emission reduction credits. If approved,
these credits may be used to offset emissions from the
facility.

Administrative Involvement and Transaction Costs
A key difference between cap and trade and project-
based trading is  the way that emission reductions are
verified and the implications for administrative involve-
ment. A cap and trade program requires preliminary
               analysis to establish an emission cap for regulated
               sources. Depending on the method of allowance distri-
               bution (see Chapter 3), additional work may be
               required to allocate emission allowances to the regulat-
               ed sources. Due to the emission cap and measurement
               requirements, there is no need for the regulating
               authority to review each emission reduction activity or
               to calculate an emission baseline for each activity.
               Instead, each regulated source measures and reports its
               total emissions, and the regulating authority focuses on
               ensuring emissions are measured accurately and an
               allowance is turned in for each unit of emissions..
                  In contrast, project-based trading often requires that
               project participants develop a project specific emission
               baseline for review by the regulating authority or other
               authorized experts." Review of such baselines can be
               contentious and resource intensive because it is
               extremely difficult to define with certainty what
               would have happened in the absence of a project.
                  To reduce administrative and transaction costs and
               address additionality concerns, the regulating authori-
               ty may establish multi-project baselines. Multi-project
               baselines use performance standards or benchmarks
               for a type of project. If the project results in emission
               rates lower than the standard, the project automatical-
               ly receives credit equal to the difference between the
               baseline and the actual emissions (Sathaye, et al.,
               2001). Standardizing baseline methodologies  in
               advance'can significantly reduce administrative costs
               and  reduce the subjectivity inherent in the review of a
               project baseline. They may not, however, always be a
               perfect test for whether emissions are below the levels
               that would have occurred otherwise. Also, multi-proj-
               ect baselines may be difficult to develop for some
               types of projects.
                  Project-based trading can reduce the costs of
               attaining  an emission  goal, but the administrative and
               transaction costs per unit of emission reduction are
               often higher than cap and trade programs; there is
               greater uncertainty and risk associated  with an offset
               than an allowance (e.g., due to baseline, permanence,
               and  leakage issues); and extensive involvement and
               oversight by the regulating authority are required to
               ensure environmental integrity. These  transaction
   Paper credits can also affect rate-based trading programs.
   Leakage can also occur in cap and trade programs that do not include all sources contributing co (he environmental problem. Sources in the pro-
   gram may shift production to other sources not participating in the program, thereby negating some of the emission reductions.
   Adequate safeguards for using an outside expert for verification include: sufficient direction and oversight from the regulating authority; accredi-
   tation of competency; and protection from conflicts of interest.
2-8
Is Cap and Trade the Right Tool?

-------
complexities vary depending upon project type.
Project-based trading can be an effective way to intro-
duce some sectors to market-based incentive pro-
grams. In addition, it can be effective for sectors in
which it is easier to measure an emission reduction
(e.g., the quantity  of gas captured from a landfill
methane recovery  project) than total mass emissions.

Cap and Trade vs. Rate-Based Trading
Under a rate-based trading approach, the regulating
authority  determines a performance standard (e.g., an
amount of emissions allowed per unit of output) for a
sector (e.g., tons of a pollutant per kWh of electricity
generated). Sources with emission rates below the
performance standard can earn credits12, whereas
sources with emission rates above the standard must
obtain credits for their excess emissions to remain in
compliance.
   Sources with low cost opportunities to improve their
emissions rate have an incentive to operate at rates
below the performance  standard. They can then sell
the resulting credits to sources that have higher costs
to attain the performance standard. Rate-based trading
programs have been used in the United States to
phase out lead  in gasoline and control mobile source
emissions.
   One consideration when evaluating rate-based trad-
ing is that if the activity level increases at a rate faster
than the emission rate declines, sources can earn cred-
its while  total emissions increase.

Potential to Limit Total Emissions
Perhaps the most important measure of a regulatory
approach is whether it can  produce the desired envi-
ronmental improvement. Emission caps set the total
emission  level, in effect, constructing a program from
the environmental goal  back to the sources. In con-
trast, rate-based trading attempts to establish an emis-
sion rate standard  for each  source that will, in
aggregate, produce the desired environmental improve-
ment. However, under a rate-based program, emissions
and the pollution load on the environment can
increase if sources increase their utilization or if new
sources are built.
   This situation raises a distinction between cap and
trade programs and rate-based programs regarding
industrial growth.  Both types of programs accommo-
         date growth. The responsibility for addressing growth,
         however, falls upon the sources in a cap and trade pro-
         gram while it falls on the regulating authority in a
         rate-based program. More specifically, under a cap,
         sources must determine how to operate new facilities
         or increase utilization of existing facilities and still
         comply with the emission cap. This approach encour-
         ages industry to innovate and find lower-cost
         approaches to reducing emissions. In the U.S. SOz
         Allowance Trading Program electricity production and
         economic growth increased while SOz emissions
         decreased significantly (see Figure 3). In a rate-based
         program, as with an environmental tax program, the
         regulating authority must periodically impose new rate
         standards to achieve and  maintain an emission target
         and prevent (or correct for) additional emissions that
         may result from increased production. This cycle of
         revising regulatory programs can create a less certain
         regulatory environment for sources to conduct compli-
         ance and business planning.

         Cost Minimization
         As with cap and trade, the feet that sources can trade
         their credits under the rate-based approach implies that
         the performance standard could be achieved at a lower
         economic cost.  This is because sources with high mar-
         ginal abatement costs will choose to purchase credits
         from firms with lower marginal abatement costs.

         Administrative Involvement and Transaction Costs
         Under a rate-based system, the regulating authority
         converts each source's emission rate and activity level
         to credits. Because the regulating authority must col-
         lect, activity level data, the data requirements may be
         greater for rate-based trading. Such data may also
         include commercially sensitive data that could be diffi-
         cult to obtain. This information, however, may be use-
         ful for other types of trading programs as well. The
         regulating authority can use the information to verify
         measured emissions.
            Like cap and trade, rate-based approaches do not
         necessarily require that the regulating authority
         approve each trade (in contrast to the project-based
         trading described earlier). Because some additional
         steps for government approval may be required, the
         level of administrative involvement and costs could be
   For electric power sources, the credits earned would be equal to the difference between the performance standard and the source's emission rate
   multiplied by the source's current heat input or generation.
 2-9
Is Cap and Trade the Right Tool?

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 Figure 3. Decoupling Economic Growth and Environmental Protection
                                                                        I
       60
       40
       20
       *-v

       -20
      -40 L	
                                                                   Gross Domestic
                                                                   Product
                                                                   U.S. SO2 Allowance Trading
                                                                   Program SO2 Emissions

                                    YEAR
                    t>

the same or slightly greater than those of a cap
trade program.
      and
Summary of Other Forms of Emission
Trading
Each of the three forms of emission trading is appro-
priate in certain situations. When achieving and main-
taining an absolute emission goal is important, a cap
and trade program can provide more certainty about
total emissions. Administrative and transaction costs
for cap and trade programs are often lower than for
project-based trading, which is burdened by higher
uncertainty and risk and the need for extensive regu-
lating authority involvement.
  Project-based trading programs have historically
evolved from the introduction of limited  flexibility in
traditional command-and-control programs.  Because
               project-based programs usually do not require net
               emission reductions, they are not effective as stand-
               alone programs. However, a well designed project-
               based trading program may complement a
               command-and-control program that establishes emis-
               sion or concentration limits. It may also complement a
               cap and  trade program in sectors for which accurate
               emission measurement of entities or activities may not
               be as well developed.
                 Rate-based trading can be an effective way to pro-
               mote efficiency if circumstances do not require an
               absolute cap on emissions. The administrative and
               transaction costs for rate-based trading programs are
               likely to  be the same or similar to cap and trade. (See
               Table 2 for a summary of the forms of emission trading.)
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2-10
Is Cap and Trade the Right Tool?

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2-11
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2-12
                                       Is Cap and Trade the Right Tool?

-------
           Developing  a   Cap
      and  Trade  Program
Introduction
    Prior to implementing a cap and trade program,
    policymakers should examine various design
    options, decide which features to employ, and
ensure that there is adequate legal authority. Key deci-
sions include determining which sources to include in
the program (i.e., applicability), the level of the emis-
sion reduction or limitation (i.e., cap), and the timing
when reductions will be required. In addition, policy-
makers should determine requirements for measuring
and reporting emissions, methods of distributing
allowances, rules governing allowance use, compliance
and enforcement provisions, and provisions for inte-
grating cap and trade with existing policies. Before
design work can proceed, it is critical to have informa-
tion on the potentially affected sources, such as their
emissions, utilization, and control options. All of these
issues are discussed in this chapter.
Guiding Principles
Several overarching principles can guide the develop-
ment of a cap and trade program.' Adhering to these
principlessimplicity, accountability, transparency,
            predictability, and consistencycan promote environ-
            mental compliance and efficient markets.

            Simplicity
            Simplicity is an important goal when designing an
            effective cap and trade program. Program operation for
            both emission sources and regulating authorities can
            be less costly and time-consuming if the rules are not
            overly complex or burdensome. Markets function bet-
            ter when the rules are simple and easily understood by
            all participants. Moreover, the environment is more
            likely to be protected when rules are clear and easily
            enforced. In contrast, complexity often requires more
            decisions, debate, and information collection. This sit-
            uation, in turn, can create uncertainty and unnecessary
            burden that may lead to delays, opportunities fore-
            gone, and ultimately higher costs. In some countries,
            complexity may also make it more likely that there will
            be litigation over contentious issues.
             Another aspect of simplicity that will increase the
            economic effectiveness of a cap and trade program is
            the fungibility of allowances (i.e., an allowance is a stan-
            dardized unit of trade that is interchangeable with other
            allowances). Fungibility is highly desirable to minimize
            transaction costs in the program and to maximize the
3-1
Developing a Cap and Trade Program

-------
efficiency of the cap and trade program to lower costs.
Simplicity is enhanced by avoiding the creation of dif-
ferent categories of allowances with different attributes,
unless it is absolutely necessary to maintain the envi-
ronmental integrity of the system. For example, dis-
counting the use of certain types of allowances based on
their geographic origin or on their ability to be banked
complicates transactions and reduces the cost effective-
ness of allowance trading and may not have significant
environmental benefits.
   More broadly, the principle of simplicity can  be
applied to all elements of the program, including:
     Applicability thresholds (determining which
     facilities are affected)
     Allocation formulas
     Trading rules and/or restrictions
     Measurement options and rules
     Reporting requirements
     Penalty assessment

Accountability
A cap and trade program must create a framework of
oversight and enforcement that will hold participants
accountable for their emissions and ensure  compliance
with the program's requirements. The  basis of
accountability is the accurate measurement and  verifi-
cation of emissions and the rigorous and consistent
enforcement of penalties for fraud or noncompliance.
The regulating authority can facilitate accountability
through clear and simple rules.

Transparency
Transparency refers to the full and open disclosure of
relevant public and private decisions, such as establish-
ing the rules and regulations for a trading program and
determining if an emission source is in compliance.
Transparency is important to a well-functioning  cap
and trade program, both in terms of its design and its
operation. Transparency of the design process can pro-
mote public acceptance and confidence in the cap and
trade program.
   Information transparency is also important to the
effective operation of an emission trading program.
Providing public access to source-level emission and
allowance data promotes confidence in the program and
provides an  additional level of scrutiny to verify enforce-
ment and encourage compliance. In some jurisdictions
these data are classified as  confidential and may require
legal changes to make them publicly available.
                   Advances in information technology and the
                 Internet have made it possible to provide interested
                 parties with timely and useful information about
                 emissions, allowances, and program results.

                 Predictability and Consistency
                 Predictability and consistency in the design and applica-
                 tion of program rules are important principles for an
                 effective cap and trade program. They help create the
                 right circumstances to encourage innovation and lower
                 costs. With a cap and  trade program, emission sources
                 have an  incentive to find better and iower-cost opportu-
                 nities to reduce emissions. This incentive depends upon
                 long-term, predictable, and consistent rules that affect
                 the economic value of emission reductions. This
                 arrangement does not mean, however, that rules cannot
                 change in response to new information. Rather, it means
                 that the framework must include the possibility for
                 change and a clear explanation of the process for chang-
                 ing the rules.



                 Establishing  Legal

                 Authority
                 As discussed earlier, there must be legal  authority to
                 establish a cap and trade program. Although policy-
                 makers can include many components in authorizing
                 legislation, the basic components are listed below.
                 Several of these components are discussed in more
                 detail in this chapter and Chapter 4.
                    Setting the mass-based emission cap: If the cap
                     is not set directly by policymakers,  the regulating
                     authority must have authority to limit the total
                     quantity of pollution from the relevant sector(s)
                     by establishing a cap on emissions.
                    Implementation dates: Sources must comply
                     with the emission caps starting in a particular
                     compliance period.
                    Sources covered: A complete control program
                     must define which sectors are subject to program
                     requirements and, within each sector, which
                     emission sources are affected. For example, the
                     scope of an electric generating sector cap and
                     trade program could include all electric generat-
                     ing units or only electric generating units above
                     a certain generation capacity.
                    Distributing tradable allowances: Traditional air
                     quality permits authorize a certain  amount of
3-2
Developing a Cap and Trade Program

-------
    emissions and are non-transferable. Policymakers
    establishing a cap and trade program must pro-
    vide for cradable permits, specifically that appro-
    priate increments (e.g., allowances) are tradable
    among participants in the program. The regulat-
    ing authority can allocate these authorizations, or
    allowances, to emit in a variety of ways, or auc-
    tion them to the highest bidders. Policymakers
    should also explicitly state which regulating
    authority is responsible for issuing and distribut-
    ing the allowances.
   Banking: Policymakers might allow sources to
    use allowances issued in one period for compli-
    ance in subsequent periods. This arrangement is
    called banking.
   Trading procedures: A cap and trade program
    needs consistent rules for conducting allowance
    transfers, as well as a system for tracking
    allowances. Policymakers should explicitly state
    which  regulating authority is responsible for
    developing and enforcing trading procedures.
   Emission monitoring and reporting: Accurate,
    comprehensive emission data are a cornerstone
    of a credible and effective cap and trade pro-
    gram. The regulating authority must have the
    authority to require standardized methodologies
    for emission measurement, collect emissions
    data to determine compliance, and publicize
    emission and allowance data to provide trans-
    parency  and promote confidence in the program.
   Compliance: Each affected emission source  is
    required to hold at least one allowance in their
    account  for each unit of emissions during the  
    compliance period. Cap and trade programs  must
    include provisions that authorize the regulating
    authority to reconcile the emissions of each
    source with the number of allowances they hold
    to determine compliance.
   Establishing and enforcing penalties for non-
    compliance: The regulating authority must have
    the authority to impose and  enforce sufficient
    penalties on emission sources that do not comply
    with the rules of the program.
  Legislation to provide legal authority can range
from a few broad sentences to many detailed  pages.
The legislation may provide only general language
authorizing the use of emission trading or it may
explicitly state the rules and guidelines for a  cap and
trade program.
             In addition to establishing this new authority, a cap
           and trade program may require appropriate amend-
           ments to a country's existing legislation. For example,
           fundamental legal issues (e.g., existing technology
           standards or taxes) may hinder the development of a
           cap and trade program if not properly addressed. Most
           countries will already  have some regulations that are
           related to environmental performance. If existing reg-
           ulations (or economic incentives) are simply in place
           to collect revenues for the government (e.g., environ-
           mental taxes set well below the marginal abatement
           cost), then a cap and trade program can likely be
           added. If there are technology standards, it may be
           necessary to make certain adjustments in existing leg-
           islation (e.g., replacing the technology standards with
           caps of equal or greater stringency, or allowing firms
           to opt out of them in  favor of participating in the cap
           and trade program). For further discussion on cap and
           trade and potential conflicts in the existing legal
           structure, see Chapter 4.
           Creating an  Emission

           Inventory
           An important step in the development process for a
           cap and trade program  is the creation of an adequate
           source-level emission inventory. The types of data and
           appropriate level of detail for the emission inventory
           will depend upon the intended use of the data. The
           emission inventory is likely to be useful in analyzing
           and making the following design decisions:
               Program applicability: The regulating authority
                may use inventory data to make decisions about
                which sectors to include, where to apply the
                obligation to hold allowances (e.g., at the fuel
                distributor or the emission source), and what
                thresholds should be set to determine if a source
                is affected by or exempted from the program
                (e.g., production capacity).
               Allowance allocations: The regulating authority
                may use inventory data to analyze the effects of
                different allocation options on emission sources
                and to decide on  a method for distributing
                allowances.
               Aggregate cap: The regulating authority will
                need the  inventory data for the affected emission
                sources to analyze the potential costs and bene-
                fits of different emission caps, as well as to
3-3
Developing a Cap and Trade Program

-------
     assess the performance of the program once
     implemented. In some cases, the emission
     inventory is used to project future emissions,
     either using a sophisticated computer model or
     using simple assumptions about projected emis-
     sion growth.
   Minimum data requirements for the emission inven-
tory include: (1) individual emission source character-
istics (e.g., size, location, name-plate capacity, process
type, boiler type, fuel type); and (2) emission levels for
individual sources based on output, fuel use, and/or
emission data. These data requirements will vary
depending upon: (a) the types of sources to be regulat-
ed under the cap and trade program; (b) the pollutant;
(c) the choice of allowance distribution method; and
(d) the method for setting the overall cap.

Inventory Level of Detail
For cap and trade programs that require emission
sources to hold allowances, sources can be inventoried
at five different levels of detail: (1) the company level";
(2) the plant level, which denotes a plant or facility
that could contain several emitting activities; (3) the
point/stack level, where emissions exit to the ambient
air from stacks, vents, or other points; (4) the
process/segment level; representing the unit operations
of specific source categories (e.g., a single boiler that
burns both coal and gas would count as two segments);
and (5) the unit level (e.g., each individual boiler)14.
  Although a full comparison of the different options
is beyond the scope of this guidebook, the most sig-
nificant factors in making this decision are:
     Program design considerations: The level of
     detail needed for the emission inventory is often
     determined by program design considerations.
     For example, if the program applicability thresh-
     old is based on the size of a combustion unit,
     then an inventory created at the plant level will
     not provide sufficient detail; additional informa-
     tion at the unit level will be necessary. Similarly,
     allowance allocation formulas may require a cer-
     tain level of inventory data.
     Cost of data collection and availability of data:
     Some options may make it easier to collect nec-
     essary data. For example, fuel purchase records
     may be kept only at the plant level rather than
     for each individual unit. Although data can be
     apportioned when necessary, it may be more cost
     effective to collect data at more aggregated levels
     of detail, such as the plant level.
     Completeness: Inventorying emissions at the
     unit level avoids many of the complications that
     may arise with other inventory levels (e.g., com-
     plex configurations of production units and
     stacks) and provides the most detailed informa-
     tion about the emission sources. However, this
     arrangement requires more data that may be
     more difficult to compile.
     Measurement Method: It is important to consid-
     er whether the data gathered for the program
     development stage will need to match the level
     used to assess compliance once the program is in
     place. If so, the regulating authority should eval-
     uate issues related to emission measurement for
     the various levels of detail. For example, if in-
     stack measurement such as continuous emission
     monitors (CEMs) is used for compliance with
     the program, a stack-level inventory would be an
     advantage  because it would include all of the
     emissions from each stack. However, for alterna-
     tive measurement methods (e.g., fuel-based mass
     balance approaches), using stack level data for
     compliance might complicate emission measure-
     ment, particularly if several units share fuel sup-
     plies but exhaust through different stacks.
Program  Design
Elements
In developing a cap and trade program, the regulating
authority should consider a number of design ele-
ments. Each design decision affects other aspects of
the program. Although these elements are discussed in
a specific order, the interrelationships between all the
design elements should be considered together when
making program decisions.
   Measuring emissions at the company level is very complicated and is not recommended for cap and trade programs. Issues such as partial owner-
   ship, mergers, and sales all effect the ability to accurately attribute emissions to a specific company.
   In many cases, unit level may correspond to point/stack level, but it is possible for a unit to exhaust to multiple stacks or for multiple units to
   share a single stack.
                                   Developing a Cap and Trade Program

-------
Applicability
After deciding that cap and trade is the preferred
approach to reducing the emissions of a particular
pollutant, policymakers must determine which emis-
sion sources to include in the cap and trade program.
Ideally, all sources, sectors, and emissions would be
included for full coverage and maximum environmen-
tal effectiveness and economic efficiency. However,
measurement capabilities and costs, available control
options, administrative burdens, political considera-
tions, and other constraints may limit participation to
a subset of emission sources.
  When determining the applicability of a cap and trade
program, there are several important considerations:
   Contribution to emissions: Included sources
     should represent a substantial portion of emis-
     sions in order to appropriately address the envi-
     ronmental issue of concern. To determine
     whether to include sources or sectors in a pro-
     gram, the regulating authority should perform an
     analysis using the existing emission inventory (as
     discussed  in the previous section), as well as an
     analysis of how future growth will change the
     existing emission patterns. In  this analysis, ,it is
     important for the regulating authority to acknowl-
  Figure 5. Leakage
  Plants within capped area reduce pollution
  by decreasing production, but import power
  from a source outside of the cap.This source
  increases its production and pollution and
  sends electricity into the capped area, so
  there is no benefit to the environment.
  This is known as "leakage".
     Uncapped sources
                    U S  EPA Headquarters Ubrary
                            Mail Code 3404T
                    1200 Pennsylvania Avenue, NW
                         Washington DC 20460
                              202-566-0556

                edge and, if necessary, address emission sources
                that they cannot feasibly include, but that could
                receive shifts in production from emission sources
                constrained by the cap. Such shifts of production
                from affected sources to other non-affected
                sources ("leakage") could undermine the envi-
                ronmental benefits of the cap (See Figure 5).
                Maximizing the coverage of emissions in a cap
                and trade program can optimize both the envi-
                ronmental effectiveness and the economic effi-
                ciency of the program. Conversely, the
                environmental effectiveness of a cap and trade
                program is diminished if a large percentage of
                emissions are outside the cap. Although the reg-
                ulating authority can implement other policies
                for emissions outside the cap, the level of these
                emissions is not guaranteed. Also, because
                sources outside the cap do not benefit from the
                economic efficiency of the trading program, the
                policies to control their emissions may be rela-
                tively more costly.
                Availability of cost-effective control options:
                Some sources included in the program should
                have a range of cost-effective abatement options
                to ensure the ability to achieve the reduction goal.
                Variation in abatement costs promotes competi-
                                            tion among control
                                            options, stimulates
                                            innovative tech-
                                            nologies, and
                                            helps lower com-
                                            pliance costs.
                                             Ability to meas-
                                            ure emissions: As
                                            discussed further
                                            in this chapter,
                                            sources that par-
                                            ticipate in a cap
                                            and trade program
                                            must have the
                                            ability to account
                                            for their emissions
                                            accurately and
                                            consistently.
                                            Alternatively, a
                                            regulating authori-
                                            ty may involve
                                            independent par-
          Capped sources  |                  ties to measure
3-5
Developing a Cap and Trade Program

-------
     and report emissions. If independent parties are
     involved, the regulating authority should have
     oversight, certification, and review procedures in
     place to promote accountability. Because each
     allowance has economic value, it is important to
     ensure that emissions (and thus allowances used)
     are quantified accurately and consistently.
     Number and size of sources: The number and
     size of sources participating in the cap and trade
     program may affect the regulating authority's
     ability  to manage the program. The regulating
     authority must balance the desire to maximize
     the coverage of the program to increase the envi-
     ronmental effectiveness and efficiency against
     the ability to operate the  program and enforce
     compliance. If sources responsible for a signifi-
     cant  portion of the total emissions.are not includ-
     ed in the program, the program may be less
     environmentally effective and less economically
     efficient. In addition, excluding some significant
     sources within an industrial sector can cause
     sources to shift activity to those sources outside
     the cap, thereby reducing the environmental
     effectiveness of the program. It might not,  how-
     ever, be necessary  to include all small sources.
     Excluding some small sources may help keep the
     total number of sources to a level that is manage-
     able  for the administration of the program.
     Simplicity: It is important to avoid overly com-
     plex  applicability criteria. Complex criteria make
     it more difficult and costly for sources and for
     the regulating authority to determine which
     sources the program covers. Complex criteria also
     increase the likelihood of loopholes that allow
     significant sources in the same industrial sector
     to avoid inclusion in the program. To this end,
     the threshold(s) for determining source applica-
     bility should be based on source characteristics
     that remain constant, such as capacity or poten-
     tial to emit, rather than characteristics that could
     vary  from year to year, such as mass emissions or
     fuel  use. This will ease administration of the
     program, provide greater certainty to  sources,
     and avoid frequent changes in an individual
     source's applicability status.
     Equity: The regulating authority should give
     careful consideration to the economic competi-
     tiveness of businesses and the effect on markets
                      that could result from including or excluding cer-
                      tain industries from a trading system. Fairness
                      relative to emission reduction potential is anoth-
                      er consideration for the regulating authority.

                 Point of Obligation
                 Closely related to the questions of which sources and '
                 sectors are covered in a cap and trade program is the
                 question of where there is an obligation to hold
                 allowances (See Figure 6). There is a growing literature
                 discussing how this would apply to emissions that can
                 be capped at several different points in an economy,
                 including:
                     Point of emissions (Direct emitters)": A point of
                      emission program focuses on direct emission
                      sources (e.g., electricity generators and large
                      industrial sources) where the pollutant(s) are
                      released  to the atmosphere. This approach works
                      well if the production or combustion process
                      affects emissions (e.g., NOx from industrial boil-
                      ers) or there are available end-of-pipe controls
                      (e.g., SO2 from  electricity generators). The U.S.
                      cap and trade programs obligate emission
                      sources to hold allowances equal to their total
                      mass emissions.
                     Upstream (Potential emitters): An upstream pro-
                      gram focuses on any point prior to the emission
                      source (e.g., fuel producers and processors such
                      as coal mines or oil refineries). An upstream pro-
                      gram does not have a direct cap on emissions.
                      Rather, the cap is set on the emission potential
                      inherent in the fuel. The restriction at the fuels
                      level restrains supply and can cause fuel prices to
                      increase relative to alternatives. This "price sig-
                      nal" encourages fuel consumers to reduce
                      demand for the fuel, either by finding more
                      cost-effective alternatives or creating new tech-
                      nologies  that use the fuel more efficiently. Iri
                      this way,  it operates much like a pollution tax,
                      but has the benefit of a cap on total emission
                      potential (CCAP, 1998; Kopp, et al,  1999).
                     Hybrid: A hybrid approach could be used to cap
                      some entities upstream and  some entities at the
                      point of emissions. For example, large emitters
                      such as electricity generators might be capped at
                      the point of emissions, while emissions from
                      transportation might be capped upstream
                      (CCAP, 2000, ELI, 1997).
B In U.S. literature, this is often referred co as "downstream," while obligations at any point after the emission source (e.g, commercial electricity
  consumers) are referred to as "indirect."
3-6
Developing a Cap and Trade Program

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r~	"	
|  Figure 6. Point of Obligation
                            UPSTREAM
                           (Fuel Producers)
                                                               Point of Emissions
                                                              -  (Fuel Consumers)
                                                                 ^.
                                                                                       DOWNSTREAM
                                                                                       (Indirect Emitters)
                                                                                       k_
   Analysts often compare upstream and point of
emission approaches on several key program parame-
ters:
    In most countries, an upstream system could
     capture the highest percentage of potential emis-
     sions. Upstream can be particularly effective
     when emissions are closely related to the fuel
     characteristics or end-of-pipe controls are not
     readily available. In addition, an upstream
     approach may better address sectors in which
     there are numerous small energy users with
     direct emissions. Advocates of the upstream
     approach also argue that it is economically effi-
     cient because it would spread the efficiencies of
     cap and trade across a larger segment of the
     economy.
    Most economists argue that upstream and  point
    , of emission approaches create  identical incen-
     tives for reducing emissions from affected
     sources' energy use because energy consumers
     face higher costs from using fuels with greater
     emission potential in both cases (Kopp, et  al.,
                1999). For example, under an upstream system,
                an electricity generator would face higher fuel
                prices if fuel producers were required to hold
                allowances. These higher fuel prices would
                encourage the generator to improve efficiency or
                switch to lower-emitting fuels in the same man-
                ner that the generator would be motivated to
                reduce emissions if it was required to hold
                allowances. However, a few analysts have argued
                that a point of emission approach provides a
                more direct signal to reduce emissions, because
                the target is the emission source. According to
                this view, an upstream system, which relies sole-
                ly on price  signals, may not provide sufficient
                incentive to find new technologies that reduce
                emissions per unit of fuel or sequester emis-
                sions. In particular, an upstream system provides
                little incentive for emission sources to develop
                and employ post-combustion control technolo-
                gies since this behavior would not be directly
                rewarded (CGAP, 1998). On the other hand,
                although it creates additional complexity, policy-
 3-7
Developing a Cap and Trade Program

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     makers can create incentives for post-combustion
     controls by awarding credits to downstream emis-
     sion sources that reduce or sequester emissions.
   *  An upstream system may include fewer sources,
     which would generally lower the administrative
     burden of a program. Although this is an impor-
     tant consideration, recent advances in the use of
     information technologies to manage cap and
     trade  programs have allowed regulating authori-
     ties to handle greater numbers of emission
     sources without being overburdened (Kruger, et
     al., 2000).
   Some analysts argue that a hybrid system may be an
acceptable  compromise. These analysts contend that
such a design would be desirable because  it would pro-
vide similar coverage of emissions to an upstream sys-
tem, while  allowing the program design to focus on the
types of emission sources that have been successfully
included in past cap and trade programs (Mazurek,
2002). Potential downsides to such an approach include
a larger  number of sources than an upstream program
and added complexity from the need to avoid double
counting emissions at both upstream and point of emis-
sions sources. For example, policymakers may include
natural gas-fired electric generators (point  of emissions)
and natural gas distributors (upstream) in a hybrid cap
and trade program. The regulating authority would
have to deduct fuel used by the included electric gen-
erators from the amount of natural gas distributed by
upstream sources to ensure that emissions  are not
counted by both sectors.

Opt-ins
Some sectors  may not meet the above criteria for inclu-
sion  in the  cap and trade  program but have individual
sources  that can meet the criteria. In such cases, it may
be desirable to allow these sources to voluntarily "opt-
in" to (participate in) the program. These sources
receive an allowance allocation and are subject to the
same requirements as sources under the cap.
Theoretically, these sources will have cost-effective
emission reduction opportunities that warrant the
expense of meeting the monitoring and other require-
ments associated with the cap and trade program. If
policymakers allow opt-ins, sources that choose to opt-
in should be subject to all the terms of the program. It
                 is imperative that any sources opting in employ a
                 measurement protocol that is equivalent in consistency
                 and accuracy to the methods used by the affected
                 sources. This ensures that the reductions achieved are
                 real, verifiable, and comparably valued.
                   Although voluntary opt-in provisions may reduce
                 costs to affected sources, they raise some of the same
                 issues associated with project-based credits discussed
                 in Chapter 2. Sources may decide to opt-in and take
                 advantage of allowance allocations that are above what
                 their emissions would have been if they were not par-
                 ticipating in the cap and trade program. In some
                 cases, they may opt-in and then take measures to
                 reduce emissions that would have occurred anyway,
                 regardless of participation in the program. Unless the
                 regulating authority can make an allowance allocation
                 at a level that equals "business as usual,"  extra
                 allowances will be  introduced into the system and will
                 undermine the environmental effectiveness of the cap
                 and trade program. Research on the U.S. SO2
                 Allowance Trading Program has shown that many of
                 the sources that voluntarily joined the program under
                 opt-in provisions16 were spurred by overly generous
                 allowance allocation formulas. Opt-ins using these
                 provisions achieved very few additional emission
                 reductions (Ellerman, et al., 2000).

                 Setting  the Level  of the Cap
                 Setting the level of the emission cap is one of the most
                 important decisions for policymakers and the regulat-
                 ing authority.  In theory, the most economically effi-
                 cient level for the emission cap is where marginal
                 abatement costs are equal to marginal benefits from
                 the reduced emissions (see Appendix A for further dis-
                 cussion). However, this level is often difficult to deter-
                 mine due to uncertain information. More generally, the
                 cap should be set at a level that is expected to address
                 the environmental  and health problems of concern at
                 an acceptable cost.
                   As with other types of policies to reduce emissions,
                 it is desirable to use atmospheric and ecological or
                 health effects models to assess  the impacts of different
                 levels of emission reductions. Models range from those
                 that describe links  between one receptor area and one
                 source, to others that describe complex regional-scale
                 relationships.  Models also can project a wide variety of
   There were chree provisions in the SO: trading program that encouraged voluntary entry into the program. The Substitution and Compensating
   Generation provisions were used to bring Phase II units into the program during Phase I. The Industrial Opt-in provision was used to bring
   industrial boilers and small generating units into the program.
3-8
Developing a Cap and Trade Program

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                                               o
                                               LLJ
                                               cc.

impacts throughout the region. Some models
address changes over short time periods, such
as episodes, while others focus on longer time
periods, and some attempt to do both.
Usually, models focus on one part of the over-
all assessment and should be linked to pro-
duce a truly integrated assessment. Emission
models develop emission data for input into
air quality models. The output of the air qual-
ity models is then translated into impacts
using a variety of models characterizing
human health and ecological welfare and
other effects.  Ultimately, selection of the best
model framework or best set of models
depends on the question being asked.
(USEPA, 2001)
   In  practice, policymakers will determine
the cap by considering a combination of science, eco-.
nomics, and political feasibility. One approach that
policymakers sometimes use to determine the aggre-
gate emission cap is finding the "knee in the cost
curve" (i.e., the point before costs per unit of emis-
sion reduction begins to rise rapidly (see Figure 7)).
Policymakers may also want to ensure that costs are
within an acceptable range. To estimate costs and
benefits, policymakers may use economic modeling to
depict optimal control decisions.
   The decision of when to implement the cap is inte-
gral to the decision on the level of the cap. Policy-
makers may need to weigh the pros and cons of opting
for a tighter cap with a later implementation date ver-
sus a  less aggressive cap with an earlier implementa-
tion date. For example, it may not be feasible to set
the cap at the optimal level for the initial stage of
implementation. However, rather than delay imple-
mentation until a later date when the optimal level
may be more  achievable, it may be advantageous to
begin the program as soon as possible to encourage
advances in control technology and influence invest-
ment decisions. Under such a scenario, policymakers
may establish a cap that declines over time to ultimate-
ly achieve the environmental goal. This is one of the
advantages of allowing emission sources to bank excess
allowances. It encourages early reductions, advances
control technologies, and reduces the economic effect
of the declining cap. For predictability, it is important
that policymakers or the regulating authority define
the decline in allowances in advance to provide sources
sufficient time to adjust to new cap levels.
                                            Figure 7. Knee of Marginal Abatement Cost Curve
                                                  Marginal Abatement Cost to Emission Sources
Possible point of regulation
balancing needed emission
      reduction and cost
                                                         EMISSION REDUCTION (PERCENT)
                                                                                              100
                                                      The level of the cap will also depend on applicabil-
                                                   ity decisions about which sources and sectors to
                                                   include in the program. In the case where policymak-
                                                   ers establish a national emission goal and develop a
                                                   cap and trade .program in conjunction with other regu-
                                                   latory tools, they must determine what portion of the
                                                   goal should come from sources in the cap and trade
                                                   program (the cap) and what portion from other sectors
                                                   and sources. Ideally, a cap and trade program should
                                                   include as many sectors  as possible to maximize  the
                                                   cost savings from trading between sources with differ-
                                                   ent marginal abatement  costs. If it is not possible to
                                                   include certain sectors under the cap and trade pro-
                                                   gram, then alternative policy instruments may be used
                                                   to reduce emissions in sectors outside the cap. Where
                                                   possible, however, these instruments should be used
                                                   to reduce emissions to levels where marginal abate-
                                                   ment costs in the uncapped sector(s) are roughly
                                                   equivalent to the marginal abatement costs in the sec-
                                                   tor(s) participating in the cap and trade program.

                                                   Length  of Compliance Period
                                                   The length of the compliance period should be linked
                                                   to the environmental problem and reflect operational
                                                   considerations. If the environmental problem is contin-
                                                   uous and long-term, as in the case of acid rain or  cli-
                                                   mate change, the compliance periods should be
                                                   continuous, covering all months of the year. If the
                                                   problem is seasonal, as is the case with ground-level
                                                   ozone in the Eastern United States, then the compli-
                                                   ance period may be seasonal, such as the five-month
                                                   compliance period each year used in the Ozone
3-9
                                         Developing a Cap and Trade Program

-------
Transport Region (the District of Columbia and 12
states in the Northeastern United States).
  The decision of whether to assess compliance quar-
terly, annually, or less frequently should also take into
account the administrative burden imposed. A short
compliance period puts a larger administrative burden
on both the regulating authority and emission sources
but allows for swifter action to correct a case of noncom-
pliance. A longer compliance period allows more flexi-
bility for the sources to achieve compliance and  reduces
the administrative burden for the regulating authority.
By lengthening the period between compliance  assess-
ments, however, cases of noncompliance can persist for
longer periods of time, possibly increasing the difficulty
of correcting those problems. Most cap and trade pro-
grams determine compliance on an annual basis.

Quantifying Emissions from
Sources  in the Program
One of the most important features of a cap and trade
program is that sources measure total mass emissions
(as opposed to  emission rate or concentration) as accu-
rately and consistently as possible. Because the emis-

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sion measurements are the "gold standard" underlying
the traded allowances, it is important that a ton of
emissions at one source is equal to a ton of emissions
at any other source. This creates a level playing field
for participants in the program and a strong foundation
upon which a market can operate.
  The emissions monitoring priorities for a cap and
trade program differ from other types of environmen-
tal regulations (see Table 3 for emission monitoring
priorities of different types of programs). In consider-
ing potential emission measurement regimes for a cap
and trade program, the following monitoring objec-
tives may be useful as a guide:
   Consistency: The regulating authority should
    create clear and consistent protocols for sources
    to determine emissions. This means employment
    of standard procedures and the use of sound
    engineering practices. This arrangement can be
    particularly challenging if the cap and trade pro- 
    gram includes sources from a variety of industrial
    sectors.
   Accuracy: For a cap and trade program, accurate
    measurement is more important than consistency
    over time.  Policymakers should consider
    enhancements to measurement methods or using
    different methods if better approaches are avail-
    able and practical. The monitoring program can
    also be designed to include performance stan-
    dards that reward sources that achieve better
    accuracy than required. For example, for less
    accurate approaches, sources should use more
    conservative estimation methods that are not
    biased toward underestimating emissions.
    Ultimately, it is most important to avoid system-
    atic underestimation of emissions.

Considerations in Choosing a
Measurement Approach

Pollutant
The pollutant to be measured, the conditions under
which it is created, and the mode in which the emis-
sions enter the atmosphere will affect the types of
emission measurement techniques available. For exam-
ple, measurement issues related to emissions of SOz,
NOx , and CO2  from stationary source combustion will
vary because emissions of SOz and COz are directly
linked to the combusted fuel, while emissions of NOx
also depend on the combustion conditions. Therefore,
3-10
                                  Developing a Cap and Trade Program

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                                                                                        (GEMS);{see:Figure

  ^qualityxontrohprocedures/record keeping and reporting^and procedures forfilling'in;missinadatajperiods;Where
  .possibleHnrentivesjarelprpviaeditOjimprow^
                                                             referenceJmeasure'ofemis'sibhsjMfthe'.GEMS
                                                     rejtestihgltsfreduced;and^he;firrnjsaveS;money.5Foa:full
receives a superior accuracyjres
&SXv&t^JS&^jmSj^--&&i&3S^$^ZlZ>%lz:vZ.<
  r JTiiK .25^'^WCu&S^ 1 i^^SteWSi^i^n^ii'w^SJ iPSiOTiSP^^SK^a^'^^^V^W
  discussion of monitoringrperformance?standards and i ncenttves;for-improvmq accuracy^
  ^.^Wfts&wsw-'^wr'^^a^.i-ww*^
  requirements'seelSaileSl 995;
    Figure 8. A Continuous Emission Monitoring {CEM} System
                                                                     Flow Control Panel      Data Acquisition and Rft

                                                                                        Handling System
3-11
                                         Developing a Cap and Trade Program

-------
an appropriate measurement method for COa, such as
mass balance based on carbon content in the fuel will
not be appropriate for NOx . Instead, accurate meas-
urements of NOx emissions from stationary source
combustion must be taken from exhaust gases.

How Emissions Enter the Atmosphere
How emissions enter the atmosphere can limit the
choice of methodology. For example, continuously
measuring actual emissions is an option only if emis-
sions are vented through a stack or other contained
area where measurement equipment can be located. In
contrast, measuring fugitive emissions (i.e., emissions
that escape directly into the atmosphere in a diffuse
manner) may depend on estimation techniques based
on inputs and defaults.

Emissions Abatement Options
The abatement options available for sources to reduce
their emissions are  also a factor in the choice of meas-
urement method. It is important that the measurement
method  be able to accurately capture the reductions
made. For example, measurement methodologies
based on fuel inputs (e.g., mass balance) may be
appropriate for sources that reduce emissions by
switching or conserving fuels, but it would be much
less appropriate for sources that use reduction tech-
nologies such as combustion modification  or post-com-
bustion  control. In choosing a standard measurement
approach, it is important to allow sources full flexibility
of compliance/mitigation options. It is also important
to consider potential technological innovations in miti-
gation approaches. Thus, it is useful to choose a
method  that can measure the reductions achieved
through various reduction strategies or to specify mul-
tiple measurement  options, some of which may be
allowed  only for certain mitigation options.

Point of Obligation
The point of obligation will influence where and how
emissions, or their proxy, are measured. Similarly,
measurement constraints will influence where and how
the emissions are regulated. If the regulation is direct-
ed at upstream sources, such as fuel suppliers, it is not
appropriate to measure combustion  emissions using an
in-stack monitor at the power plant where the fuel is
burned. Instead, the fuel supplier's compliance with
the cap  and trade program should be judged based on
the amount and characteristic of each type of fuel sold,
                 and the monitoring method would focus on determin-
                 ing the total amount of each type of fuel sold.

                 Frequency of Measurement
                 Although a cap and trade program requires a complete
                 accounting of each unit of emissions, the minimum
                 frequency of measuring emissions or the parameters
                 used in calculating the quantity that is emitted wiil
                 need to be determined (e.g., continuous emission
                 monitoring, periodic monitoring, or the use of emis-
                 sion factors). The nature of the problem to be solved,
                 the potential variability of the measured parameters,
                 and the length of the compliance period will influence
                 the appropriate frequency. For a cap and trade program
                 aimed  at solving a problem caused by a total accumula-
                 tion of emissions in the atmosphere, such as acid rain,
                 the frequency will be dictated by the ability to capture
                 variations in emissions and contribute to an accurate
                 estimate of total emissions. For an episodic problem,
                 such as ground-level ozone, more importance will be
                 placed on the frequency of measurement because
                 aggregation of emission measurements must be at fre-
                 quent enough intervals to investigate individual
                 episodes. Furthermore, greater frequency of measure-
                 ment is warranted when emissions, or the parameters
                 used to calculate emissions, have  the potential for high
                 variability (e.g., for units that use  fuels with varying
                 characteristics or for units in which emissions can be
                 affected by the way the unit or control devices on the
                 unit are operated). Both the U.S. SOz Allowance
                 Trading Program and the  OTC Regional NOx Trading
                 Program  in the Northeastern United States (which  is
                 aimed  at addressing episodic ground-level ozone)
                 require reporting of hourly emissions which are the
                 average of at least four measurements taken each hour.

                 Frequency of Reporting
                 In addition to deciding upon the frequency of meas-
                 urement, the regulating authority should consider how
                 often to receive the data. The RECLAIM emission
                 trading program in California uses computers to get
                 the source measurement data reported to the regulat-
                 ing authority in real time. The U.S. SO2 Allowance
                 Trading Program,  which requires sources to record
                 hourly data, requires sources to compile and send
                 emission reports to EPA on a quarterly basis even
                 though compliance is determined on an annual basis.
                 Factors to consider when  setting the frequency of
                 reporting include: allowing enough staff time to review
                 the data (e.g., not waiting until the end of the year  to
3-12
.Developing a Cap and Trade Program

-------
  irr8rBN!%fl*^

                     veryi infrequentlyjOrare very
                  smore expensiveiCEMS;
                     ^^
  measurementiS'nignirelativejtOitneiemissionsKrhese
  ,a&nO-i?OC C:ae^f-..'Aj>iOX'S*^;<^ *.^>,~-Ci3(M.'-i. >>3S&>^W'-:W*:itt^:^>;;^>>iWC^i^<^:OC>iv -,***.' v>-i* .w*1  v'"'-?? *i *:{;,* s-r  ^ffl.-.-^'^wsgjjj
 ssmeasure^S02 emissions because the characteristics!
   HS.-SX T^.ffiiaStSI'Ki^f^fZ'^f.yz.-tx.'f'. !J)4lRi^WSWlST.MBM!
   andwthetresultmg;Sp2:emissionsTare;yeryJow.l
review all data at once); giving time to sources to cor-
rect any errors found during review; and providing
timely, reviewed data summaries to the public.

Cost and Feasibility
Within a cap and trade program, there may be sources
that emit small quantities of emissions because they
are small, clean, or operated infrequently. Alternative
and less costly methodologies may be appropriate for
such sources due to the high cost of the standard
methodology. It is important to the integrity of the
trading system to ensure that less accurate methodolo-
gies are conservative in nature (i.e., the methods overes-
timate rather than underestimate emissions), as well as
to keep the number of sources treated in this fashion
relatively small. It is also important to keep in mind
that the cost of accurate emission monitoring should be
considered in light of the cost savings afforded by the
cap and trade approach over traditional approaches to
environmental protection. The added cost of accurate
measurement may be a small percentage of the savings
achieved by implementing a cap and trade program ver-
sus another form of regulation, and the resulting accura-
cy and confidence in the emission data may be well
worth the expense (Ellerman, et al., 2000).

Quality Assurance and Quality Control
(QA/QC)
Simply requiring the most accurate emission measure-
ment methodology will not ensure an effective trading
            system. Effective implementation is critical. It is
            essential that the measurement techniques are stan-
            dardized, commonly applied to program participants,
            implemented properly, and validated for individual
            applications. In addition, regardless of what measure-
            ment systems are used to quantify emissions, it is
            imperative that any system be subject to a well-
            defined and continuous quality assurance and quality
            control (QA/QC) program. These QA/QC programs
            should be based on national or international standards
            (e.g., International Standards Organization) and must
            be documented with records that can be audited.

            Missing Data Substitution
            It is essential to account for each unit of emissions
            from a source because cap and trade programs assess
            compliance by comparing the total emissions and the
            total number of allowances held. In real-life situations,
            however, monitored data may be unavailable because
            monitoring equipment occasionally functions improp-
            erly or is being tested or maintained. Therefore, there
            is a need for rules to  provide a standard methodology
            for substituting for missing data periods.
              This standard methodology should provide incen-
            tives for regulated sources to keep records in good
            order, to keep measurement equipment well main-
            tained, and to have procedures that ensure that faulty
               i ^tr *-->{\>;^-XIi  *JiJ*<'< W~^C^^Kl0^3P~'-'-r''' ^5Wes>^^-'^'*'jw'tVv-1^ C*0 .. X^ Wft<. f. - '
                f-.'is'.taf-ar". -'>av-rs         .*j
              LJhe1UiS;S02;Allowancejrrading;Rrogramtequ!res|
             eitmimiswsssaw^
             fSsourcesito.testieaehcontmuous.emissions^onitoft
               tested'atjleast annually-against arijihdependentrefffl
               ?^s^:.i^t*^^
               AfAH^HTwm+-L*.*J-rt*>i AW *H *>*i*v+idii*%:4-L*./Or7dLJI;*nw i ifftf ur?i
                          }5joI5&i-^a,'-"6*i''-iJO.rf~*.'v=,> i 1*i'''p I  {*^^* *' f ^*- -"* XT'
                 	odipriortOfCertifying;the.GEMifor,,use^
                 ^M^5SS5TO3Wa^L!S^^^^^!.^*^^
                 jiindependenfereference'method^onsistsoftjr*
                 :,.^^.^,^1..m*^^^^^-^^-S,^W1^X?r^^.*J  ^
                               Jiprobeiintoithelexhaust stack|
              grated analyzen to compare thejeading with theffi
                   ^^'<'if:w*^'testidefermines!iMhere;is-anyl
              ,-
              systematic-bias in theiCEM readings relative to the?
              a*^r^^?^^^^fe*^^^si.s'.^.r#.f^?!^^^
              ireferenceimethod. If thej,GEM;systematically under^;
             s*^.W?!*^TffiiiSffSaw^pito'^^
             itestimatesiemissions/theToperator.'mayieither.fiXithel
             *i$iim>(m&iii>iimw^
              m)onitoriandsretestiitoricalculateia;bias'adjustrnent*
              Ifactolv (Based; oh i d ifferences; betweeh;theLGEM; readi*
              "	  	    "T38^&f\>&t@$>>*-te-'f*-	
                                 !;method)ithatnsT;
3-13
Developing a Cap and Trade Program

-------
ic7Ji!'-----^~oy"'-.TC\>-*W("yi6S:
   measurerrient;aevice1(e.g|cdritihuoUs:emission
   ^^f^jfK^S^SSS^^^E&^W^W^^
  foKaTparticufar=holir,:thenitne rules!requireithat:a

                   r^
  yativeivalue/depends'pn^
  lthejrnonitbring:systerfiihas!beeniable!to;prbduce
  tute,aata1calculatiohlvaries:frpmTa)'theTayerage:Or

                           ximumipbtehtiaHvalue
tb!b);alvery;conseryative
   forifongrorjfrequentmissihgfdatalpertdds;
equipment will be replaced or repaired in a timely
fashion. To accomplish this most simply, the rules
could require a very conservative substitute value
(e.g., a value that would result in the maximum poten-
tial emissions) to be used for any hours of missing
data. Another option, which is more complex, would
be to consider the frequency and length of the miss-
ing data periods in determining a substitute vaiue.
This way, an average or slightly conservative value is
used for short and infrequent periods of missing data
and a very conservative value is used for long or fre-
quent missing data periods.

Allowance  Distribution
  The distribution of allowances may be one of the
most difficult issues for policymakers when develop-
ing a cap and trade program. Distribution decisions
have economic, equity, and political ramifications."
Cap and trade programs create a valuable asset for
those who own or control the authorizations to emit.
If emission sources receive allowances through a  no-
cost allocation, they capture the gains from these valu-
able assets. Under an auction, the government cap-
tures the value of these assets in the form of increased
revenues. Some analysts have argued that the revenues
from allowance auctions can have economy-wide effi-
ciency or equity benefits if they are distributed in
certain ways (e.g., used to reduce distortionary taxes or
distributed in lump sums  to households or other
groups.)18
   Different types of allocation formulas can create
"winners" and "losers" among sources participating in
a cap and trade program. It is important to note, how-
ever, that the method for distributing allowances will
not affect the environmental integrity of the program
if the program is  properly enforced.
   The first major step in  the allowance distribution
process is to decide whether the allowances will be
allocated at no cost to the emission sources (usually
based on some form of operating data), sold by the
regulating authority through an auction or a direct
sale, or distributed by some combination of these sys-
tems. To date, existing cap and trade programs have
allocated allowances at no cost to sources.
   Whatever allowance distribution method  is select-
ed, policymakers can include set-asides or pools of
allowances from within the cap. Existing cap and
trade programs utilize set-asides to provide allowances
for new sources or to provide an incentive or compen-
sation for certain types of behavior (e.g., early reduc-
tions, energy efficiency measures, or renewable
energy generation). This section explains the incen-
tives and decisions associated  with allocations, auc-
tions, and direct sales.

Allocations
If policymakers decide that allowances will be allocat-
ed free of charge, many different methods can be used
to distribute the allowances. The regulating authority
will need to consider the following issues:
    Data foundation: In general terms, there are
     three different aspects of a unit's operation that
     may be measured and used (individually or in
     combination with performance standards) as a
     basis for allocating allowances: mass emissions,
     fuel (or heat) input,  and  production output (e.g.,
   For a more detailed discussion of che equity, economic, and political ramifications of different distribution schemes, see Burtraw, et a]., 2001 and
   Ellerman, et al., 2000.
   For a more detailed discussion of the equity, economic, and political ramifications of different allowance distribution schemes, see Burtraw, et al.,
   2001; Ellerman, et al., 2000; and Dinan and Rogers, 2002.
3-14
                                  Developing a Cap and Trade Program

-------
  sioWstai^ardi^pourasto^O^mmBHj^a^tKe!
  KL^^J>T^.l5R#!S5S^"*^*^^
  ^^^..^.V^.-,,.^,-.-.^^-^,..-.,-
  primary-basis ofia-permanent allocation^This
 .
 &ensureSjthatthe!plants;with!the-highest emission
 'lljSiSilRSS^.:^
             encouraged'tojreducejthe.most/while
                   reduced emissions; will need to
  is^wi^^^^fe^
  aicombmation of* past activity,! evels and an: emission,
              '
                            .lnlbothsprogra
                                        .
                 arejratonetedidownrtoimatchime
                                .=
                     /in-botniprogramslnewlunits
  must purchase allowances for complianceHn,the
  jyjiVJK.*.^: _ 4M^iN^i^^<<^vS!*^;:8.K!-.*NWJtt'Jv^^
 <5oisof^e1U;S5SOMIIo^
 ^"^At^^^^^m^m^^
    ..
  untts'may,purenasei,tnese:allowancesjn;theimarke
          '                  '
                    1,    
             NOx trading programS;in;the
             ^V^^
          sternvUnitedStatesiutnize an updating inp
           l?&SiSS?RT^^
  or:outut-based?allocationischemeithe:methodolo
                           .-Thetreatment ofcnew,
     quantity of electricity produced). The measures
     of input and output will vary by sector, but any
     of these processes could be used as a basis for
     the allocation of allowances. Policymakers should
     consider the character and quality of existing
     data (e.g., it may be difficult to base allocations
     on historic output if multiple sectors with differ-
     ent produces are included  in the cap and trade
     program) and the behavior they want to reward
     (e.g., allocations based on  historic emissions ben-
     efit the largest and least-efficient emitters,
     whereas allocations based  on historic input or
     output benefit those that  used the most fuel or
     produced  the most product). Additionally, alloca-
     tions could be based on the above information in
     conjunction with a performance standard, control
     measures, or existing control technology require-
     ments, again depending upon the resources
     available and the desired effect.
               Reference period: The reference period for allo-
                cations could be historic, current, or even pro-
                jected. Though an important decision in any
                allocation scheme, the relative importance of the
                reference period decision increases with the
                length of the allocation, as further explained
                below. Allocations using historic reference peri-
                ods are attractive to firms that typically  have
                been big emitters, or in the case of input or out-
                put approaches, near their maximum  capacity in
                the past (whether  they have subsequently
                reduced these activities or not) because they are
                guaranteed a relatively large allocation under the
                new cap and trade regime. Using the  average of
                several years' data can smooth out possible irreg-
                ularities (e.g., extreme weather conditions, plant
                shutdowns for maintenance).
                   An important issue to consider when deter-
                mining the reference period is how the  choice
                will affect sources that implemented  emission
                reduction measures prior to the start of  the cap
                and trade program. For example, if the
                allowances are allocated based on historic emis-
                sion levels, choosing a recent year for the refer-
                ence period will penalize those sources that
                voluntarily reduced emissions early. If emission
                sources predict that such a choice may be made
                in the design of the program, it could provide a
                disincentive for sources to take early actions ben-
                eficial to the environment and human health.
                One way to avoid this problem is to choose an
                earlier year as the reference period. However,
                this may have a negative impact on the  availabili-
                ty or quality of the data used. Another option is
                to choose an allocation method that is not based
                on historic emissions, but one that may still be
                based on some historic information. In the U.S.
                SOj Allowance Trading Program the allocation
                method  uses a performance standard  applied to
                historic utilization (i.e., heat input). This heat
                input data was readily available and did not
                reward plants with high emission rates.
               Allocation period: Policymakers must decide
                whether allocations will be permanent or updat-
                ed periodically. Because updating systems
                change allowance  allocations at periodic inter-
                vals, entities may have an incentive to do more of
                the activity that will earn them more  allowances.
                Therefore, updating allocations can influence
3-15
Developing a Cap and Trade Program

-------
     future behavior. The time period of the interval
     will affect the level of influence updating has on
     future behavior. For example, if updating is done
     annually based  on output, it could provide a
     strong incentive to increase output in order to
     receive additional allowances. If, however, the
     time period is longer (e.g., 10 years) the effect
     will be considerably less. Permanent allocations,
     on the other hand, provide no such incentive
     because changes in behavior will not affect
     future allocations."
     Length of allocation: The regulating authority
     may decide to allocate allowances to emission
     sources in advance of the allowance vintage peri-
     od (i.e., the period in which  the allowance can be
     used for compliance). Having allowances allocat-
     ed in advance can add liquidity to the market
     because sources and other market participants
     can trade future allowances. This also helps emis-
     sion sources develop and implement compliance
     strategies in advance  of the compliance period
     (e.g., a source that installs an emission control
     device can sell future excess allowances to gener-
     ate revenue to help offset the cost of the control).
     Preserving the cap: Once policymakers deter-
     mine the method for distributing allowances and
     calculate the  sources' allocations, policymakers
     should compare the resulting total allocations
     and the size of the cap. If too many or too few
     allowances were created while calculating
     sources' allocations, policymakers can employ a
     ratchet (i.e., a formula that adjusts each source's
     allocation proportionately). The resulting total
     allocation will then match the number of
     allowances in the cap. This ensures that the cap
     is not inflated through the allocation process.20
     Incorporating new sources: Policymakers must
     decide how new entrants into the program will
     obtain the allowances needed to operate. In
     some systems with updating allocations, new
     emission sources may receive some allowances.
     In the case of permanent allocations, new units
     may obtain needed allowances from the market.
     In a permanent allocation system, facilities that
     are shutdown continue to receive allowances
     indefinitely. These allowances may then be used
                      by the owners of the shutdown facility to cover
                      emissions at new or other existing facilities that
                      they own, or they can sell the allowances in the
                      market. This system works well when there are
                      many'facility and allowance owners and no
                      monopoly exists on current allowance holdings.
                      Alternatively, an allocation set-aside could be
                      created for new entrants. The set-aside could
                      hold a specific percentage of the overall cap to
                      cover growth in new sources.

                    Finally, some analysts have noted that both eco-
                 nomic theory and empirical experience suggest that
                 there is not a competitive barrier to new entrants that
                 do not receive no-cost allowance allocations in cap and
                 trade programs. These analysts argue that emission
                 sources that receive no-cost allowances allocations
                 have the same marginal "opportunity cost" for every
                 ton emitted as the marginal cost paid by the new
                 entrant. In support of this argument, there is no evi-
                 dence of entry problems for new electric power plants
                 under the U.S. SCh program, which requires new
                 power plants to purchase allowances from the market.
                 There has been significant entry by new units, even
                 coal-fired units that do not receive a no-cost allowance
                 allocation (Ellerman, 2003).
                 Auctions
                 Auctions are an alternative approach to distributing
                 allowances. Under this approach, sources are required
                 to bid for the number of allowances they would like to
                 purchase (i.e., as opposed to receiving an initial
                 amount of allowances free of charge via allocations).
                 There is considerable research in economic literature
                 that supports the view that auctions are more economi-
                 cally efficient than allocations. Supporters of auctions
                 argue that auctions:
                     Create a source of revenue that can be used to off-
                      set administrative expenses or distributed to
                      affected groups. If the revenue is used to replace
                      existing distortionary taxes (e.g., labor taxes) it can
                      create additional economic benefits (Crampton
                      and Kerr, 1998). Distributing auction revenues,
                      however, may be politically contentious and there
   For further information on alternative allocation methods, see ICF, 1999, and Harrison and Radov, 2002.
   In developing the U.S. SO; Allowance Trading Program, the U.S. Congress initially allocated about 10 percent more allowances than it estab-
   lished by the cap. However, it also required EPA to proportionally ratchet allocations back down to the cap level.
3-16
Developing a Cap and Trade Program

-------
     is no guarantee that revenues will be used for eco-
     nomically beneficial purposes.
    Collect "windfall" profits that might otherwise
     accrue to emission sources if allowances are allo-
     cated at no charge.
    Avoid politically contentious issues regarding
     allocation methodology and lead to an efficient
     distribution of allowances.  .
    Provide an immediate price signal in the
     allowance market.
    Create an equal opportunity for new entrants
     into the allowance market.
   In establishing the design of an auction, the regulat-
ing authority will need to consider the following issues:
  *  Frequency of auction: The following are factors
     to consider when determining the frequency of
     conducting auctions (e.g. annually, semi-annual-
     ly, quarterly, biannually): (a) the lifetime of an
     allowance and the length of the compliance peri-
     od; (b) the administrative burden of conducting
     auctions; and (c) other methods of distributing
     allowances. If the auction is used in conjunction
     with other allowance distribution methods and is
     intended as a means  to provide an early price
     signal to the allowance  market it may not be nec-
     essary to conduct auctions as frequently.
     "Spot" and "Advance" auctions: Spot auctions
     refer to allowances that are  sold for current use.
     Advance auctions refer to allowances for a future
     compliance period that are  auctioned in the cur-
     rent year, even though they cannot be used for
     compliance until the future compliance period.
     Early auctions can facilitate development of an
     active future and options market, thus improving
     risk allocation.
   *  Bidding procedures: There are many approaches
     to conducting auctions. The auction can be
     designed so that all successful bidders pay the
     same price or the price they bid. Bidding options
     for conducting the auctions can be categorized as
     either sealed bid', ascending bid, or declining price
     auctions. Ascending bid auctions may take the
     form of "ascending-clock," or English auctions.21
     Generally, with  sealed bid auctions, potential
     buyers submit bids for a specific quantity of
     allowances. The auctioneer ranks the bids by
     price and, starting with the highest bids, tallies
                the requested allowances until it is equal to or
                greater than the number of available allowances.
                The price of the last winning bid is called the
                clearing price. Those who bid at least as much as
                the clearing price receive allowances at that price
                (i.e., uniform pricing methodology) or the price
                they bid (i.e., "pay-your-bid" methodology.)
                With ascending bid auctions, potential buyers
                have the opportunity to increase their bids,
                changing losing bids into winning bids. When
                there are no more bids, the allowances are dis-
                tributed to the highest bidders. Descending
                price actions, also called Dutch auctions, are the
                reverse of ascending bid. Generally, the auction-
                eer starts with a high price for each allowance.
                Potential buyers can accept the price for a specif-
                ic number of allowances. The auctioneer
                decreases the price until all allowances are sold.
                   The different auction approaches have differ-
                ent effects on bidding behavior, which can thus
                influence the efficiency of the allowance distri-
                bution.22 With  "pay-your-bid" pricing, potential
                buyers try to bid slightly above the estimated
                clearing price. Ascending bid auctions reveal
                greater information about what a potential buyer
                is willing to pay for allowances. This improves a
                bidder's value estimates and, as a result, the effi-
                ciency of the final allowance distribution
                (Fischer, et al., 1998)".

                             ^^Ms^mmv'?^^^*?^'^

               availab!e-forspurchase.The direct salejoffered;a.small
               JBSH8ffi39i&i!8l!^
               percentabe]of,all6wances'at'a fixediprice of;$1;500
                              ."w--i'"r.'wwciirvvf,!:;.<:,>??>:<" a|lowance,price;(marginal
three jtimesstheiprp
                                because-allowance'prices
               muchHbwerthanTexpectedfanditheallowance.rharl
               fraK-^socoswAjeK-x-W s"3xx&t:'\g*-',i.te3 i^oe^'ic ..ffrel^-w? w^r-X-vJ!v*'*-V"^"i;:ir
               ket was highly, liquid.
   For more information about forms of auctions, see Crampton and Kerr, 1998.
   For more information about the effects of bidding behavior with different forms of auctions, see Crampton and Kerr, 1998.
3-17
Developing a Cap and Trade Program

-------
         fe=M35K';SM^'rKS^^SS^**!^X^^
       84':v '!jrTT*'sj ".fwi.w^C.-r*^gMSS88^
  |Jhe;Ui5?SO2 Allowanceafrading Program Teatured!a;special;5et-aside:oT allowances as an-added incentive for elec-
  A>Tftf^nfmaoT.:f/\mf\AnitAf\rnn m/'iai'ralfa'rictman/i.i.cirla^Anar/ivf arTi/rian/'w1anrIrrAnau/ar\Fa:anam\i:nanaratmninmnramc^ -.
^*;*3^J^3W.SK^JW^
tri^powe^compante^oiundertake:aemandTSide%nergy,efficienGy;andrrcnewableienergy;gener^
;ii^^.5Wi^;w^iv^^w*^vjJ^wa>*X'^fe^!4wiv.^i^yMw^.i^'"^rfjir^'"c-^x;^:vK^-^yfr^->?^                                                 ~.t..'Kyv..'^
  K'^E'S^SBSiTSsa.^'5K!i^;^>;fiSHS!^^xfe^,r,^&5^^<^^^^
                ^^;337Si3pi^:Siailffi?MiiSSi^^
                ngs or renewable enerqy?qeneration,and!ERA awarded allowances at a'pre-determinedirateione
                :-rB^^^T^^:f^rs?^is:>ilsSJt?^*?rod^
                                                 JlVJSPSW !"', .-x-.: . K . /V^9B^3iMi>W*i:CyjS^> i^iNW^lW . OeSSfiSJeivKi
                                                 ForjrenewabletenergyJgenerated.fMS
    w^i{s^';^^-^r^''^^'X^";J^*w?>^""^^^^s^r^7^^?^-^^^
    fAsjtnefirst>prpgram>tolprovidejactualiemission;credits:orjallowancesifor;eTriciency;and|renewabfe{energyiprpj^l
    ^^^S^iS!3^J^ V^^^^j^^^K^L<^K!^'^v^^^
  iSiiaBisassswa^^assitssisjiSisasi^^
  conservative and atlowances:pnces;were too low to provide an adequate incentive for;additional:activit
  i&SSi^!^jaB^ft!^S9SS!SiS^^
   Auctions may also be used to distribute only a por-
tion of allowances with the remainder distributed by
an allocation method. Some analysts have proposed
beginning with an allocation system and transitioning
to an auction-based system over time (Kopp, et al.,
1999). This would increase economic efficiency over
time  and decrease political opposition from emission
sources worried about the cost of allowances.

Set-asides
Another tool that can be used in allowance distribu-
tion is an allowance set-aside. Under a set-aside, the
regulating authority withholds a certain number of
allowances from within the cap for a specific purpose.
The set-aside can be a fixed number of allowances or
a percentage of the total amount of allowances.
   The regulating authority can distribute the set-
aside allowances for purposes such as an incentive for
certain  technologies, as a way to address equity issues,
or as  a reserve for new units as explained in the earlier
section. Policymakers can create set-asides that last  for
a fixed  period, such as five years, after which the set-
aside expires, or it can last in perpetuity.
   Policymakers or the regulating authority should also
address how excess allowances from the set-aside will
be managed if they are not distributed. Options for
                                                     managing excess set-aside allowances include cancel-
                                                     ing the allowances, saving them for future use, and
                                                     distributing them to sources through an allocation or
                                                     auction. Canceling decreases the quantity of allowable
                                                     emissions (i.e., the cap) and may therefore increase
                                                     compliance costs for sources. Saving excess allowances
                                                     for the future can provide flexibility in the future for
                                                     unforeseen circumstances (e.g., many new emission
                                                     sources in the cap and trade program)  but it reduces
                                                     the number of available allowances in  current years
                                                     and can lead to increased compliance cost for current
                                                     emission sources. Distributing excess allowances
                                                     through an allocation or auction is perhaps the most
                                                     common approach for existing cap and trade programs,
                                                    , but policymakers must address the same issues dis-
                                                     cussed earlier in the sections for allowance allocation
                                                     and auction.
                                                        The most important aspect of set-asides is that the
                                                     allowances come from within the cap so that new
                                                     allowances do not inflate the cap and undermine the
                                                     ability to achieve the environmental goal. If a set-
                                                     aside will be  used, policymakers will need to decide
                                                     the basis for awarding allowances from the set-aside
                                                     and the size of the set-aside allowance pool that will
                                                     be awarded.
3-18
                                    Developing a Cap and Trade Program

-------
Allowance Use
Policymakers or the regulating authority must create
rules governing the use and trading of allowances.
These rules should be neutral (i.e., favoring no particu-
lar individuals or groups of market participants) and
provide for low-cost exchange among participants.
  Accounting for allowances works like a banking sys-
tem. Each affected emission source should have an
allowance account for holding their allowances.
Transfers of allowances between these accounts
should be made as simple as possible, with few limits
or restrictions to impede the market. There are, how-
ever, two possible categories of restrictions on
allowance trades that may be considered  temporal
and spatial.

Temporal Considerations
Allowances are typically allocated for use in a specific
compJiance period. Policymakers might consider
whether current allowances can also be used for com-
pliance in future periods, referred to as "banking" (see
Figure 9). Allowing banking in a cap and trade pro-
gram creates additional flexibility for sources,  encour-
ages early emission reductions, can reduce compliance
costs, and, partly for these reasons, can increase eco-
nomic and political support for the program.
  Although the ability to bank allowances in a cap and
trade program can provide significant reductions early
in the program, policymakers must recognize that
banking can also delay the achievement of the emis-
sion target if banked allowances are used. Because

  Figure 9. Banking Emissions
                  	Allocated Allowances
                                    ; Use of banked allowances
                                  YEAR
           banking does not delay achievement of cumulative
           reductions, this tradeoff does not represent an environ-
           mental concern for problems such as acid deposition
           and climate change, where the environmental problem
           is caused by total accumulation of a pollutant in the   .
           atmosphere. However, for problems such as ground-
           level ozone, where the environmental problem is
           caused by short-term  episodes of high emissions,
           analysis should be undertaken to weigh the potential
           effects of banking. Nevertheless, the U.S. experience
           with limits on banking has shown that such limits
           complicated or hindered the operation of cap and trade
           programs and failed to provide apparent benefits.
              "Borrowing" is another form of temporal flexibility.
           With borrowing, allowances from a future compliance
           period are brought forward to meet a compliance obli-
           gation in an earlier period. As with banking, borrow-
           ing provides compliance flexibility and can be helpful
           in smoothing out spikes in allowance prices (Ellerman,
           2002). For example, if prices reach a certain level,
           sources might be allowed to buy allowances  from the
           government that would be deducted from allowances
           available in future compliance periods. The  potential
           downsides of borrowing are that emission reductions
           are delayed and there is a greater risk of future non-
           compliance if an emission source cannot "repay" the
           borrowed allowances. In addition, borrowing can cre-
           ate an incentive for emission sources to act to disrupt
           the cap and trade program's performance and longevi-
           ty in order to avoid "repayment" of allowances.
           Furthermore, the health and environmental  benefits
           of emission reductions today are delayed until the
                         future. All else being equal, benefits
                          in the near term are better than bene-
           	 fits in the future.
                            There is little experience with bor-
                         rowing, so policymakers should care-
                         fully  assess the potential
                         environmental and programmatic
                         effect of delaying some emission
                          reductions and weigh these  effects
                          against the potential flexibility and
                         cost savings of borrowing. In addition,
                          policymakers should apply a discount,
                         or interest, rate on borrowed
                         allowances that is at least as  high as
                         the discount rate applied to  the capi-
                         tal the source saves by not undertak-
                          ing the abatement or purchasing
- Actual Emissions
3-19
Developing a Cap and Trade Program

-------
  sidrifSOurces-areigroupedHhtOitwoicategorieSiWtth?;
  ^tir*^^?ifixfcy^>r^..*:&L?M^i^^^
  QveriapptntfcompiiariceiperipdsKj^pmeisburcfeiSj
  cbmpliance;ipasedjp^

  source^n^nexW{^&"}RV',Jxv1*^ttL",?J&&4^
SuhaertaKihgieartyjreductibhSiahdsmayjhavecon^
StriDuteaitOiVolatilityJmitneimarketlthatireqtiirecIS
S^ainr;r>rnnfam'(rewis?w^^^7^M^?nss>Wi;P(wtl^*'*'>;'^^
  ed;With:banking;What:has resulted is;a segmented
  allowanceimarketianaiaistratifiedipirice'structure
  iwhich,values banked allowances significantly less
  a?^^^agr!ssg!sssM-!i^8e8SS!^^
  than:present>yeahallpwaricieSi(Farrell; '
                  allowances. In lieu of this discount rate, sources will
                  find it less expensive to delay abatement, invest the
                  capital saved, and borrow allowances.

                  Spatial Considerations
                  Because a cap and trade program allows for'the flexible
                  use of allowances across the geographic scope of the
                  trading program, a common concern for a cap and trade
                  program aimed at reducing emissions with localized
                  impacts (e.g., SOz and NOx ) is that hotspots may
                  occur."
                    Assuming that a firm's objective is to maximize
                  profits, those with (ow marginal abatement costs will
                  offer to sell their allowances to firms with higher mar-
                  ginal abatement costs.  If sources with high marginal
                  abatement costs (i.e., net buyers of allowances) are
                  congregated in specific areas,  those areas are likely to
                  experience less environmental improvements than
                  others (depending also on meteorology and wind pat-
                  terns). Furthermore, such areas could experience
                  increased emissions and  harmful local environmental
                  or human health effects, even as the larger goal of
                  aggregate emission reductions is achieved.
                    For pollutants with localized impacts, an evaluation
                  of potential trading patterns may be  useful. Potential
                  trading patterns can be assessed with economic mod-
                  els or with less resource-intensive  methods such as
                  spreadsheet analysis. If the results indicate that geo-
                  graphic trading patterns will arise, it may be necessary
                  to assess where the largest emission  reductions are
                  likely to take place compared  to where the most sensi-
                  tive environmental areas are, and whether the program
                  will adequately address the environmental problem
                  (see Figure 10) or be less effective than direct controls
                  on sources. This involves an analysis of the source-
                  receptor relationship and includes predicting changes
                  in concentrations or deposition resulting from changes
                  in precursor emissions, the influence of emission
                  sources in one region on concentrations or deposition
                  in other geographic regions, and the levels of concen-
                  trations or deposition in certain sensitive receptor
                  regions.
                    If spatial issues are likely to arise, then the cap and
                  trade  program will need to be designed accordingly.

                  23 This issue is not relevant for greenhouse gas emissions since these
                    emissions do not have local air quality impacts, and trading patterns
                    will not have localized environmental effects. However, ancillary
                    reductions of criteria pollutants may have local benefits.
3-20
Developing a Cap and Trade Program

-------
 Figure 10. Spatial Considerations
 Where are emission reductions most likely to occur?
                                 5*.*$!fcfe^3SiS&S^1KM^^



                   iyltHetradingTprovisiohS'haW.ho
wv"vv"-'--^.:,Kw:idv4r,.:?;^^^
rl^frFirstandforemostotherjegulatoryiStandardsite.gi/ambientairtqualityiStandards^echnologyLandiperformance^^
$$%t;m^^f,;H:>^^^
gjrequirements) protect the locahair-qualityrfromfexcessipollution^The^UnitediStatesemploysiconventionahpollutiorigli
"***, ** - x.vi'/-:^\w^\fciir^4sK^^^^.vy^.xy^iJ4^^^1^^^:W'ifK^7A*^^^-^-^.l&w'*vz*T^^r.^^$s^*^*1!
-------
 Figure 11. Trading Zones
Generally, there are three approaches for addressing
this issue. The first is the possibility of introducing  .
spatial restrictions on trading. For example, if unac-
ceptable concentrations or deposition are expected to
arise in a particular area, trading restrictions could be
imposed by introducing "zones" where net flows of
allowances into the sensitive area are prohibited or
discounted by an appropriate amount (see Figure 11).
A drawback of trading restrictions is the effect on fun-
gibility of allowances and market efficiency. Spatial
restrictions on the use of allowances mean that an
allowance is not a standard commodity that is fully
interchangeable with all other allowances. This lack of
full fungibility can diminish the economic efficiency
of the cap and trade program and can complicate the
allowance market (e.g., lead to price stratification
between allowances of different zones).
   A simpler way of achieving the same effect as dis-
counting without affecting fungibilicy is to have a high-
er retirement rate (e.g.,  1.5 allowances per  ton of '
emissions) in the  zone of concern. This does not pro-
hibit trading or differentiate among types  of allowances;
it simply makes it more expensive in such zones.
   The second approach is to restrict trading between
different categories of emission sources. This
                                             approach can be effec-
                                             tive if the cap and
                                             trade program includes
                                             sources with different
                                             characteristics that
                                             influence, the local
                                             effect of the sources'
                                             emissions (e.g., stack
                                             height). For example,
                                             the regulating authority
                                             may restrict a tall-stack
                                             source from trading
                                             allowances to a short-
                                             stack source because
                                             the shorter stack wiH
                                             likely have a greater
                                             impact on local air
                                             quality.
                                                The third approach
                                             is to adopt a "tiering"
                                             of environmental poli-
                                             cies, requiring sources
                                             to comply with local
                                             environmental quality
                                             provisions as well as
                 those imposed by the cap and trade program. In its
                 simplest form, this allows the appropriate regulatory
                 authority to limit emissions of the sources identified
                 as contributing to the local air quality problem, while
                 not tampering with the allowance program. This third
                 approach is the one employed by the U.S. SOz
                 Allowance Trading Program.

                 Allowance Accounting
                 Each source that is responsible for compliance should
                 have an allowance account. These accounts are the
                 official records for allowance allocations, holdings, and
                 transfers and can be used to track compliance. Initial
                 allocations (or initial winning bids in an auction) pro-
                 vide the beginning balance for the allowance accounts.
                   Policymakers might also consider whether the pro-
                 gram will allow other interested parties to have
                 allowance accounts and hold allowances. These non-
                 source accounts provide the vehicle through which
                 organizations, such as brokers or environmental
                 groups, can hold and trade allowances. Brokers,
                 investors, and other market makers may play a crucial
                 role in facilitating allowance trades. Because the
                 allowance brokering and pooling functions are intend-
3-22
Developing a Cap and Trade Program

-------
ed to facilitate sources' efforts to maximize the cost
savings of their compliance strategies, these non-
source accounts should be integrated with the account
system for emission sources.

Allowance Serialization
Allowances can be serialized to facilitate cracking the
allowance from creation to use for compliance. There
are a number of benefits to identifying allowances by
serial number. Although tracking serial numbers
increases the administrative burden to both regulators
and industry, it provides additional transparency and
protection against accounting discrepancies. The use
of serial numbers could also facilitate record keeping
so allowance holders can track the different costs
incurred in acquiring allowances. This may be neces-
sary for tax purposes. Finally, the inclusion of serial
numbers in the allowance tracking system provides the
opportunity to analyze trading patterns and the move-
ment of allowances over time. This may be useful for
assessing the impacts of the trading program.24 At a
minimum, allowances should be identified by vintage
(i.e., the compliance period for which they are issued)
to identify when the allowances are authorized for
compliance use.

Property Rights
The program rules must clearly define the legal rights
and responsibilities of emission sources and the nature
of allowances. Because allowances can be traded, the
rights and responsibilities of ownership must be estab-
lished so that these rights and responsibilities can be
transferred from one participant to another (AGO, 1999).
   When addressing allowance use, the regulating
authority might want to consider certain property
rights issues, namely entitlements and takings. Both
can be addressed in the implementing legislation or
program rules. The type of legal system in place will
also affect whether or not allowances are perceived as
property rights.
    Entitlements: Sources that have historically pollut-
     ed with limited or no restrictions might argue that
     they have an implied right to allowances based on
     their historical emissions levels (AGO, 1999).
   * Takings: If the implementing institution reduces
     the number of allowances at a later date, partici-
     pants might argue that they are entitled to com-
              -'^{ixXi'viBOiSiSixo.'K 3^:0^'~'?l6BOtf-0'.-?*iO'jt^^*"'>^'*>-6-"---X>OiJs *t" t"vWtf<>aYTOW.  <"viwCi y*. i >
              rightsfThisiprovision was!inserted-to,obviate a cnal-
              erhment.decide:to-alteKthe;ernissibnsciapj(i:e^tb
              reduce the numberof available'allowances):
              ;^ V9w.- iWy'Wfi."^! Vi**x^wcv*'!>ini'i;-: >ywwx f'-.-i, i-.;*1"*?  **.;i?vvxKv'
-------
the regulating authority completes the compliance
determination and deducts allowances for compliance.

Enforcement

Penalties for Noncompliance
Stringent penalties for noncompliance are an integral
feature of a well-functioning cap and trade program.
These should be applied automatically in cases where
a source does not have sufficient allowances to cover
mass emissions during the compliance period. In cases
where there is noncompliance with requirements of
the cap and trade program (e.g., measuring emissions,
reporting, and other requirements), the penalties
should be determined based on the nature and severity
of the violation. The penalties should be sufficiently
high to provide the appropriate incentives for compli-
ance and can take the form of allowance, financial,
and/or criminal penalties.

Excess Emission Offsets
In cases where a source does not have sufficient
allowances to cover its emissions, an allowance restora-
tion rate of at feast one-to-one should be applied to
maintain the environmental integrity of the program.
Under a one-to-one rate, one allowance from the next
compliance period would be retired for every unit of
excess emissions in the current compliance  period.
Alternatively, the shortage of allowances can be  pur-
chased from the allowance market.
  Aside from the one-to-one allowance restoration rate
to maintain environmental integrity, the regulating
authority should apply financial penalties for noncom-
pliance if the goal is to deter such behavior.  The exis-
tence of a one-to-one restoration rate without other
accompanying punitive measures  for noncompliance
implies that sources can, in effect, use allowances from
future compliance periods to attain their emissions
reduction target. This can result in a scenario in  which
the emission cap is never attained. Hence, it is very
important that the incentives deter noncompliance.

Financial Penalties
Deterring noncompliance can either take the form of
allowance or financial penalties. With allowance penal-
ties (i.e., where a source would have to turn in a multi-
ple of its allowance shortfall at a ratio greater  than
one-to-one) the aggregate cap of emissions in the next
compliance period is reduced. The environmental bene-
                  fSUnder5the!U:S?5O2.Allowance;Tradingiprogram?th
                  ^penaltyjconsistsfofafonejtO;one:allowanceTrestora
                  Sstion=rate;and-a rinanciahpenaltv applied at a'leveKi
                                      ^M?g^~w-j^mK&i^j^k;,i
                                      irs);:adjusted'annually,for infla?
                                      i^^^asg.iS5S5^^assg;K;Bl
                                 cl.5lnlT996;triisifevel!S3fiifihariciaifMnal
                                 s^^^M^m:^^^^m^m^^.
                                 Kf*n:hArannrnvimatoKr:thraa-timoc>.tha
i! a i lyywd 11 tes,-f iciu.. 111* i.yyvjji 111 >j ic.veii.oiji [ r id n ua i j pe n ai-^g
SftyiwasitrwughttOfB^bpVpxinMteTy^tK^
5SpfeSte*ig^K*p^^?f-^mSBf.^
5| expected; market price;0fan;allowance. Based onitnejlft!
.fisCias^iBKSS^aK^feKtCaiS^^*^^
                   *ty was tnougnt to :fje approximately tnree times t
                   ^^^^^MS^^^^m^^if^^^^^'^^ss,^
                   ;expected:marketprice;0f an allowance. Based on
                   linflation^adiustedipenalty amount and;actuai ma
                   S="tb08^!a~^^fe^CP'3^TrfSA1!^^
                  rMcould,sinTretrospect?be.too stringent; For.:example;%:^B
                  S^t'S^*SSfi^SSfe%SSS|8S!SSi^
                  Slwheninon^complianceiresultsTromlimperfectiOrilateyg
                  jiS^^^^S'i!S^iSS^;sm^^:5^A*^^aii
                  ipviewed?as' ACHaSr'iS'fsi
  Additionally/states within.'SSS!^34WS'!l|!^?7S^^^*F
  jofiimposmgifinanciahpenaltiesiirhisipenalty.'howev^g
  ier/mayjnotibeisufncientiyjnighyfortexarnple/during^-:
  ^^E^.;5s^isy^-a8asig*!i^*^w^^!8^^
                    ci, (i lay  l iui:u*:j3ui HVICI luvc-i nuii."i:v/KvrAM^^^^-&^'&K^i
                    1syear,!ithe:pncefofaiNOx:allowanceifluctuated|l;|g
                    '*&$&!!s^&^^^
                    between 1 US 5500*a ha ?3;000?Somefsburces=mid nt%|
                    i;^^atA^^5^^^S^S^,^SifiJ;*iSS'SSS;S%ii-'^**^:~tS^ -if.^.ra^S^'.JJ55ev^^^!^-:-S^t;?
                 fits of the program increase due to the allowances that
                 are deducted as a penalty, but this could lead to further
                 noncompliance because the necessary reductions are
                 greater in the following compliance period.
                    Alternatively, market volatility may tempt some to
                 speculate and intentionally be in noncompliance if they
                 believe the market price for allowances will drop in the
                 future. Furthermore, taking allowances out of the mar-
                 ket reduces the supply and raises the price of allowances
                 for all participants, not just those that are out of compli-
                 ance. However, this should not be a significant factor
                 unless there is large-scale noncompliance. For these rea-
                 sons, a financial penalty (in addition to the one-to-one
                 offset) may be preferable to deter noncompliance.
                 Policymakers or the regulating authority should set the
                 level of the financial penalties significantly higher than
                 the expected marginal abatement costthe expected
3-24
Developing a Cap and Trade Program

-------
market price of allowancesto create an effective deter-
rent for noncompliance. Policymakers could also create a
graduated financial penalty to reflect the severity of the
violation or the length of delay in making payment. For
example, if a source exceeded its emission cap because
of an accounting error, the penalty might be twice the
price of allowances, payable in 30 days. For a more seri-
ous violation or if the penalty is not paid in 30 days, it
could grow to several times the price of an allowance. If
the penalty is in dispute, the source could put funds
into an escrow account awaiting adjudication.
  The allowance price from which the penalty is cal-
culated can be based on a projection of the allowance
price (established during the development of the pro-
gram) and adjusted for inflation. Alternatively, it can
be based on a multiple of either the actual average
price or the highest monthly price of allowances for
the preceding year in which the program was in opera-
tion. Establishing the penalty based on a multiple of
the projected market price of allowances can be diffi-
cult because different economic models often yield
substantially different estimates. However, indexing
the compliance  penalty to actual prices can  also be
difficult without a liquid market/exchange. In some
cases, a periodic, government-run auction can reveal
price information that the regulatory authority can use
to set the penalty level.
   If a source is  out of compliance with the  monitor-
ing, reporting, and/or other requirements specified by
the regulating authority, financial penalties  should
also be applied. These also can be graduated depend-
ing on the nature of the noncompliance (or  "degree of
fault"), with higher penalties for repeat. To  maintain
consistency, the penalty levels should, to the extent
possible, be defined in advance. Finally, to ensure that
the penalties are enforced in a timely manner, the
penalty rate might increase if the source does not pay
the penalty within a specified period of time.
   The revenues from these penalties might be collect-
ed and redistributed in several ways. For example, they
can be collected by the national treasury and  redistrib-
uted in the same way as income taxes or they can be
paid directly to the regulating authority to offset pro-
gram costs. The revenues may also be collected in a
special fund to provide resources for research and devel-
opment into abatement technology and/or environmen-
tal purposes related to the pollutant being regulated.
             Regardless of the type and severity of penalties,
           they should be objective and automatic. Eliminating
           penalty negotiations between regulating authority and
           emission source promotes impartiality and equity and
           reduces opportunities for dishonest behavior. In addi-
           tion, it sets clear expectations so that sources know
           the consequences for noncompliance.

           Criminal Penalties
           The regulating authority might also impose criminal
           penalties on individuals who knowingly violate any
           requirements, with maximum sentences for first-time
           and repeat offenders. Criminal penalties provide direct
           incentives for the legally responsible individuals ("des-
           ignated representatives" or owners and operators) at
           the affected sources to behave responsibly. Owners,
           operators, and designated representatives should be
           required to sign each form that is submitted to the reg-
           ulating authority for the source (e.g., allowance trans-
           fers or emissions reporting) indicating that they are
           liable  for acts and omissions within the scope of their
           responsibilities under the cap and trade program.


           Other  Design

           Considerations

           Integration of Cap and Trade
           with Other Policy  Approaches
           There are a number of ways in which  policymakers can
           integrate cap and trade programs with other approach-
           es for  environmental policy. Command-and-control
           approaches can be compatible with cap and trade, but
           policymakers should identify the relationships
           between the different policies and ensure there are no
           contradictions or duplications. With command-and-
           control, the regulating authority specifies sector-wide
           technology and/or performance  standards that each of
           the affected sources must meet, whereas cap and trade
           provides sources with the flexibility to choose the
           technologies that minimize their costs.
              Depending on the type of pollutant that is being
           regulated by cap and trade, integration with com-
           mand-and-control approaches can aid in the preven-
           tion of hotspots that may result from the use of
           allowances.  For example, additional reductions
3-25
Developing a Cap and Trade Program

-------
through a cap and trade program could be layered on
top of existing requirements.25
   Finally, with regard to integrating alternative forms
of emission trading, if the regulating authority decides
to establish more than one type of emission trading
program, each should affect distinct sectors. If
desired, allowances from a cap and trade program
could, in theory, be fully interchangeable with offsets
from project-based mechanisms or credits from a rate-
based program. However, the regulating authority
must ensure that project-based mechanisms do not
undermine the environmental integrity of the cap.
Stringent oversight, verification, and conservative
crediting methodologies need to be established to
account for uncertainties and to avoid the creation of
"anyway" tons, paper credits, leakage, or double
counting (see Chapter 2).

ji||OnejiTi^nanismltnat;ha^
  trading between allowances and'creditSjfrom:rat&-

          Cspurcesfaffectedibyith^ratejbaseditradingi

  program can|purehase;asimany allowances from
iasitheyiw!shrH6wever/sdurees:regulatediby7cap;ahdp
  trade-programicanonly/purchasexreditstrom^SIM
  m^^^m^^-^m'A'f'^S4^^MM^fmyM^im'^&
  f.f*t ttf~**r-li .Bh tfj. *Li. j.i> ^.***fc*.^*^.J r^. _.Mi &K.>K rf* fl.. ffr
 isoursmndeSthfrate|bed|>rogra^
 i^J^?ft^^^i:C^^^^'^^Kff^?;,\^
  Tradmg:Rrbgram;isTstillriri|itSiinfahcy;henceitilSitoos|
  iffijSioS^irfv^u&^w.:!!:^^^
                                                        ;ij^?^y<^i^?ii)^i(sw^ws4r^ir^,>^^^
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                                                        CT;.^>T<^2^;s^^^.!&*!%flW*^^
                                                       aasspciatediWith;:assessingjnetiflpvvs;
"  For more information about layering command-and-control and market-based programs, see Schreifels, 2000.

3-26                                  Developing a Cap and Trade Program

-------
       How to  Implement
       and  Operate  a Cap
     and  Trade  Program
Introduction
   The credibility of the cap and trade program and
   confidence in the market depend on the accuracy
   of emission measurement and enforcement by
the regulating authority. Because allowances, and
therefore emissions, have an economic value, sources
might misrepresent emission data if there are no con-
sequences or low probability of discovery. The regulat-
ing authority must ensure that enough resources are
dedicated to verifying emission reports and auditing
affected sources.
  The regulating authority must also ensure that
allowance accounting is undertaken with the appropri-
ate scrutiny and security to avoid errors and fraud.
Computerized accounting systems for emissions and
allowances can facilitate the management of these
responsibilities.
  This chapter describes the functions necessary to
implement and operate a successful cap and trade pro-
gram including tracking information on emissions,
allowances, and compliance; auditing and verifying
emissions reports; providing technical support and poli-
cy guidance to regulated sources; and costs and
resources necessary to operate a cap and trade program.
               Integrated

               Information Systems
               Perhaps one of the most important lessons learned
               from existing cap and trade programs is the need for
               comprehensive, accurate, transparent, and timely infor-
               mation about emissions and allowances. The regulat-
               ing authority that operates the program must collect,
               verify, maintain, and disseminate the data if the pro-
               gram is to operate with environmental integrity, eco-
               nomic efficiency, and public credibility. Computerized
               information systems are the most effective method
               available today to process and disseminate these data.
                 Using an information system to collect and manage
               large amounts of data on emissions and allowances can
               provide numerous benefits, including:
                  Increased data accuracy: Tools such as electronic
                  reporting and automated data quality checks
                  reduce errors and eliminate redundant data entry,
                  Reduced time and costs: Electronic reporting
                  and automated data quality checks reduce the
                  time and costs required to complete, process,
                  and review paper forms. In addition, the elec-
                  tronic storage of data can significantly reduce, or
4-1
How to Implement and Operate a Cap and Trade Program

-------
     even eliminate, the costs associated with the col-
     lection, transportation, storage, and dissemina-
     tion of paper forms.
   *  Enhanced access: Electronic data storage makes
     it easier and faster to retrieve, analyze, and evalu-
     ate relevant data on demand. Improved access to
     data can also promote confidence in the trading
     program by permitting emission sources and
     interested members of the public to retrieve data
     to ascertain compliance, evaluate a program's
     effectiveness, and make informed decisions.
     Data transparency can also facilitate efficient
     markets, build public acceptance, and foster
     credibility (Krugei, et al., 2000).
     Improved consistency and comparability:
     Electronic reporting and electronic data storage
     encourage consistency by requiring all emission
     sources to report the same information in a  com-
     mon reporting format.  This consistency pro-
     motes comparability across time and among
     program participants, leading to a fully fungible
     tradable commodity and efficient market.
   In the early stages of a cap and trade program, the
data system may be as simple as a spreadsheet with
manual audit procedures. As an interim measure, this
approach can be reliable if volume is low, and it might
provide an opportunity to assess whether automation
is necessary and to what extent. As resources become
available and the program evolves, the information sys-
tem can be modified, expanded and, if appropriate,
automated to address the needs of the program.
   A comprehensive information system should
include modules to collect, review, and manage data
on emissions and allowances and a module to deter-
mine compliance.26

Emissions Tracking Module
(ETM)
The most data-intensive component of the information
system may be the emissions tracking module, or ETM.
The purpose of the ETM is  to collect, review, and
maintain relevant emission-related data from each
source. The type and quantity of data collected will
depend on the measurement requirements for the cap
and trade program.  For example, a program that relies
on emission factors  to calculate emissions from combus-
tion sources might require participants to report data on
 the type and amount of fuel consumed, the combustion
 technologies installed, and the emission factors used. A
 cap and trade program requiring continuous emission
 monitoring systems might collect data on measured pol-
 lutant concentration and volumetric flow of exhaust gas.
 Although the frequency of reporting will depend upon
 the calculation method, the length of the compliance
 period, and administrative requirements, it should be
 frequent enough to supply sources, the regulating
 authority, other market participants, and interested par-
 ties with timely information about emissions and facili-
 tate compliance determination.
    Regardless of the method used to  calculate emis-
 sions, the data must be consistent, accurate, and
 objective if sources, market participants, and the pub-
 lic are to  have confidence in the program. To facilitate
 access to the data, the regulating authority can make
 the emission data from the ETM available to interest-
 ed parties through a publicly accessible interlace (e.g.,
 the Internet). The data are useful to  market partici-
 pants who can use them, along with allowance data, to
 gauge potential supply and demand for allowances.
 The public,  interest groups, and academics can use
 the data to evaluate the effectiveness of the cap and
 trade program (e.g., emission reductions and environ-
 mental effects). However, simply making data avail-
 able  may not be sufficient. True transparency
. necessitates  making the data available in a useful and
 usable format (Teitenberg and Wheeler, 1998).
 Determining the appropriate format will depend on
 the type and quantity of data collected, as well as
 their end use.               (
    Due to the potentially large volume of data, the
 regulating authority operating the program might ben-
 efit by requiring all sources to submit emission-
 related data electronically. Electronic submissions
 improve accuracy and reduce the burden on sources
 and the regulating authority by eliminating the need
 for redundant data entry, facilitating automated data
 quality checks, and providing immediate feedback
 about data quality.  In the event that electronic sub-
 mission is not feasible, sources might submit data on
 diskettes, compact discs, or paper forms. The regulat-
 ing authority can then transfer the data to the ETM.
 This manual process could be cumbersome for the
 regulatory authority and prone to data entry errors.
    After sources submit emission data, the ETM
 should check the data for omissions, mathematical
26  For more information about data systems for cap and trade, see Schreifels, 2001.

4-2                         How to Implement and Operate a Cap and Trade Program

-------
errors, and methodological problems. If the ETM uses
electronic reporting, it can acknowledge the submis-
sion and report the results of the quality check direct-
ly to the sources. The ETM can also perform
in-depth analysis and quality assurance checks. For
example, the system might compare the submitted
data to historical data from the source and similar
facilities to search for inconsistencies. Potential prob-
lems that the ETM identifies might be reported to
the regulating authority so an auditor can check the
data and, if necessary, request additional information
from the source. In the absence of a computerized
information system, the regulating authority should
oversee these functions.
  Once the data passes the data quality check, it can
be recorded in the ETM and made available to inter-
ested parties. An automated data quality check
reduces the time and cost of data review in two ways.
First, the ETM identifies minor errors immediately
and reports to the source  so they can correct the
errors. Second, the regulating authority can focus on
problems identified by the second stage of the review
in order to prioritize in-depth reviews. The automated
data quality check can also reduce processing delays
and provide interested parties with faster access to
emission data.

Allowance Tracking Module
(ATM)
The Allowance Tracking Module, or ATM, is the
accounting system for the  trading program, keeping
track of account information, account holdings, and
transactions. As with other components of the system,
public access to the data is important. Market  partici-
pants, including sources, brokers, and other allowance
owners, can use the data to verify transactions and mon-
itor holdings. The public,  interest groups, and academ-
ics  can use the data to evaluate the  effectiveness of the
cap and trade program, identify barriers to cost-effective
trading, assess overall market activity, identify trading
trends, and analyze the emission implication of trades.
  The potentially large volume of transactions in a
trading program may necessitate electronic submission
of transactions. As discussed earlier in the section on
submissions of electronic  emissions data, electronic
submissions have many benefits, including improved
accuracy, reduced burden  on the regulating authority,
immediate feedback and transaction confirmation to
participants.
                         us  EPA Headquarters Library



                                    202-566-0556


                      The ATM can play a critical role in ali allowance
                   transactions, including the issuance, transfer, retire-
                   ment, and cancellation of allowances. The regulating
                   authority can use the ATM co issue and distribute
                   allowances according to a prescribed method (e.g.,
                   allocation formulas, auctions, sales). A computerized
                   ATM can also ensure that trades are valid by reviewing
                   the data to verify that account numbers are correct,
                   the seller owns the allowances being transferred, and
                   the allowances are still valid (i.e., they have not been
                   retired for compliance or cancelled). Once the infor-
                   mation is verified, the ATM can deduct the traded
                   allowances from the seller's account and add them to
                   the buyer's account. If the transaction is not valid, the
                   ATM should notify the buyer and seller and, if appro-
                   priate, record the failed transaction as an acknowl-
                   edgement that the transaction was submitted.
                      The ATM, in conjunction with the Reconciliation
                   and Compliance Module, can facilitate compliance
                   assessment by retiring the appropriate number of
                   allowances from each account. In addition to issuance,
                   transfers, and retirement, the ATM can facilitate can-
                   celing allowances for environmental or other reasons
                   (e.g., administrative penalties, purchases by environ-
                   mental groups).
                      ;S. -r--ix>'w>K;Sxcx.t^(Ci'''"-  *<*"<>;. oiiw^K*^. rtooS.x AM* !*ee xx'ff'K
                      FJL<> 14*&t>6tTSV*}tS><>&F>XS&v&r wjf jn* | %>;*-*<
                      MlowancSMarkec
                      Tne;publicican!participatelin?emission;traaing!proj
                      grams by.purchasingTallowances.'Environmental ana
                      ~~:Kf.i ^v^^*;Z*<&&WW~^'&^<>--'.~Jxx&^W^w^'rU&W^^
                      student qroupS;Havejtaken advantage of.this^option,
                       ^SKfs^tf^^^sh
                      purcnasingiallovyaricesjwith;the!intehtiprij3firetlring
                    Jail'''t"OZf^^fitfXf^:-...>X>ff-m-* . ^ *W*ii
                    SthemifrornlthetsystemlRetiring-allowancesiforithe
                    ^'^^iWS^^S^fsA^K^t^^'-^-K^Tv: ^^S^S?***^**
                      enVirpn'mentTpreyentsjtnern>from^ei.hg used>t6
                      iW5*!ijB$a>$^^
                      emitipollutipnrForjexample/initheiUiSJSOj'lIsi
                      'i II  Wf***J*' WftiTTflSf*;'i*Xj;;'if *,\.3=4SK5*,:,*? 'WiW*NS5$W.Xyr; ";.iew, y>3-
                      Allowance TradingiRrogram; these groups acquired a
                      tota|!bfi934!allowancesiinltfi^period;of;1994jto
                      tptaliof$1,925{ailowances Jmthejirst;.yeaiv'oftneipro
                      gram:{rnis;represented?abputM;percentpf.ithe-annuT
                      allowance's) thesetrarisactibhsare.syrnboliKbfsthel
                      8^^as^8^-3^.^fc^^$^f*:#-'ra';^^
                      tOitake";direct:action!on;behalfofstheirenvironment;
4-3
How to Implement and Operate a Cap and Trade Program

-------
Reconciliation and
Compliance Module (RCM)
The Reconciliation and Compliance Module (RCM) is
the vital link between the ETM and ATM to deter-
mine compliance. At the end of each compliance peri-
od, the RCM compares a source's allowance holdings
against the total emissions from the period. If the
source's emissions are equal to or less than their
allowance holdings, the source .is in compliance (see
Figure  12). Conversely, if emissions are greater than the
allowance holdings, the source is not in compliance
and is subject to any noncompliance consequences and
penalties.
  The RCM, in conjunction with the ATM, should
deduct the appropriate number of allowances from
each source's account. The deductions might  be
made on a prescribed basis (e.g., first in, first out) or
by specific instructions as to which allowances are to
be deducted. The latter approach may be desirable for
a variety of reasons (e.g., tax consequences, forward
trade contracts).
  If the source is not in compliance, the RCM
should:
   Instruct the  ATM to deduct all allowances from
    the source's account and withhold future
    allowances equal to the overage penalties.
   Report the noncompliance and emissions over-
    age to the regulating authority for enforcement.
 Figure 12. Reconciliation
                            Allowances
                       Auditing  and
                       Verification
                            Beginning of year
                     15,812
Auditing and verification of emission data can take
several forms. If data submitted by sources are required
in a standard electronic format, regulating authorities
can use software to audit the data and identify poten-
tial discrepancies or issues to investigate. The regulat-
ing authority can use these electronic "desk" audits to
target more in-depth audits. If sources submit emis-
sion data using paper forms, the audit and verification
will be more resource intensive. For this reason, requir-
ing sources to submit emission data in standard elec-
tronic format is strongly recommended.
   When sources use measurement devices, either to
measure actual emissions or to measure some other 
parameter involved in calculating emissions, such as
fuel flow, the regulating authority should review data
collected from measurement devices for reasonable-
ness. In addition, the audit should review results of
any quality assurance and quality control tests per-
formed on the measurement equipment to ensure that
the equipment is operating properly. If possible, the
regulating authority should compare submitted data to
independently obtained data.
   Verification of submitted emission data should also
involve field audits  visits to the emission sources
 especially when sources use measurement equip-
ment. Such field audits can include observing quality
assurance tests, reviewing on-site records, inspecting
measurement equipment, and/or comparing installed
measurement equipment to independent reference
          methods. Such field audits can be per-
          formed on a random sample of all sources,
          and/or field audits can be performed on
	      sources identified with potential measure-
          ment or data problems during the electron-
          ic desk audits.
                            Net Allowance
                            (Bought and Sold)
                     -3,201
                            Total Allowance         12,611
                            Available for Compliance
                            Deductions for
                            Emissions
                     -11,867
                            Allowances Remaining
                            (Source in Compliance)
                     744
4-4
How to Implement and Operate a Cap and Trade Program

-------

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  state:andMocalenvironmentaLagencies^EPA regional
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Technical  Support for

Regulated  Sources
An important element of implementing and operating
a cap and trade program is the ongoing technical sup-
port for sources. The program is more likely to be suc-
cessful if the regulating authority and emission sources
keep open lines of communication on the rules and
procedures of the program. Before implementation of
the program begins, sources may benefit from work-
shops that explain and clarify the rules of the  program.
In addition,  throughout the life of the program, as new
issues arise,  new sources and new employees enter the
program, and revisions are incorporated into program
rules, a continued dialogue between the regulating
authority and the sources will facilitate the smooth
operation of the program.
   It is wise  for the regulating authority to plan work-
shops for sources after the rules of the program have
                   been publicly disseminated but prior to the beginning
                   of the program. The workshops can address all aspects
                   of implementation for which the sources are responsi-
                   ble, and should inform them about the role of the reg-
                   ulating authority. For example, the workshops could:
                       Explain the applicability criteria of the program
                        and address questions about which sources are
                        and are not affected.
                       Explain the allocation process, including when
                        and how each source  will know its allocation or
                        the procedures for participating in an auction, if
                        applicable.
                       Address source responsibilities, such as the pro-
                        cedure for identifying the person who will be
                        responsible for making submissions and demon-
                        strating compliance for each source.
                       Discuss the requirements for measuring emis-
                        sions and reporting to the regulating authority.
                       Outline the procedures for reporting allowance
                        trades to the regulating authority.
                       Answer any questions related to the determina-
                        tion of compliance and potential enforcement
                        actions.
                     During implementation of the program, it might be
                   necessary to supplement the initial published rules of
                   the program with guidance documents that focus on
                   .specific questions or clarifications regarding the rules.
                   It is likely that the initial rules of the program will not
                   cover all of the situations that actually arise.
                     Sources may need interpretations of the rules by
                   the regulating authority to help apply the rules to the
                   source's unique circumstances. This may be particu-
                   larly true for emission measurement and reporting.
                   The more individualized the measurement methods
                   and the more options available, the more questions
                   are likely to arise. For consistency in the program, it is
                   important that sources receive the same guidance.
                   One option to ensure consistency  is for the regulating
                   authority to create a guidance document that includes
                   answers to both commonly asked questions and
                   unique questions. The regulating  authority can modi-
                   fy the document as new guidance  is created. Such a
                   document is useful as an internal reference to help
                   maintain consistency over  time, as well as to provide
                   information to the  public and sources.
4-5
How to Implement and Operate a Cap and Trade Program

-------
Administrative  Costs

Associated with  Cap

and Trade
Although cap and trade programs can cost significantly
less than more traditional policy options, the programs
require resources to operate efficiently and effectively.
Regulating authorities should consider these costs
when designing the program so they can identify
appropriate funding sources and budgets.
  The smaller a cap and trade program is, the more
likely it can operate effectively and efficiently with a
simple spreadsheet or paper-based system. However,
as che number of participants or data requirements
increase, a computer-based system with automated
data processing becomes necessary. The costs of
designing and developing17 such a system can be con-
siderable, but the savings in staff time and error
reductions can help offset some of the expense.
Additionally, the system may undergo modifications as
program rules change, automation is enhanced, or
technologies improve.

Enforcement
Oversight and enforcement assure that sources are
accountable for their emissions and compliance with
the program requirements. The functions of oversight
and enforcement include the verification of emissions
and the enforcement of penalties for fraud or noncom-
pliance.

Additional Costs
  Other costs associated with cap and trade programs
may include:
   General administration.
   Recording allowance trades.
   Providing public access to program information
     (e.g., emission reports, allowance holdings and
     trades).              .
   Monitoring program results.
   Responding to questions from program partici-
     pants and the public.

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-------
               Assessment  and
             Communications
Introduction
his chapter describes how outreach and communi-
 I cations can facilitate a credible and successful cap
 I and trade program and discusses some of the com-
munication issues that are unique to emission trading
programs. The chapter emphasizes the importance of
transparency (i.e., the full and open disclosure of rele-
vant public and private decisions) for cap and trade pro-
grams. Finally, the chapter discusses ongoing data
collection and assessment recommended for cap and
trade programs to determine whether they are deliver-
ing the desired environmental and economic results
and to identify potential improvements. These include
environmental, economic, and market assessments.
Communicating Status
and Results
Research has shown that public acceptance of a govern-
ment policy is critical to ensure successful implementa-
tion; keeping stakeholders informed and involved helps
build trust in both the policies themselves and in the
regulating authority (Jasanoff and Wynne 1998). In
addition to simply conveying information, communica-
tion and outreach activities can help generate public
support for cap and trade programs. This support is par-
ticularly important in the case of environmental issues,
which frequently engender considerable public debate
between competing interest groups with differing val-
ues and objectives. Because there are many misconcep-
tions about cap and trade, regulating authorities
implementing cap and trade programs need to provide
complete, accurate, and balanced information on how
the program works and how it will help achieve envi-
ronmental objectives. It is also important to engage in
communication and outreach activities in the begin-
ning of the policymaking process and  use these activi-
ties throughout implementation to develop credibility
for the new approach to emission control.

Multiple Audiences for
Outreach
The  audience for most outreach activities is highly var-
ied, and each constituency has a unique set of con-
cerns. For example, the general public and the
environmental community may be primarily interested
5-1
                           Assessment and Communications

-------
in learning how the trading program affects human
health and ecosystems, particularly in and around their
own communities. The affected emission sources, on
the other hand, may need access to account informa-
tion or guidance on how to measure and report emis-
sions (see Chapter 4). The academic community might
show a preference for technical information, such as
data on long-term emission trends or prices.
Policymakers might be interested in whether program
goals are being met (e.g., whether emissions are
decreasing, by how much, and where). Policymakers
might also be interested in the program's overall cost-
effectiveness. The needs of each of these stakeholder
groups can be met through a well-designed monitoring,
assessment, communication, and outreach program.

Information  for the Market
Another important role of a communication program is
to provide information to the emission sources to help
facilitate market operation. Sources need to know what
their reporting requirements are under the system, how
to comply with program rules and regulations, and
whom in the regulating authority to contact regarding
questions. Moreover, for a cap and trade system that
relies on trades recorded  in near real time, it is neces-
sary for the regulating authority to provide data on
allowance availability and individual accounts.
  Fortunately, recent advances in information technolo-
gy are making it possible to provide data relevant to cap
and trade programs in  real time and in many highly
useful forms (Kruger, et al., 2000). For example, before
an allowance trade is completed and money changes
hands, the party acquiring allowances may want to
know that the ATM has recorded the transaction.
Availability of this information helps keep the program
running smoothly and efficiently without long lag
times. Ultimately, transparency of information makes
the market more efficient by letting those who wish to
buy and sell allowances know who is trading and what
volume of allowances are being traded. This informa-
tion allows participants to make trading and compliance
decisions more easily and quickly than if critical infor-
mation were not available.
                                                  s
                 bers of; academia-provided input through pa rticipa-
                 tion"iri1the'AcidiRainrAdvisoryi,Gommittee;(ARAG)
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                fihstitutionsHntootminstances/thennvolvementofft/s
                ^Tw>^j'swi4.rw??s^sscaj&^                         'i*!*1
                Ithese gn3Ups|earlyjntfe
                Iovercblrie;misco"nc1Mfo^^
                t^HSSi^SSi^^SSKS^^gSS^^paii^^J^^^
                jmstrument and to educate stakeholders on the!
                              >K,TSi'VS^j*fjB4f?1.::(ii56(i(GS''>rSB6ni-'1 ViSBSfiftiJSKflKii;; iS1I-^&.!ay-W
                              !;implementationibecause-it;proa
                ^^.^-.^^^^P**!^^^
                Iduceda cadre of,knowledgeable individuals whofs
                ?^^^S^i>T<^^^.v^;^^r:^inS^SSSx;:;;^^^^-^^^^^<^^^^
                ^were;committeditO'makmg,theiprogramlworfc
                r^y,^;x^oi;^/^^WJ
-------
     pollutants from each plant (i.e., plants can emit
     more when they operate more). The market-
     based incentives in cap and trade can also spur
     innovation and new technologies.
     "Emission trading is unfair." A second misper-
     ception of emission trading is that it is unfair
     because companies can buy their way out of
     their responsibilities to reduce emissions.
     Similarly, some have argued that  emission trad-
     ing favors  large companies at the expense of
     small companies. These arguments ignore the
     fact that under a cap and trade system, compa-
     nies that buy allowances are essentially paying
     for emission reductions at other companies.
     Moreover, small companies often benefit the
     most from cap and trade because they may have
     fewer internal options for emission reductions
     and they may benefit  from the flexibility of buy-
     ing allowances. In addition, the largest and high-
     est emitting facilities often have  the lowest cost
     per ton for reducing emissions. This was the case
     in the U.S. SCh Allowance Trading Program,
     where the highest emitting plants in the
     Midwestern United States made the  most signif-
     icant emission reductions.
     "Companies will cheat" Some believe cap and
     trade will  allow companies to avoid their obliga-
     tions because enforcement and oversight is left to
     "the market." In fact,  if programs are properly
     designed, accountability can be better under a
     cap and trade program than under conventional
     approaches. Cap and trade programs require the
     creation of compliance structures that are useful
     regardless of whether any trading occurs.
     Participating sources must fully account to the
     government for each ton of emissions according
     to stringent emission measurement protocols to
     ensure completeness, accuracy, and consistency
     of emission data. Automatic financial penalties
     can be used that are set at levels  that discourage
     noncompliance. The regulating authority's role in
     the program is to ensure emissions are measured
     accurately and that all participating sources are in
     compliance. Finally, reported information on
     emissions can be made available to the public on
     the Internet or through other means. This trans-
     parency can help build the necessary confidence
     in the efficacy of the cap and trade approach.
               "Trading doesn't clean the air." Critics of emis-
               sion trading sometimes argue that trading does
               not reduce emissions; it merely shifts the loca-
               tion of existing pollution. However, this argu-
               ment fails to account for the cap. Under a cap
               and trade system, the overall level of emissions is
               reduced and capped. The environmental objec-
               tive is embodied in the cap and the economic
               objective in the trade. Moreover, the larger the
               overall reduction reflected in the cap, the less
               concern there is about the environmental
               impacts of any individual trade or group of
               trades. This point is particularly relevant in
               addressing concerns about hotspots that may
               arise due to trading. Economic and atmospheric
               modeling done in conjunction with an EPA
               study of the U.S.  SOa Allowance Trading pro-
               gram showed that in the Eastern United States,
               the difference in  acid deposition with and with-
               out trading was less than 5 percent. Differences
               in deposition of less than 10 percent are not
               expected to measurably change the acidification
               of lakes and streams (USEPA, 1995).

             ;jw**-i*^^1;:-Er;*ow.Vji^^lW'w^M ws^W* -CKX ' .^j-w wvwocii*x'XT"*. VV 
             mJthelUmted States werelnegative, acceptance of
                                    oA:fli ,*vw .ifs w<",s*'uft'X ior,v-.~;!<
                                   wn-astneprograrrfhas
                                    v<"V.itilx**A A4fUjSk'/>'KK^.~^U!A.MUkQCi?A%Ai
tiresults.^Several;o
achieved;environmentat
                                         Several;obserers
(iavWhotedlthatthe:
                                     effectivelyiCdmmUhiC3y
                                     "
             ingithe.benefits^ofdhelSOi^capfandltraaeiprogram
            Ito;the1publicandierivironmental:grbups:has[beenjtb
            888ss^x&vwK<&^ri;^
                   l 995)? Essentially, the?argumenf isitrtat:the
                  !^
             cost savings from sthe allowance grading program
             were,usedlt6!buy2additibnallenvironrnentalibene|
             ftmiS^"**We^^
             fits;and:to:therefore;easeithe;concernsiOf environ-;
             mentalists:over%MK''&K* fS&iWte
                                                        (KrugeriandiDean;^?)?;
5-3
Assessment and Communications

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                                                                           irhe'geographie;compbnent-oftGlS


  =K**rM 1^*ttS^^<*vw'J5^,v^*<^r."<^SSX*.|^rfl>-|:?^*^E|^^
  analyzenationalf regional-^and^tate-level trends;acGordmg;tothegeographicand;environmentaharea on
  iftfii^*'^fe..W&S^g1&^^
G?V>ii * rt^ft *>.:^^*Vtt^^;^-t|p...      -	rrrr    .	~r;-y        /"-;!
   \  K  ^  fL^   h  If200
    1995 Supplying Activity
19% Supplying Activity

      '          "
                Theiprbximity^
                                                                     	correlationicorroborates-EPAsLobserya
                                                                     iss^sss^^sssysip^psi^^^s^ssigite*
                                                                          companyi(or>geographiorcgion)r
                                                                          :--s55-;H ; ^%^'. rj* .xtf.^^S^^^,'o:'>A^i:;:.*ift''.tc;ssi.r;-?:-siierK:i
                                                                                              "v;-r^
5-4
                                        Assessment and Communications

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     Independent analysis also shows that emission
     trading can lead to greater human health and
     environmental benefits than non-trading policies
     (Burtraw and Mansur, 1999).
Modes of

Communication
By far the most effective means of communication and
outreach is the World Wide Web. Electronic informa-
tion can reach a vast audience at low cost. For exam-
ple, visitors to EPA's Clean Air Markets Web site28 read
more than 300,000 files every month. A well-designed
Web site should be user-friendly, rely on intuitive navi-
gation, and, ideally, undergo usability testing before it
is made available to the public. It should also be regu-
larly updated to reflect the latest program data and
developments. An up-to-date Web site can greatly add
credibility to the trading program and can be used to
provide information that builds confidence in the cap
and trade program (see box on C-MAP).
  Information can also be made available to the pub-
lic via print media. Depending on available budget, a
regulating authority may prepare and distribute fact
sheets, brochures, and topical reports that can be dis-
tributed by mail. Periodic newsletters are another
effective means of keeping the public informed of the
program's status and results,  including emission
reductions to date, auction results, and  allowance
prices. Similarly, information can be conveyed at work-
shops and conferences.
  Regardless of the mode of communication, it is
important to bear in mind that keeping the public
informed about the status and results of the cap and
trade program can help ensure the program's success
by highlighting its environmental and economic bene-
fits, facilitating market operation, and building public
and decisionmaker support. To ensure that adequate
resources are available to meet public demand  for
information throughout a program's lifetime, a  com-
munication function should be designed at the pro-
gram's outset, rather than on an ad-hoc basis after
results are available. Consistently available, up-to-date
information will help build public confidence in the
cap and trade program.
         Continued Assessment

         Environmental Assessment
         A cap and trade program, by setting a quantifiable emis-
         sion goal and using accurate and consistent emission
         measurement, lends itself well to periodic assessment.
         Reviewing emission levels will help determine how
         effectively the program is operating and whether the
         emission cap level has been achieved. Equally important
         to program success is determining how the environment
         is responding to emission reductions and whether over-
         arching objectives for environmental protection are
         being met. Periodic measurement of these environmen-
         tal endpoints will help provide information on how well
         the cap level is protecting the environment.29
            The scope of the assessment is determined, to a
         large extent, by the specific policy questions being
         addressed. Continued assessments can include evalua-
         tion of emission data, ambient air concentrations mon-
         itoring data, and pollutant deposition monitoring data.
         Assessment may also include an evaluation of end-
         point parameters or receptors, such as changes in sur-
         face water chemistry resulting in decreases in acid
         deposition. Examples of environmental endpoints
         include acidic levels of rainwater and sulfate deposi-
         tion levels for acid rain, and ground-level ozone levels
         for NOx emissions.
            In order to evaluate the effectiveness of environ-
         mental policies and programs, a strong commitment to
         long-term monitoring programs is  critical. Effective
         assessment requires a full  suite of monitoring capabili-
         ties, including tracking stack emissions, analyzing
         atmospheric concentrations of pollutants, measuring
         wet and dry deposition to  land and water surfaces, and
         evaluating environmental impacts  through surface
         water chemistry and biological monitoring. These pro-
         grams not only help in evaluating environmental com-
         pliance and progress towards program goals (e.g.,
         through tracking emissions reductions), they also
         enable assessment of the effectiveness of emission
         controls in addressing human health and environmen-
         tal concerns. Over the long term, investment in such
         program accountability mechanisms will yield great
         benefits through their contribution to the credibility
         of the policy.
28  The Web site's URL is www.epa.gov/atrmarkccs.
29  For a detailed discussion on ecological assessments and analytical tools in the context of acid deposition in the United States, see USEPA, 200i.
5-S
Assessment and Communications

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                                                 ,XX>f,v'f',**->ity~,-.',,K&i6&^!^!S!&^^^
                                                                                yearfof,iF?hase}IIFaffeetiedemissi6n
                                                                                fe5(saass:iSfe'5
                                                                                sburces.'achieved.totaltSOi'emisiM
Figure 14. SOz Emissions From Affected Emission Sources
                                                                               {33?percen0elativeScft1 990llevels);
                                                                                             -''''-1''*''-"-"-"^*--
                                                                               Gorriparedito;200Qlley
                                                                               foftalhaffectiedisdurcescsihcell 980;
                                                                               1988iinaicate thatambieMSOzicon?
                                                                               centrations are decliningifsee Figure
                                                                               y^w^Sfi^sw'ite^^sPft^:irsi^L-^ia.-yi.!.-**!.'.'iKas's.'^s:aa^1!-1s'wi.
                                                                               NortKeastern?UnitediStates-and
                                                                               Mid^tlanticfHolland; etialil 999);
                                                                               ^^S^S^Jfeua^Xs^f^WKJ ^rf.ife^ic^^'X^'-, tfU^-j.^^; ^.^SW-?-,tf.
                                           'prominent trends in.tKe;Nbrth"east andrMia-Atlantic:states1
5-6
                                          Assessment and Communications

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     Surf ace Water Imparts: A'recent study^examining:surfa^
                                                     regions ofithe.Eastern
                                         except Virginia
  ?i$$Ps^^S!S!8^
  Nitrateconcentrations-nave;decreased:significantly{intheGatSKilland?AdirondackMountamsano Vermont since
  1990/lncreasing Acid:NeutralizingjGapacityfANOidembnstratesihat recovery is occurring in the Adirondacks and
Rennsylvariia/spurred]by.tnejsulfate!reductions!achievediby,tne;prdgram?(USEPAf2003).
Lo*S,3-;i>^COOl^-faanc^^'X J^Vw                                                            i.lW&iaifXA.S

    Figure 16. Trends in Wet Suifate Deposition
      1989-1991
                                                                 WetSCV

                                                                  (kg/ha)

                                                                     0
    Source: National Atmospheric Deposition Program
      i999_2001
                                                                 Wet SO42

                                                                  (kg/ha)

                                                                      0
    Source: Lynch et. al., 2000. (Units are in kilograms per hectare)
5-7
Assessment and Communications

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ipontmuedtEcoriomi^
 SiivaluaMne^rBficM
 *^tf^^7&^?j>^^-^*^tfK^m<^fer^^^^
                  NAPARjprpducedja!:<:qrnprehensive]lntegrafed
                                                              mortalityandimorbidity^EstirnateSiOMne
                                                                                 --
  /^^riii^awj-.T^^K-^v--. ^Si'.'iNJf.l^^Sii^Vx-^vjk:.^ ^^k^h^
                                      bf/attaim'rigithemissioffreduc^iohptargetjhave";D
                                      IMSLW!Si^<:i^*raM^^
                          
Economic Assessment
Economic assessments are useful to evaluate whether
the cap and trade program is delivering the expected
economic benefits. Assessments include a comparison
of the environmental and human health benefits (or
damages avoided) as a result of the program, and the
total costs of compliance (NAPAP, 1998; Burtraw, et al.,
1998). These types of analyses can be used for a more
comprehensive cost-benefit analysis to evaluate
whether further emission reductions and/or additional
control programs are warranted.

Market Assessment
Market assessment (i.e., tracking allowance trading
activity and prices) is another important aspect of a cap
and trade program. The volume of activity (i.e., the
number of transactions that occur) indicates whether
the market for allowances is liquid and whether it is
working effectively to minimize the economic costs of
achieving the emission reduction target. Of particular
importance is a measure of the number of allowances
traded in "arm's-length" transactions, or trades that
occur between unaffiliated companies. It is these
trades that have market significance (Kruger and
Dean, 1997) and  demonstrate that an allowance market
has developed.
Program Refinement
Once a cap and trade program has been implemented,
assessment of the program is valuable to ensure its
effectiveness. It is important not only to assess the envi-
ronmental and economic effectiveness of the program,
but also to assess the implementation. Policymakers
should consider whether these procedures could be
improved or if they could be more cost-effective.
  After gaining some experience of program imple-
mentation, policymakers should consult with the
emission sources, as well as use the experience from
the sources to assess whether changes are warranted
in the implementation rules and procedures. In addi-
tion, input should  be solicited from other stakehold-
ers. Based on such input, it can be determined
whether the program would benefit from refinement
and if so, a process and timetable can be established.
It is important to minimize disruption in the program
and realize that some changes, even if they would
have been a better choice from the start, are not worth
implementing because of the disruption they would
cause. The sources, as well as the regulating authority,
have learned the rules and any changes, even improve-
ments, might require more time on their part to learn
and implement. On the other hand, it is very possible
that there will be changes where the benefits will out-
weigh the disruption caused by change.
5-8
                                   Assessment and Communications

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   v^.^s^*K.'jw*,''*i'>v$.<:isr'i 9ssps,;> ipi^i**^^:**!*^^^^'^^*^^^*'^"^

   ImplementationlExpenencEinlhe
   .sxxkrijuuJExxkA.fi)'-' ;^;iVr4'-l?>'^"X*^V)^.*,S.,v:.V^.itf.Jf--N^<.>w;v^
   Under.theiUiSi'SOzrAllowanceiTradingiPrpgramlEPA
  years]pn!mplementatipn,tb;solicitinputon;the
   measurement;requirementS;ofthe>procjramSTheiEPA
 I office responsible.for, the design:andiimplementaT
 vAcftsiWOflCT6;'W!a(n>=o4:~ alSo^-*^';.->5*iSC*,V>ti>j<)W-i'i0>4*>,!iVX
  5ti6nW>theprpgramilea?thelstakeh'older;prqcess!:rhe
   s^?^SH^Tt?>K."r.'A'^-:w,-^s^K^;-i?^^::^^>z^

   prpcessiinyotvedthefregulatedjpowerjplantsithat
   were implementing tHe requirements;;thestate:and
   groups.intiefiestedjinltne
   Based:io^h^put;fromjtJ^stakenPtajBr;prpcess;
   ment:rules;andip'roceduresaimed;at streamlining
   H;;fov Ti-:^^^^:^1ivi'*^,;:?H /i^(JJ5l!S8'fi$^5WB^
         maintaining:or.;impr6yingitnequality!bfthe
             '                             1H
   emissions datajanditne)integrity ^."^rim,^

rt "sions;which;yvereiir
                                  ,ras appropriate
                                   '
                                    . Once the revised?
         fcs
   rules-were finalized^EPA-provided an;additionaliyear;
   ; .-^iivw.*"jvC3>. . \?6tJ*io'.jo\.-(^tjiRfAu.?W'.^p-x.-.Vv<.;. x*".*'!**.-. .-. ^SM,;;. isv.^*^ I-'AV^^I-JV '^ .i'v-'
   before requiring their.use.-ThisaaveiSOurcestime.to
   ic jL^ftfuMMii! i6.c,*..>uoe<^.x.c.:!< * ^'-6*; ,<). i*vx x*wiT*uo.XrSrttt\>><*>,xrtftox*';.f9Cr>1K>a?fti>icj
   learn;andlirnplement;the;newjrulesl
5-9
                                                 Assessment and Communications

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             Glossary  of Terms
Acid deposition: The process by which acidic particles,
gases, and precipitation leave the atmosphere. More
commonly referred to as acid rain, acid deposition has
two components: wet and dry deposition.

Acid rain: The result of sulfur dioxide (SOz) and nitro-
gen oxides (NOx ) reacting with water in the atmos-
phere and returning to earth as rain, fog, or snow.
Broadly used to include both wet and dry deposition.

Acid Rain Program: The regulatory program created
under the U.S. Clean Air Act to reduce acid rain. It
employs a cap and trade framework to reduce SO2
emissions from electric power plants. The Acid  Rain
Program is aJso known as the U.S. SOz Allowance
Trading Program,- the U.S. SOz cap and trade program,
and the U.S. SOz emission trading program. The Acid
Rain Program also requires reductions in NOx emis-
sion rates from coaJ-fired power plants.

Addidonality: A determination of whether emission
reductions from a project would have occurred under
normal business conditions (i.e., in the absence of a
crediting program).
       Affected source: A facility that produces emissions and
       is subject to the provisions of an emission control regu-
       lation.

       Allowance: An authorization to emit a specific amount
       of a pollutant under a cap and trade program. For
       example, in the U.S. SOz Allowance Trading Program,
       one allowance is the authorization to emit 1 ton of
       SOz. Allowances are used for compliance and can be
       traded among sources participating in the cap and
       trade program.

       Anyway tons: See "Additionality."
       Arm's length transactions: Allowance transactions
       between companies, that are unaff iliated with one
       another.

       Ascending bid auctions: An auction in which both
       price and allowance quantity are determined through a
       process of open competition. Each bidder has full
       information about the current clearing price and can
       update their bids to increase price or change quantity,
       changing losing bids to winning bids. Those willing to
       pay the most win the allowances.
Gtossary-1
Glossary of Terms

-------
Banking: A form of temporal flexibility that gives
sources the opportunity to save unused allowances
and/or offsets for use in a later compliance period.

Broken The person who acts as an intermediary
between a buyer and a seller, usually charging a com-
mission.

Bubble: A regulatory term that applies to the situation
when a company combines a number of its sources in
order to control pollution in aggregate; under a bubble
facility operators are allowed to choose which sources
to control as long as the total emissions from the com-  
bined sources is less than or equal to the amount each
source would have emitted under the conventional
requirement
Gap: The overall emission limit that a group of affect-
ed sources cannot exceed under a cap and trade pro-
gram. May also be referred to as the aggregate
emission quota, level, target, or budget.
Cap and trade: A market-based policy tool that estab-
lishes an aggregate emission cap on total emissions
from a group of sources and creates a financial incen-
tive to reduce emissions. The emission cap is
expressed as allowances distributed to individual emis-
sion sources that must surrender allowances to cover
their emissions. The program provides the flexibility
for sources with low-cost reductions to reduce even fur-
ther and sell allowances to others with higher costs of
control, resulting in achievement of the environmental
goal at lowest cost.
Clean Air Act Amendments (GAAA) of 1990: A reau-
thorization of the Clean Air Act passed by the U.S.
Congress in 1990. The CAAA, which included provi-
sions for the U.S. SOz Allowance Trading Program,
strengthened the ability of EPA to set and enforce pol-
lution control programs aimed at protecting human
health and the environment.

Cornmand-and-control: A policy tool in which the reg-
ulating authority establishes the necessary emission
reduction or applicable emission limit for specific
sources, typically by setting a source-specific emission
rate standard or mandating the installation of specific
emission reduction technology.
Credit: Under a rate-based trading program, credits can
take the form of an authorization to emit a specific
quantity of emissions (e.g., 1 ton) when an emission
source achieves an emission rate below the specified
       performance rate. Under a project-based trading pro-
       gram, once certified by an authorized expert to ensure
       the emission reduction is real, additional, and long-
       term, a credit is an authorization to exceed a rate or
       other pre-existing standard by a specific amount (e.g.,
       1 ton).
       Crediting period: the number of years during which an
       emission reduction project is eligible to receive credits
       for actual emission reductions.

       Designated representative: Under the US. SOz
       Allowance Trading Program, the individual who repre-
       sents the owners and operators of an affected source
       and performs allowance transfer requests, emission
       reports, and all correspondence with EPA concerning
       compliance with the U.S. SOz Allowance Trading
       Program.
       Downstream: A type of cap and trade system in which
       affected sources are those facilities or consumers after
       the point in the product cycle where the emissions
       actually escape to the atmosphere.  For example, elec-
       tricity consumers are downstream from the emissions
       that occur at the electricity generator.

       Emission target: The level of allowable emissions in a
       cap and trade program. See also "cap."

       Environmental integrity: The ability of an emission
       control policy, such as an emission trading program, to
       achieve its environmental objective (e.g., reduce or
       limit emissions to a specific quantity).
       Flue gas desulfurization (FGD): Post combustion con-
       trol technologies designed to remove SOz from flue
       gases. FGD technologies can be grouped into two gen-
       eral categories of wet and dry processes. In the most
       common type, a wet limestone scrubber, the flue gas
       enters a large reaction vessel (spray tower or absorber),
       where it is sprayed with water slurry containing lime-
       stone. The calcium in the slurry reacts with the SOz to
       form calcium sulfite or calcium sulfate that is removed
       from the reaction vessel and the water is removed. The
       thickened waste can either be disposed of or used to
       produce a by-product such as gypsum.
       Fuel flow meter: An instrument that measures  the vol-
       ume or mass of fuel burned.
       Fungibility: The interchangeability of allowances,
       credits, and/or offsets, assuming that each represents a
Glossary-2
Glossary of Terms

-------
consistently measured and standardized unit of emis-
sions.

Ground-level ozone: The occurrence in the tropo-
sphere {i.e., at ground level) of a gas that consists of
three atoms of oxygen (Os) and is formed through a
chemical reaction involving oxides of nitrogen (NOx ),
volatile organic compounds (VOC), heat, and light. At
ground level, ozone is an air pollutant that damages
human health, vegetation, and many common materi-
als and is a key ingredient of urban smog.

Hotspots: Geographically and temporally concentrated
pollution levels that exceed desired emission levels or
ambient air quality standards. Under some circum-
stances, hotspots may result in conjunction with an
emission trading program if appropriate safeguards are
not designed into the program (e.g., a stringent cap).

Leakage: Occurs when economic activity is shifted as
a result of the emission control regulation and, as a
result, emission  abatement achieved in one location
that is subject to emission control regulation is offset
by increased emissions in unregulated locations.

Marginal abatement cost (MAC): The amount of
money a source  will need to spend to reduce the next
ton of emissions of a specific pollutant.
Mass balance approach: An emission estimation
method in which inputs and outputs are compared to
calculate the emissions of the relevant pollutant.
Net buyer: Under a cap and trade program, an
allowance trader that acquires more allowances than
they sell.
Nitrogen Oxides (NOx): Gases produced during com-
bustion of fossil fuels in motor vehicles, power plants,
industrial furnaces, and other sources. NOx is a pre-
cursor to acid rain  and ground-level ozone.
Offset: An emission reduction of a specific quantity of
a pollutant (e.g., 1  ton) verified through a project-
based  trading program. An offset can be applied to reg-
ulatory emission limits as an authorization to emit that
specific quantity of pollutant. See also definition of
"credit."
Ozone Transport Commission (OTC) Regional NOx
Trading Program:  A NOx cap and trade program
adopted by jurisdictions (states and the District of
Columbia) in the Northeastern United States to
address ozone transport in that region.
       Paper credits: Generated under project-based trading
       programs if the emission baseline for a project is set at
       a level greater than the one at which the source actual-
       ly operates. If such a baseline is used to calculate the
       quantity of credits or offsets generated by the project,
       the resulting credits or offsets do not reflect real emis-
       sion reductions. Similarly, paper credits could also
       occur under a rate-based trading program if the per-
       formance standard is set at a level above which a source
       actually operates.
       Performance standard: A quantity of emissions allowed
       per unit of heat input or product output.
       Permanence: A concept associated with project-based
       trading'that refers to whether carbon stored in the
       biosphere  (i.e., carbon sequestration and  sinks) might
       later be emitted to the atmosphere (e.g.,  by a forest
       fire). Permanence should be addressed so that offsets
       awarded for carbon stored in a tree which later burns
       down are not used to allow extra emissions elsewhere.

       Point of emission: A type of cap and trade system in
       which affected sources are those facilities where the
       emissions  actually escape to the atmosphere. For
       example, the U.S. SOz Allowance Trading Program is a
       point of emission program because the affected
       sources are electric generating units that combust fos-
       sil fuel and emit pollutants into the atmosphere. This
       kind of program is often referred to as a downstream
       program in the United States and a midstream program
       in Europe.
       Project host: An emission source that hosts a project  to
       reduce emissions and generate offsets under a project-
       based trading program.

        Price signal: An indicator of what people or businesses
       are willing to pay for allowances or what firms are will-
       ing to accept as payment for their surplus allowances
       (or credits). Transactions, whether auctions or sales,
       provide a signal of the price that emission sources and
       other market participants are willing to pay for
       allowances.
        Ratchet: A procedure that adjusts each source's alloca-
        tion proportionately, so that the total allocation matches
        the  number of allowances in the overall cap. This sys-
        tem promotes environmental integrity by ensuring that
        formulas used to determine allocations do not inflate
        the cap.
Glossary-3
Glossary of Terms

-------
Rate-based trading: A trading approach in which the
regulating authority determines an emission rate per-
formance standard (i.e., an amount of emissions
allowed per unit of heat input or product output) for a
sector (e.g., tons/kWh) and allows sources that over-
and under-comply with.the standard to trade credits.
(The rate .difference needs to be multiplied by each
sources' utilization to establish a tradable mass emis-
sion based credit or offset.)

Scarcity value: The economic value of an allowance or
credit due to the limited quantity available.
Scrubber A post-combustion control technology utiliz-
ing a  sorbent to remove SOz from the emission stack.
See also "Flue gas desulfurization."

Stationary source combustion: The process of burning
fuel by a source, such as a boiler, that is in a fixed loca-
tion (i.e., not mobile).

Source: An entity that releases airborne pollutants into
the environment.

Sulfur dioxide (SOz): A gaseous pollutant that is pri-
marily released into the atmosphere as a by-product of
fossil  fuel combustion. The largest sources  of SO2 are
power plants that burn coal and oil to make electricity.

Trade: An exchange of allowances, offsets, or credits
for cash or other considerations under an emission   
trading program.
Trader: Anyone who buys or sells allowances.

Transaction costs:  Financial costs associated with a
transaction under an emission trading program. The
costs  are usually related to identifying, verifying, and
certifying emission reductions. These may include
partner search costs, travel and communication, negoti-
ation  activities, legal and contracting costs, potential
litigation costs, ex-post challenges, opportunity costs
associated with delays and uncertainties, and other
related costs.
Upstream: A form of cap and trade where the obliga-
tion of compliance is placed 'upstream' of the actual
emission sources (e.g., at the fuel producer), such that
the affected sources under the program are not the
facilities where emissions actually escape to the atmos-
phere.
        Vintage: Represents the first year, or compliance peri-
        od, in which a particular allowance can be used for
        compliance in a cap and trade program.
Glossary-4
Glossary of Terms

-------
                                     Acronyms
ARAG     Acid Rain Advisory Committee
ATM     Allowance Tracking Module
CAAA     Glean Air Act Amendments
GEMS     Continuous Emission Monitoring System
CH4      Methane
C-MAP    Clean Air Mapping and Analysis Program
COz      Carbon Dioxide
DAHS     Data Acquisition and Handling System
ELI      Environmental Law Institute
EPA      U.S. Environmental Protection Agency
EPBs     Environmental Protection Boards
ETM     Emissions Tracking Module
FGD     Flue Gas Desulfurization
GHGs     Greenhouse Gases
ISO      International Standards Organization
MAC     Marginal Abatement Cost
MMBTU  Pounds per million British Thermal
         Units
MSD     Marginal Social Damage
NAPAP    National Acid Precipitation Assessment
         Program
NOx     Nitrogen Oxides
OTC     Ozone Transport Commission
QA/QC    Quality Assurance/Quality Control
RCM     Reconciliation and Compliance Module
    RECLAIM  Regional Clean Air Incentives Market
    RFF      Resources for the Future
    SIP       State Implementation Plan
    SOz       Sulfur Dioxide
    TEV      Total Economic Value
    USD      U.S. Dollar
Acronyms-1
Acronyms

-------

-------
                                        References
AGO, 1999: Australian Greenhouse Office. National
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Baumol and Gates, 1998: Baumol, W. and W. Gates. -The
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Benkovic and Kruger, 2001: Benkovic, S. and J. Kruger.
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Burtraw, et al., 2001: Burtraw, D., K. Palmer, R.
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     Carlson, et al., 2000: Carlson, C., D. Burtraw, M.
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     CCAP, 1998:  Center for Clean Air Policy. U.S. Carton
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     CCAP, 2000: Center for Clean Air Policy. An Upstream/
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     CCAP, 2001: Center for Clean Air Policy. Developing a
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References-1
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Dinan and Rogers, 2002: Dinan, T. and D.L. Rogers.
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Ellerman, 1999: Ellerman, A.D. The next restructur-
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Ellerman, et al., 2000: Ellerman, A.D., P. Joskow, R.
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ELI,  1997: Environmental Law Institute. Implementing
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Fischer, et al., 1998: Fischer, C., S. Kerr, and M.
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     Harrison and Radov, 2002: Harrison, D. and D. Radov.
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     Holland, et al.,  1999: Holland, D., P. Principe, and J.
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     IGF, 1999: ICF. Economic analysis of alternative meth-
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     Kinner, 2002: Kinner, A. The Ozone Transport
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     Kramer, 1999: Kramer, J. The role of CIS in acid rain
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     Kruger, et al., 2000: Kruger, J., B. McLean, and  R.
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        John Wiley & Sons, Inc., 2000.
References-2
References

-------
Loeb, 1995: Loeb, A. Addressing the public's goals for
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Mazurek, 2002: Mazurek, J. Cap Carbon Dioxide Now.
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-------
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  Williams, Wilkins, Philadelphia, PA, 2001.

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                              The  Optimal
             Level   of  Pollution
     According to economic theory, excessive levels of
     pollution occur due to so-called "market fail-
     ures," such as the public goods nature of envi-
ronmental quality, imperfect information, and other
factors. Hence, according to economic theory, govern-
ments should intervene to provide the correct incen-
tives for pollution control. Determining the optimal
level of pollution control requires an analysis of the
level of the environmental externality that is being
generated as a result of an economic activity. An exter-
nality is defined as a cost or a benefit that is not being
properly accounted for by either the producers or the
consumers of the activity. For example, consider the
case of a firm located upstream that is emitting pollu-
tion into a nearby stream. As a result, ecosystems
downstream may be adversely affected (e.g., fish popu-
lation decline, decline in recreational fishing and
swimming, adverse health effects from contaminated
drinking water). These are all examples of negative
externalities (i.e., costs). If these effects are  not reflect-
ed in the firm's production costs, and hence in the
market price of the economic activity, the firm will
emit a level of pollution that is above the social opti-
mum. Generally, two conditions need to prevail for an
external cost to exist: (1) an activity by one party caus-
          es a loss of welfare to another party; and (2) the loss of
          welfare is uncompensated.
            Figure A-l depicts the socially optimal level of pol-
          lution. The Marginal Social Benefit (MSB) curve
          shows that initial emission reductions provide greater
          benefit than subsequent emission reductions.
            Pollution abatement, however, costs less for the ini-
          tial reductions but each additional (or marginal) unit
          of pollution control costs more than the previous unit.
          Thus, the Marginal Abatement Cost (MAC) curve is
          steeper as the quantity of emission reductions is
          increased.
            The optimal level of pollution control occurs where
          MAC = MSB. Hence, to achieve this level, the regu-
          lating authority would want to limit the aggregate
          level of emission reductions to the level Q*, which
          reflects the marginal cost associated with that level of
          economic activity, P*.
A-l
The Optimal Level of Pollution

-------
 Figure A-1. Economically Efficient Control of Pollution
                     CAP AND TRADE
   I
   <
Marginal
Social Benefit
Marginal
Abatement
Cost
                           Q*
               Quantity of Pollution Reduced
The Economics of

Emission Trading
Cap and trade programs are superior to the more tradi-
tional command-and-control approaches for environ-
mental regulation because the emissions
targetestablished via the capis achieved at a mini-
mum economic cost through the trading of the
allowances. The regulating authority determines the
total allowable level of emissions and issues allowances
for this amount (ideally Q* in Figure A-1 above). The
allowances are then allocated to the sources, which are
allowed to trade with other sources in the allowance
market. In this way, firms with low marginal  abatement
costs will opt to reduce emissions beyond the number
of allowances they hold and sell the excess allowances
to firms with higher marginal abatement costs. Thus,
marginal.abatement costs across all sources are equal-
ized and the costs of attaining the environmental target
are minimized.
A-2
                   How to Develop a Cap and Trade Program

-------
Example Assessment
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B-2
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-------


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B-3
                                       Example Assessment of the Potential For Cap and Trade

-------


v>EPA
United States
Environmental Protection
Agency
     Office of Air and Radiation Clean Air Markets Division (6204N)
     EPA430-B-03-002
     www.epa.gov/airmarkets
     June 2003
                                                                             i

-------