PB81-214249
Brokering Emission Reduction Credits
A Handbook
(U.S.) Environmental Protection Agency
Washington, DC
,
jf
Jan 81
U.S. DEPARTMENT OF COMMERCE
National Technical Information Sorvico
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! " :-K Regulatory Reform Staff
Controlled Trading Project (PM-223)
U.S. Environmental Protection Agency
.-. I REPHOOUCED Br
NATIONAL TECHNICAL
INFORMATION SERVICE
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SPIW6FIELD. V» 22161
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REPORT DOCUMENTATION
PAGE
i. REPORT NO.
EPA 230/3-81-002
J. Recipient's Accession No.
21424 9
4. Tttto md Subtitle
s. Report one - Dare or issue
January 1981
BROKERING EMISSION REDUCTION CREDITS
7. Authorta)
Regulatory Reform Staff, Controlled Trading Project
9. Performing Organisation Rapt. No.
9. Performlrai Organization Name end Address
Regulatory Reform Staff
Controlled Trading Project (PM-223)
U.S. Environmental Protection Agency
^01 M Street, S.W.
Washington. D.C. 20^60
10. Proiact/Task/Work Unit No.
11. ContracttC) or QranttG) No.
(O
(8)
12. Sponsoring Organization Name and Address
13. Type of Report & Period Covered
HANDBOOK
14.
IS. Supple
wy Not.
Papers presented at conference on Brokering Emission Reduction Credits
January 26, 1981, Washington Hilton Hotel
IS. Abstract (Limit 200 worts)
Controlled trading allows industry and individuals to profit from pollution control
by allowing plants to decrease emissions below required levels and obtain state-approved
credit for the reductions. They can then use these emission reduction credits (ERCs)
themselves or sell them to other firms. Most firms, however, are busy running their on-
going businesses 'and are unaware-of'the potential cost savings -they can achieve through
EPA's Controlled Trading program. Brokers can assist these firms in recognizing and
realizing the potential for cost savings. In January 1981, EPA sponsored a conference
on brokering emission reduction credits. Over 200 environmental engineers, consultants,
venture capitalists, plant managers, industrial location specialists, accountants and
lawyers attended to learn more about this new business opportunity. EPA conpiled a hand-
book on Brokering Emission Reduction Credits to help these and other prospective brokers
get started. The Brokers' Handbook includes: a description of EPA's Controlled Trading
Program; an examination of the potential benefits available to firms contemplating ERC
transactions and exploration of the many services ERC brokers could perform; a case
study of one California firm's brokering experience; an examination of how brokers can
determine supply and demand for ERCs and for brokers in a given area; a discussion of
options trading in ERCs; and an examination of tax considerations related to the financ-
ing, creation, banking, and use of ERCs.
17. Document Analysis a. Oescilptora
b. Mentrnen/OpeitCndad Terms
Regulatory Reform
Controlled Trading
Brokering
Bubble Policy
e. COSATI Field/Group
Offset Policy
Banking
Emission Reduction Credits
EPA Conference
Air pollution; market in
1*. Availability statmwi:
No restriction
Available from NTIS, Springfield, VA 22161
19. Security Clns (TM* Report)
UNCLASSIFIED
20. Security Clen (This P*c«
UNCLASSIFIED
21. No. of Pasts
22. Price
(SeeANSI-Z39.in
See Instruction* on (reverse
OPTIONAL FORM 272 (4-77)
(Formally NT1S-3S)
Department of Commerce
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EPF- ^30/3-El -00,
BROKERING EMISSION REDUCTION CREDITS
Table of Contents
Topic Section
INTRODUCTION .. .. ... ....... 1
..OVE.RVIEW OF BANKING AND TRADING 2
OVERVIEW OF PRIVATE TRADING a-....... ^. ..................... 3
CASE HISTORY 4
MARKET ANALYSIS 5
FINANCING EMISSION REDUCTION CREDITS .6
OPTIONS TRADING 7
TAX IMPLICATIONS OF BROKERING 8
SUPPLEMENTAL INFORMATION ....................................... 9
a. Bubble Policy Fact Sheet
b. Expenditures to Create and Purchase Offsets-
c. Summary of Bubble, Offset, and Banking Transactions
c. Washington Post Editorial - Selling the Right to Pollute
d. Wall Street Journal Advertisement - Emission Reductions
for Sale
e. Contacts For More Information
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INTRODUCTION
0.0-
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Controlled
Trading
What it is-
why we need it
The EPA has begun encouraging states to adopt a series of
"controlled trading" steps to speed progress towards clean air
with less expense and administrative hassle. Since 1970 EPA
and the states have sought better air quality through rules
which apply specific, uniform emission limits generally based
on a known feasible control technology to every emission point
within a regulated process. That approach produced large gains in
many areas, because it dealt with sources that were easy targets,
whose Initial costs of control were relatively low. But for many
urban basins and more Intractable pollutants, it has left us far
from attainment of ambient air standards. Now we face more diffi-
cult problems and the possibility that past gains may slow or
be reversed.
There are several reasons for this. First, air is limited,
while our population, production and Industrial base will continue
to grow. The atmosphere cannot expand; the more dirt we put into
1t, the dirtier 1t will get. Second, rules are general statements
that can't fit every case. They leave plant managers little room
to adjust broad requirements to particular situations. And they
treat similar processes equally, Ignoring both different impacts
on air quality, and the chance that equivalent emission reductions
might be more easily obtained from other processes in the same
facility or area. Because some sources are undercontrolled under
this approach, while many are controlled more than they need be,
the result is excess costs and a powerful reason for industry
to try to limit Its obligations by resistance or delay. Finally.
and most importantly, the present system discourages innovative
control technology. A source that Installs known controls can
generally count on keeping enforcers off its back, regardless of
those controls' cost or effectiveness. A source that develops
more effective measures receives no reward for doing so. Horse
yet, 1t risks making Itself a target for extra regulation, since
it may have shown.its Industry can do more. For most firms, it
is simply not "profitable" to Invest in innovative efforts to do
more than the law currently requires. This point 1s critical, for
in the long run only Innovation can produce improved air quality
at reduced rather than Increasing costs.
Present regulation can deal with these threats- to air quality
in two ways. It can try to squeeze more.emission reductions out
of regulated sources, imposing much heavier costs per pound than
for Initial reductions. Or it can reach out to regulate smaller
For further information on controlled trading, please
contact:
Michael Levin
Chief, Regulatory Reform Staff
Office of Planning and Evaluation
Environmental Protection Agency
401 M Street, S.W. (PM-223) .
Washington, D.C. 20460
(202) 287-0750
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sources. Both.tactics mean more government intrusion and
enforcement burdens, as well as smaller payoffs per regulatory
action. Both mean more industry resistance and politicial
problems. Both pose direct conflicts between growth and
clean air. . . : v "'-'' .".'.' ' "',- . .'-.
Controlled trading offers a way out of this trap by
putting the profit motive to work for pollution control, within
the present regulatory system* Most generally, it would allow
any source to:meet its emission control responsibilities by
securing required reductions from any points within its own
or other facilities, so long as air quality and the enforce-
ability of the resulting trade in levels of control remain
equivalent. If a source can find or finance ways to remove
twice the amount of a relevant pollutant at $5 per pound
either within its own plant or from neighboring plants
it can halve the $10 rounds it is now required to remove.
In short, it can trade a relaxation of controls where control
costs are very high, for increased controls where costs --
either of internal reduction or external purchase are
relatively low.
Thus controlled trading allows a source to get someone
else or some other process to meet required emission
reductions. And a market'for those reductions will let sources
anticipate their availability and cost, creating greater
certainty and more reductions.'
This simple step can carry large benefits. First, as
studies of existing sources under the bubble indicate, it
can yield savings of millions of dollars, without adverse
impacts on ambient air quality. Plant managers who produce
such savings by redistributing controls will continue to
search for further inexpensive reductions and will have
a personal stake in the new configuration, instead of viewing
controls as an interference imposed from outside.
Second, controlled trading builds on the plant-specific
expertise which control agencies can never duplicate. Instead
of stopping with enforcement of a uniform rule, it encourages
plant managers to tailor nationwide requirements by counter-
proposing a different mix of controls that will produce the
same result. Since no intrasource trade will take place unless
savings are realized, and no ihtersource trade will take place
unless both parties benefit, this leaves state agencies free to
focus on technical air quality while reducing wrangles over
industry costs.
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Third, controlled trading makes it profitable for
the first time for firms to innovate by controlling
more than required. Sources which produce such extra
emission reductions can benefit by using them for a cost-
cutting bubble, or selling them at a profit to new plants
in need of offsets. These benefits can be magnified
by banking, which creates a continuous incentive for firms
to control as far as possible when replacing current controls, by
allowing such firms to store reductions for future use or sale.
Banking also provides Innovation insurance for existing
sources, which can secure offsets to make up the difference if
a new method of pollution control falls short of applicable
requirements.
Fourth, controlled trading encourages voluntary extra
reductions by regulated and unregulated sources. me
prospect of substantial savings or profits can induce many
firms to Install controls that would be difficult to mandate
by direct regulation. The prospect can also Induce effective
but difficult to require process changes. And it can make further
reduction feasible for those low-control-cost but low-profit
sectors of the economy that have often been treated lightly
under State plans.
........... Finally, controlled trading can ease political and admini-
strative pressures on hard-pressed State air agencies. It
Injects needed flexibility .Into the regulatory process, enlisting
industry as an ally rather than an adversary. It can sharply
reduce compliance costs, without changing the way emission
obligations are set and enforced. It offers a route to
attainment which does not Involve additional direct regulation.
With banking, 1t can spread permit approvals over time, relieve
pressures to find offsets during politically-charged new source
reviews, and help communities plan for growth based on known
amounts of emission credits. It gives enforcement agencies
something positive to distribute, not additional obligations.
And it reverses present incentives for industry to delay rather
than speed negotiations. A source which can benefit from a trade
is losing money each day that trade 1s delayed, and will do
everything possible to assure a prompt resolution.
Controlled trading currently consists of the bubble, new
source offsets, and banking. EPA is exploring other steps
including marketable permits and methods of allocating the clean
air increment in so-called PSD areas -- that would expand the
universe of traders and trades, provided that air quality end
enforceabUHy are preserved. The important point is that
these steps, like .the existing ones, will give sources a range
of ways to meet air pollution requirements as cheaply and
efficiently as possible, and that they must reinforce each other
and environmental goals -- alike.
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OVERVIEW OF BANKING AND TRADING
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LEGAL FOUNDATIONS OF MARKETS IN AIR POLLUTION
REDUCTION RIOTS . .-; ..
John S. Hoffman
Strategic Studies Staff
U. S. EPA, Energy Policy Division
Washington, D. C.
The viewpoints expressed in this paper do not necessarily represent EPA's
views.
President Gladollar had just received Chief Environmental Engineer Cleansweep's
"unusual" report, which suggested that their company, UNITED UNIVERSAL, INC.,
spend half a million dollars more on air pollution control than necessary
to meet recently promulgated state air pollution regulations for their No. .
#2, #3, and #4 manufacturing, painting, and assembly lines for Widgets.
Having survived the apolexy possible in reading the first page of the report,
Gladollar read on, thinking that either he was going to have to fire the
poor boy or give him a mandatory vacation. However, the report began to
make more sense as it continued; a method to Cleansweep's madness did seem
to exist. That crazy engineer planned to sell sane of the "surplus" emission
reductions he would "produce" for a profit, to "bubble" some of the surplus
reductions, to hold seme to gain a future expansion permit, and even to
take a " flyer" by holding seme reductions for speculative profit!! Gladollar
was pleased to see his best engineer thinking of ways to make money, but
this proposal still seemed very, very strange.
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President Gladollar Calls His Lawyer
Not being one to waste time, Gladollar picked up his phone and called his
lawyer, Mr. Sharpeyes, who instantly suggested a meeting of all the Princi-
pals, including the company's controller, Care fellow. Within a few minutes
time the meeting was convening in Gladollar's spacious office overlooking
the bay. A brown haze obstructed the view.
The Meeting
Gladollar anticipated a few minutes of wry amusement. He turned to his Chief
Engineer and, chuckling, asked him who was going to buy "clean air"? When
Cleansweep replied immediately that a broker had obtained an unofficial of-
fer from Cosmic Connections for 30% of United Universal's surplus Emission
Reductions at a price twice the cost, Gladollar's mood began to change fircm
a haughty sense of fun to a deeper and more profound enjoyment.
President Gladollar:
Are you telling me that they would pay us money for
this thing? Why?
Engineer Cleansweep: Because, apparently, Cosmic Connections plans to make
a major expansion this year. Under the Clean Air Act,
they need to obtain a construction and operating per-
mit to do that. Tb obtain that permit they need to
obtain reductions in emissions from an existing
source that go beyond the reductions required in the
State Implementation Plan. And, I guess, they simply
can't produce those reductions as cheaply as we can.
President Gladollar: So you're saying that since we can make these reduc-
. tions cheaper, we can sell them to Cosmic Connections
. ;/ -.. ."...' so they can get their permit. That's incredible, but
is it really legal?
Lawyer Sharpeyes: Well it certainly is. Offsets have been part of the Clean
Air Act since 1976. Over 650 have taken place in this
state alone. Most companies have produced and used
their own emission reductions, but a few have bought
them fron other firms. One right here in this county.
Controller Care fellow:
Engineer Cheapcontrol:
Okay, but even if we can get a firm contract from
Cosmic Connections, why put new equipnent in all our
plants? Changing one process would provide suffi-
cient reductions to make that sale. Why control
more?
Because we can bank the emission reductions, hold-
ing sane of them for our own future offsets, using
some fbr a bubble, and holding seme fbr future
sales. My cost estimates show...
President Gladollar:
Engineer Cleansweep:
Now hold on a minute.
stuff?
Cleansweep, what's this banking
Banking is a new state program that allows you to get
credit for qualified surplus emission reductions in
the form of an Emission Reduction Credit or "ERC" as
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President Gladollar:
its called. You can'save, sell or buy it just like
any other commodity, subject,,pf course, to seme
government rules', but it's still valuable...
Now hold your horses, Cleansweep. Are you saying that
we own these emissions, so that if we reduce them we
own the air left over? . . .
Engineer Cleansweep: Well, that's not exactly.... - Its more like, well.., -
Sharpeyes,,why don't, you explain.
Lawyer Sharps yes:
Sure, Jim. Look we"dori't'own'emissions and we don't own
the air; What has'happened is that the state has taken
advantage of an opportunity under the Clean Air Act, a
federal law, to create property rights useful in certain
administrative and regulatory activities that the state
has undertaken to meet that federal law. We don't own
the physical emission reductions, which makes sense, since
it's hard to possess something that disappears when we
create it. (Ha, Ha).
Gladollar chuckles - Everyone else is silent.
What we can own is an Emission Reduction Credit, a crea-
tion of rules of the State Implementation Plan, created
by the state as a convenience to managing society's ccm-
mon air resources; Our rights to use the ERC, sell it,
even hold it, are all set down in that state rule.
President Gladollar:
You mean if we want to increase our pollution again
we can't automatically do it?.
Lawyer Sharpeyes:
That's right Sam. The EEC can only be created by going
through a set of regulatory activities of qualifying,
quantifying, and perfecting our claim. We've got to
show that our proposal would result in a real surplus
reduction uncalled for in the State Plan, a reduction
that is both permanent and enforceable. Once the state
qualifies, quantifies and accepts our proposal it would
then make us an offer, so to speak, of a new enforcement
agreement. If we exercise that agreement, we are on the
hook. We get an ERC and a new compliance agreement. To
change that agreement we have to - and I'd like to em-
phasize that this is absolutely required - go to the
Regulatory Agency and apply, through a "trade-off pro-
cedure, for a change in the compliance agreement. If on
balance our ERC is sufficient to meet all the air qua-
lity tests, then the agreement can be changed. If not,
we're out of luck.
President Gladollar:
So what you are saying is that every creation or use
is like a regulatory activity, and we're not able to
do anything we like.
Lawyer Sharpeyes:
Exactly. Of course, as you know from the size of our
legal staff, we are never free to do exactly what we like.
Any property right we have at best gives us a limited
8
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bundle of privileges and obligations. Property rights
never give unlimited licenses to do whatever we want.
We can't build without zoning; we can't drive our trucks
without licenses; we must operate our plant according
to safety rules. In that sense an ERC is no different
than any other property right. It's just a new one,
with a different set of obligations.and responsibilities
than we are familiar with.
President Gladollar: You're not kidding. Tell me what else is so unusual
about it.
Lawyer Sharpeyes: Well, for one thing, it contains sane of the seeds of its
own destructionsort of an automatic inflation index.
Engineer Cleansweep: A what?
Lawyer Sharpeyes: Well, built into the ERC is a pre-defined manner for
shrinking its usefulness. This was mandated by part of
the Clean Air Act that required states to have the abi-
lity to revise their plans as necessary for any of a
number of reasons. When an ERC is created it achieves
its legal status to meet Clean Air Act requirements by
being part of the State Plan, which includes a rather
elaborate accounting system to relate pollution fron
sources like us to ambient air concentrations over this
region. All the regulations passed are intended to bring
total areawide emissions down to a level compatible with
; clean air. Now suppose there is a miscalculation. The
air doesn't get cleaned up as scheduled by law. Then,
we have the ERCs around threatening to dunp even more -
pollution into it. What should we do?
Everyone is blank.
Well, we need a plan that will reduce emissions even more
-we need more emission limits. The problem is that the
ERCs themselves could be so large that they alone would
prevent attainment, so we need sane method of adjusting
their value. Federal law allows the state to choose the
method as long as it conforms to the law. Sane.states
choose moratoriuns - you can't use it until the air is
clean, not very good for the owner who wants to do sane-
thing now. Other states choose percentage adjustments-
which is what our.state chose. In that case, if the state
rolls back emissions 20% overall, we lose 20% of our ERC.
Controller Care fellow: Without condensation? Why that sounds unconstitu-
tional.
Lawyer Sharpeyes: Not at all, Mark. Remember it's an inherent part of the
way the ERC right is defined. No one else is taking some-
thing from us the states would just be exercising a
conditional clause in our contract, so to speak. The
adjustment is a rule'of the game we agree to when we play.
Really, it's the best feature of the whole system, because
we know exactly where we will stand ^_f something happens.
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That's .what we are;af£er' in every contract.
President Gladollar: CleahsweepV .suppose we get an adjustment of 20% dcwn-
wards; how. much/would the remainder appreciate?
Engineer Cleansweep: I don't know exactly;-'but I'd imagine quite a bit.
Don't forget we have-new regulations to meet - every-
one would. The-,cost.of .new. and additional regulation
is likely to be'higher than this .cost of past ones.
In general, the air agency has chosen the cheapest
ones first. ;Aiso,;we,,. / : . .
Controller Carefisllow: Okay. But why bank now instead of later?
Engineer Cleansweep: Well, besides possibly losing our opportunity to bank,
if we don1t bank new, we will have to put on the con-
trol equipment to meet the existing regulation, equip-
ment that will be useless i f we decide to go to our
solventless production process that would produce the
extra reductions. Why not just go straight to the
different process right away? Sure, it's more expen-
sive in the first phase, but when you take into ac-
count the value of ERC and the cost of losing the
. control equipment if we decide to get extra control,
it's a lot cheaper in the long run, and I think
better.-^^You know,
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your basic thinking sounds awfully good. Ihis finan-
cial report you did, though, was really terrible
no internal rate of return is listed, no breakdown on
cost, or timing. Get together with Care fellow and
work out one of our normal capital budget requests.
Sharpeyes, I want you to do a detailed memo on the
legal issues you think are relevant I want you to
.be generating the questions, not just the answers.
Well gentlemen, it looks like we may be able to do
sane business. I've got a Board meeting, so I'll be
seeing you later.
President Gladollar gets up and leaves.
Lawyer Sharpeyes: Congratulations, Cleansweep. it looks like you may fi-
nally make us money.
Controller Care fellow: AMEN.
Epilogue.
On May 30, 1981 a transaction was completed between United Universal and
Cosmic Connections fbr the sale of 200 tons per year hydrocarbon ERG. A
note in United Universal's Annual Report indicated an extraordinary one
time profit of a two hundred thousand dollars. President Gladollar was
very happy; Engineer Cleansweep was given a very large bonus and promoted
to Vice President of Engineering.
'11
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OVERVIEW OF PRIVATE TRADING
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; PRIVATE , .TRADING- OF {..* ;-'?'.
EMISSION REDUCTION- GRED'itS
' Prepared by:'
Q. ,K s>re*it.,;,.N,w., ..
'Washington, 'D.C . 20006 ,.-.'.
in conjunction with . '
Controlled Tradihg Project
Regulatory Refonn,.Staff - .
U.S. Environmental'Protection kgency
By buying and selling emission reduction credits (ERCS); firms can signifi-
cantly reduce their costs of meeting air quality requirements. This manual
examines the potential benefits available to firms contemplating ERC transac-
tions. The manual emphasizes the many opportunities available to ERC brokers
firms or individuals providing necessary services to firms buying and sell-
ing ERCs in order to reduce their costs of pollution control.
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TABLE OF CONTENTS
Section
1.. PRIVATE TRADING OP EMISSION REDUCTION CREDITS . 1
1.1 The Uses of Banked ERCs 1
1.2 The Role of Banking 2
1.3 The Role of Private Trading 4
1.4 Evaluating Alternative Trading Systems 6
1.5 The Advantages and Disadvantages of Private Trading 6
1.6 Scope of this Manual 8
2. THE ROLE OF BROKERS IN TRADING ERCS 9
2.1 Who Might Become a Broker? 9
2.2 Functions Performed by Brokers 10
2.3 Legal Status and Duties of Brokers 14
2.4 The ERC Broker as Agent 15
2.5 Compensation for Brokers 16
2.6 Dealers and Brokers Dealers 16
3; " THE'ROLE OF A PUBLIC AGENCY IN PRIVATE TRADING> - 19
3.1 Providing an Information Clearinghouse 19
3.2 Providing Guidance About -Brokerage Agreements 21
3.3 Establishing a Price Disclosure Mechanism 22
3.4 Acting as a Broker 24
3.5 Coordinating with Other Brokers 25
4. ADMINISTERING PRIVATE TRADING 28
4.1 Staffing 28
4.2 Financing 28
4.3 Arranging On-Going Publicity 29
-3
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LIST OF EXHIBITS
Exhibit Page
1-1 Creation and Uses of ERGS: Bmnission Offsets and the Bubble 2
1-2 The Use of Brokers Can Make Private Trading More Efficient 5
2-1 Boles of Brokers in ERC Banking and Trading 12
3-1 Developing an Integrated Banking and Trading Program 20
3-2 Program Elements and Interrelationships 26
-14
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PRIVATE TRADING OF EMISSION REDUCTION CREDITS
By establishing an emission reduction banking and trading program, commu-
nities can take an important step toward minimizing the costs of achieving air
quality goals. A banking and trading program allows firms to receive credit
for reducing their emissions beyond the level required in the state implemen-
tation plan. Firms creating "emission reduction credits" (ERCs) hold a poten-
tially valuable resource. ERCs can be "banked" or stored, used to reduce the
costs of meeting air pollution control requirements or sold to another firm
for a profit.
Through the banking and trading program, firms can reduce the costs of
achieving the required levels of pollution control. Minimizing pollution con-
trol expenditures will enable industry to shift scarce capital resources to
increased production. From the community's perspective, the program promotes
a healthy economic environment without compromising efforts to achieve a
healthy physical environment. Banking and trading is an important part of
EPA's Controlled Trading initiatives.
The need for banking and trading can be traced to the inherent limits in
our existing regulatory program in which EPA and states set specific emission
limits for classes of polluting sources. Although these emission limits
reflect cost considerations, they are necessarily based on average or model
facilities. Because of differences in the age and operating characteristics
of industrial facilities, a wide variance typically exists in the costs of
clean-up within a specific source category. And an even greater variance in
con- trol costs exists across different industries emitting the same pollutant.
The goal of a banking and trading system is to encourage the maximum
clean-up at those emission points where control costs are relatively inexpen-
sive. For example, a firm that can reduce its emissions beyond current
requirements at a cost of $250/ton can get credit for doing so and can earn a
return on this investment by selling these emissions reduction credits to a
firm that can only achieve required reductions at a higher cost.
1.1 THE OSES OF BANKED ERCS
A banking and trading program offers firms considerably more flexibility
in developing a compliance plan to meet air pollution control requirements.
Instead of simply determining the technology, fuel or process changes required
to achieve an emission limit, firms now have the opportunity to consider two
important additional options:
(1) whether to invest in more controls than required in order
to create and bank an emission reduction credit either for
current or future use or sale; and
(2) whether buying. ERCs from another firm would be a less
expensive means of compliance.
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- 2 -
In deciding how to comply with an emission limitation, firms will want to
carefully compare their costs of control at different emission points within
their own facilities and to the costs of control of other firms. Thus, pollu-
tion control requirements can be examined in the same manner as other factors
of production (e.g., land, labor, and raw materials) and firms can use banking
and trading to minimize their costs.
ERCs can be used by firms wherever a substitute emission reduction is a
permissible means of achieving compliance. (See Exhibit 1-1.) The three spe-
cific uses of ERCs are:
(1) under the bubble policy, which allows existing sources to
reduce the costs of meeting current or future more strin-
gent emission limitations;
(2) emission offsets in nonattairiment areas which allow new or
expanding sources to locate in areas that violate air
quality standards;
(3) emission reductions by new or expanding firms to satisfy or
to get exemption from permit requirements in prevention of
significant deterioration (PSD) areas.
EXHIBIT 1-1
CREATION AND USE OF ERCs
Bubble applications
Offsets in Non-
Attainment Areas
PSD Requirements
1.2 THE ROLE OF BANKING
Bubble applications, offset cases, and PSD permits have occurred in the
absence of a banking and trading program. For example, in the four years
since the adoption of the offset policy, over 600 cases in which new or
expanding firms have arranged for offsets have been documented. Similarly,
over seventy bubble applications are now being processed by states and EPA
with anticipated savings of over two million dollars per application.
118
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- 3 -
SAVINGS THROUGH DSE OP THE BUBBLE
The fact that significant cost differentials exist for reducing the costs
of meeting pollution control requirements is vividly illustrated by several of
the initial bubble applications submitted to state agencies and EPA:
Narragansett Electric Company; This bubble, which was approved in Janu-
ary, 1981, will save the company an anticipated $3 million in fuel costs an-
nually. The application involves increases in sulfur emissions at one boiler
as a result of burning higher sulfur oil and reduced emissions at a second
unit either through the use of natural gas or by ceasing operations. In addi-
tion to significant cost savings, the bubble will result in a 30-50 percent
decrease in sulfur emissions and will cut consumption of imported oil by
50,000 barrels per month.
3M Company; This pending bubble application involves the use of an inno-
vative control technology to reduce hydrocarbon emissions on several tape
coating lines in exchange for relaxed controls on other lines. 3M estimates a
savings of $3 million in capital expenditures and $1-2 million in annual oper-
ating and maintenance costs.
Although the achievements of these programs to date.have been significant,
even greater cost saving opportunities exist, in almost all the offsets and
bubbles cases, emission reductions were achieved within a single facility.
Few cases have involved more than one plant, despite the fact that less expen-
sive emission reduction from neighboring sources may have been possible.
There may also be situations as is typically the case with small firms or
for new firms locating in an area).where internally generated emission reduc-
tions for either bubble applications or offsets are not feasible. These firms
must seek other firms to take advantage of these programs.
In the absence of a banking system, arranging offsets or bubbles between
two different industrial facilities not under common ownership is very diffi-
cult. Without a banking system, firms cannot receive advance 'credit for
reducing emissions beyond legal requirements and therefore would not volun-
tarily do so. As a result, no ready supply of emission reductions has existed
in the past and firms seeking emission reductions have had difficulty finding
needed reductions from other firms.
Administrative delay-, and uncertainty are additional factors limiting the
purchase and sale of emission reductions. A firm negotiating to purchase
emission reductions from another firm needs some assurance as to the quantity
and characteristics of the .commodity it is purchasing. In the absence of a
banking system which serves to quantify, verify and certify reductions, no
such certainty exists.
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1.3 THE ROLE OF PRIVATE TRADING
By December 1980 three areas had adopted comprehensive banking programs.
Within the next 12 months approximately 20 additional states and localities
will have comprehensive banking systems in operation. The spread of banking
systems throughout the country provides the necessary foundation for increased
activity by firms buying and selling emission reduction credits in order to
reduce their costs of meeting control requirements. This manual focuses on
private trading among individual firms, the most straightforward arrangement
for bringing together firms interested in buying and selling ERCs.
The primary feature of private trading is that transactions occur through
private negotiations without direct government involvement. Private trading
characterizes the process by which most commodities (e.g., cars, houses, land)
exchange ownership in our economy. But certain inefficiencies exist in private
trading. For .example, firms interested in purchasing offsets often will not
have the knowledge of potential sellers or the expertise to evaluate offers,
arrange financing, execute a contract, etc.
As with the sale of many other commodities, businesses have been formed
that can earn a profit by assisting firms in arranging transactions. (See
Exhibit 1-2.) Real estate brokers, stock brokers, and commodity dealers are
_ju_st_ a few examples of situations where intermediaries serve an important
function in making~the market work. Environmental engineering firms have
already functioned as brokers..in several major offset cases. As banking and .
trading activity increases, brokers are likely to become an important feature
of ERG trading. ' :
THE BEGINNINGS OF A MARKET
Will firms actively participate in buying and selling ERCs? At least
initially, firms are likely to be reluctant because they are uncertain of the
market price and of future.availability. But during the past year, several
promising signs have appeared that suggest a market for ERCs will develop:
Several environmental engineering consultants have played
an important role in locating offsets for new and expand-
ing firms.
New firms have recently been started to aid industry in ERG
banking and use of the bubble policy.
Several firms seeking to sell ERCs have placed advertise-
ments in major business journals.
Each of these activities represent important steps toward creating a viable
market for trading ERCs.
i -8
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EXHIBIT 1-2
THE USE OP BROKERS CAN MAKE PRIVATE TRADING MORE EFFICIENT
PRIVATE TRADING
PRIVATE TRADING WITH BROKER
The ERG seller needs an effective
way to seek out potential buyers.
A broker brings potential
buyers and sellers together.
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1.4 EVALUATING ALTERNATIVE TRADING SYSTEMS
Because private trading is the most direct means of bringing together
firms seeking to buy and sell ERCs, it is the approach many communities are
likely to adopt. There are, however, other ways to structure transactions
involving the sale of ERCs. Two potentially attractive trading systems
described in companion publications are:
Public Ruction System. The auction system uses a local
organization to administer the entire auction process:
accepting ERCs to be put up for sale, determining which
firms are eligible to participate, conducting the auction,
and recording the sales which occur. Public auctions are
open and avoid problems that may arise when potential
buyers are excluded from the opportunity to purchase ERCs.
It is the most efficient means of bringing together groups
of interested buyers and sellers of ERCs.
Central trading System. A single organization, called a central
trading exchange, would be responsible for buying ERCs from producing
firms and reselling them to user firms. The association would be
charged with negotiating purchase prices, setting resale prices, and
acquiring and maintaining an ERC inventory. The central trading
system is particularly useful in protecting small businesses, in
providing a stock of ERCs that are readily available to potential
buyers, and in providing a ready market for firms creating ERCs.
This system is expensive to start, and sales and purchase prices may
'be'difficult to determine. .
Because of the particular strengths and weaknesses of these systems, a
community may want to structure a trading program which combines aspects of
two or more of these prototypes. For example, in Puget Sound, firms creating
ERCs have up to seven years to use or sell them through private negotiations,
after which time they would be sold through a public auction.
1.5 THE ADVANTAGES AND DISADVANTAGES OF PRIVATE TRADING
In examining the desirability of relying primarily or exclusively on pri-
vate trades, a community will want to carefully consider a number of factors.
Likely advantages of private trading include:
Little public involvement or resources are required. A key advantage of
private trading is the minimal amount of public financing needed to administer
the program. Because firms finance their own trading activities, the public
role is limited. To the extent that a public body gets involved to provide
information and assistance,-these functions will be neither time-consuming nor
very expensive.
Brokers play a multi-functional role. In addition to bringing ERC pro-
ducers and users together, brokers are likely to serve a number of other
important purposes as well. Brokers can act as channels of information; for
example, spreading the word about innovative abatement technologies among
interested firms. Brokers also may provide technical and financial assistance
, no
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to firms at all stages of the banking and trading process, from identifying
possible ways of producing ERCs through the final sale of ERCs to another
firm.
Gaps in coverage by brokers can be filled by a public agency. Although
brokers can perform many services, the local public agency can fill gaps in
this service by providing information clearinghouse activities. The clearing-
house function gives prospective buyers and sellers of ERCs a central location
for obtaining information; this information can be used to supplement informa-
tion from brokers or it can help trading parties decide if they need the ser-
vices of a broker. The public agency also can selectively serve as a broker
for proposed developments of particular interest to a community.
Limited Public Resources Can Be Effectively Used. By allowing private
trades to encourage the production of inexpensive ERCs, scarce public resouces
can be carefully targeted to achieve economic development goals. Local
economic development agencies can participate in the private marketplace by
buying or subsidizing the purchase of ERCs by firms selected by the community
for economic assistance.
Likely disadvantages of private trading include:
Private trading is difficult to use to influence economic development.
Because the public sector has very little involvement in or control over the
private trading of ERCs, it will be difficult to control trades to effect
'desired economic development objectives.'' Under a central'trading'system, for
example, the central'trading exchange can use the purchase and resale of ERCs
as a way of directing economic development. If it wants to encourage growth,
the sale price of ERCs can be set low; if additional ERCs are needed to expand
the industrial base, the purchase price for ERCs can be raised. Private trad-
ing is far more limited in its ability to achieve these objectives.
Private trading limits the access of potential buyers to available ERCs.
By definition, private trading does not ensure the same degree of free and
open access to the system as does either of the other trading system options.
Even where brokers are used to arrange transactions, all interested buyers do
not have an equal chance of buying a particular ERC. Trades are arranged
selectively rather than publicly.
In addition, private trading may not result in public prices because
transaction information is known only to the parties involved (buyer, seller
and broker). This failure to disseminate price information may interfere with
the efficient functioning of the market. Potential buyers and sellers will
not have any information about past sales prices and therefore will have no
basis for their own decisions. It is possible, however, to require price
disclosure as part of a formal banking and trading system.
Firms may try to use their ERCs for anti-competitive objectives by refus-
ing to sell them to competitors, or by cornering the local market on ERCs to
prevent competitors from moving iri. Although private trading does not directly
prevent this type of behavior, antitrust restrictions would apply to deter
such actions.
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The costs of bringing buyers and sellers together may be higher with
private trading than with the other two trading mechanisms. The absolute cost
of making trades may be quite high for buyers and sellers. The producer and
purchaser must find each other, either on their own or through a broker, and
time consuming negotiations are likely. Moreover, the agreed-upon sale price
must also cover the broker's commission, raising the cost of the transaction.
An auction or central trading system would involve lower costs of bringing
together firms interested in buying and selling ERCs.
A community considering private trading as the sole or primary trading
mechanism should weigh carefully all these advantages and disadvantages in the
context of its particular local conditions and economic development objectives.
1.6 SCOPE OF THIS MANUAL
Because of the demand for emission reduction credits for use as offsets by
new or expanding firms and for use in bubbles to reduce control costs for
existing firms, some private trading is likely to occur once a banking system
is adopted by an area. But trading activity, at least during the initial
months following adoption of a banking program, will probably be limited.
Some firms may be reluctant to sell, their ERCs, fearing that few will be
available for purchase in the upcoming years. Many more firms will be unaware
of the possible profits from conducting an "emission reduction audit" of their
facilities to establish the costs of creating bankable reductions. Until a
number of trades have occurred, the absence of any clear price signals may
deter activity by potential buying and selling firms. Finally, the costs of
bringing together interested firms may initially be high.
This manual explores a number of constructive actions to overcome these
potential difficulties. Chapter 2 examines the role of "brokers" in assisting
firms interested in buying and selling ERCs. Chapter 3 discusses possible
activities for public agencies, particularly air pollution control agencies,
economic development, and planning organizations that want to pursue a trading
program as part of a comprehensive program to achieve the full economic and
air quality benefits of controlled trading.
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2. THE ROLE OF BROKERS IN TRADING ERCs
Brokers play an essential role in many markets, although the types and
extent of services provided as well as the functions performed may vary con-
siderably. For example, stock brokers provide investment counsel as well as
stock transfer services. On the other hand, most real estate brokers perform
more limited counseling functions; their primary role is to bring buyers and
sellers together. Die kind of market involved will determine both the need
for and the opportunities available to brokers. The particular services and
functions provided by ERG brokers, described in Section 2.2, are likely to be
qualitatively different from those performed by other brokers, largely because
of the more technical nature of the market.
In addition to performing the obvious role of bringing buyers and sellers
together, ERC brokers may also provide technical assistance on pollution con-
trol options, permit changes, and other regulatory requirements. This Chapter
discusses the possible roles of brokers in ERC trading including:
who is likely to act as an ERC broker;
the possible functions brokers could perform in trading
ERCs;
the legal status of brokers as agents and fiduciaries;^/
the ways in which ERC brokers may be compensated for their
services; and
the possibility of brokers taking on the additional role of
buying and selling ERCs themselves.
2.1 WHO MIGHT BECOME A BROKER
The use of brokers to trade ERCs is a specialized application of the more
general activity known as brokerage. Brokerage involves the bringing together
of parties interested in making a transaction. If the subject is a real estate
transaction, a real estate broker is generally used; "media brokers" are used
to arrange the sale of radio and TV stations, including the transfer of broad-
cast licenses; stock brokers arrange transactions in registered securities.
In each instance, the broker acts as an agent on behalf of a principal (either
the buyer or the seller) and is paid a commission which is usually a percentage
of the amount involved in the transaction. Historically, brokers have played
important roles in fostering economic and social development of all kinds by
helping to make markets work.
!/A "fiduciary" is someone entrusted with the responsibility to act on
behalf of one party with respect to other parties involved in a business situ-
ation (e.g., a trustee).
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A number of individuals and organizations might have the skills and in-
terests necessary for providing services to interested firms. The following
groups are likely to have the qualifications which would enable them to act as
private ERG brokers:
consulting engineers;
industrial real estate brokers;
industrial locators and developers;
vendors of pollution control equipment;
pollution control engineers;
venture capital firms and financiers; and
other professionals who specialize in environmental and air
pollution issues.
The skills and qualifications necessary for ERG brokering reflect the
functions that brokers are likely to be asked to perform. In addition to the
general financial and pollution control knowledge needed by most brokers, ERG
brokers will need to be familiar with various aspects of industrial develop-
ment, permit requirements and administrative procedures, state and local rules
for banking and trading, and tax and financing matters. The specific combina-
tion of skills will depend on the particular services a broker chooses .to
provide.
2.2 FUNCTIONS PERFORMED BY BROKERS
Generally speaking, the primary function performed by ERG brokers will be
to bring together a buyer and a seller. ERG brokers may also perform other
functions, however, including:
appraising the market value of a potential ERG and the
costs of producing it;
providing assistance in securing financing for producing or
purchasing a surplus emission reduction;
counseling potential ERG buyers and sellers about market
facts and trends;
arranging other services such as engineering analysis and
performance bonding where necessary;
providing assistance in preparing appropriate paperwork and
securing necessary permits; and
supplying legal advice (only in the case of licensed
attorneys) or accounting services for tax planning.
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In addition to facilitating trades of existing ERCs, brokers also may take
a major role in assisting firms who would like to produce ERCs for trading (or
banking) purposes. This responsibility would be especially appropriate for
brokers with training or experience in pollution abatement strategies enabling
them to identify possible sources of ERCs. While such a service is not typi-
cally associated with brokerage duties, it is clearly one which ERC brokers
may find desirable to offer.
Exhibit 2-1 depicts the possible roles for ERC brokers in each of the six
key phases of the banking and trading process: identification and creation of
potential emission reductions; confirmation and quantification of the emission
reduction; certification of the ERC; banking the ERC; trading of the ERCs; and
using of the acquired ERC.
1. Brokers can play a pivotal role with respect to the identification
and creation of emission reductions. This role could involve:
locating sources with the potential for creating low cost
emission reductions (e.g., conducting an emission reduc-
tion audit);
evaluating alternative control techniques in terms of
their engineering feasibility;
assessing capital and operating costs of alternative emis-
sion reduction techniques, including process or'input
changes, .revamping product.lines, etc;
appraising the potential market value of a proposed emis-
sion reduction; and
. arranging the financing necessary to create the reduction.
CONDUCTING AN EMISSION REDUCTION AUDIT
In the absence of a banking and trading system, firms have little reason
to examine their production facilities to determine the possibilities and
costs of creating bankable emission reductions. Once a banking system is
developed which allows them to receive credit for these reductions, firms will
want to assess their potential for creating reduction. Plant managers may be
instructed to review control strategies to determine the cost at each point
source of more stringent controls. These emission reduction audits will pro-
vide useful information to plant managers and financial planners in evaluating
whether it is less expensive to meet control requirements through the use of a
bubble and whether any needed offsets should be created internally or pur-
chased on the open market. Through these audits, firms will also be better
able to determine whether they can sell ERCs that they produce and earn a sig-
nificant return on investments in pollution control.
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EXHIBIT 2-1
ROLES FOR BROKERS IN ERC BANKING AND TRADING
Banking and Trading Process
1.
2.
( Creation of
I Emission
I Reduction
Confirmation
of Emission
Reduction
Potential Broker Services
Locating eligible sources
Evaluating engineering feasibility
Studying economic feasibility of
various control strategies
Appraising market value of reductions
Arranging financing
Documenting emission reductions
Performing engineering analyses
Preparing application and technical
documents
Monitoring
Verifying performance
3.
j Certification
i of Emission
i Reduction Credit
\
\
\
/
/
Preparing required application
Verifying eligibility
Documenting application
4.
5.
;
Conducting market value appraisals
Evaluating proposed uses
Locating trading partners
Arranging financing
Evaluating potential trades
Providing tax planning and legal advice
6.
Use of
Credit
Evaluating potential uses
Submitting permit application
Performing engineering analysis
a Obtaining financing
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All of these services could be provided by private brokers on behalf of
either buyers or sellers of ERCs. A broker retained by a buyer to locate ERCs
could act as an agent in identifying potential ERC producers. Alternatively,
a broker might be retained by a firm desiring to create and sell ERCs for the
most advantageous price. Here, the broker could assist in identifying the
most economically attractive and technically feasible emission reductions, and
in transforming these reductions into ERCs through the official confirmation
and certification process.
To perform these functions, ERC brokers will need a fairly detailed under-
standing of air pollution control technology and the likely cost of different
control strategies. Brokers experienced as consulting engineers might be re-
tained to work with the plant manager to identify innovative control strate-
gies. By performing this service, brokers will in effect also hasten the
dispersion of an innovative control technology.
11. The confirmation of emission reductions requires official verifica-
tion of the quantity and permanence of the emission reduction created. Brok-
ers could assist sources in preparing the appropriate technical documentation
required for permit and banking applications. Depending on the type of trans-
action this might involve monitoring analysis of production or input data,
stack tests, etc. In most instances it will be necessary to provide documenta-
tion for emissions levels both before and after the emission reduction occurs.
. . 111. The certification of emission reductions and their conversion into
ERCs is the third phase of a banking and trading program. Brokers are likely
to be involved in preparing the required applications and technical support
documents required by the air pollution control agency.
IV. The fourth stagebanking the BRCsrequires little action on the
part of sources. In general, sources with banked ERCs need to do nothing to
retain that status. However, these sources might hire brokers or consultants
to appraise the current market value of banked ERCs and the desirability of
trading at a particular point in time. This sort of appraisal can assist
sources in deciding whether and when to trade.
V. Brokers are likely to play a major role in the fifth stagethe ac-
tual trading of ERCs. Whether retained by a firm needing to buy or one wish-
ing to sell, a broker can perform the important service of finding another
party to consummate the transaction. Brokers can inform firms of potential
bubble opportunities. In addition, a broker might perform other valuable ser-
vices- in connection with the trading of ERCs. For example, brokers can help
to arrange financing for a particular transaction as well as tax planning
assistance and general legal advice in consummating a trade. Brokers will
also be involved in working with the air agency to determine the quantity of
ERCs at a particular location needed as offsets, or to bubble.
VI. Brokers also may participate in the final stage of a banking and
trading programthe use of ERCs to satisfy a permit or SIP requirement.
Based on guidelines published by the local APCA, a source may propose a use
for a particular lot of ERCs. To help the local authority make a determina-
tion on the proposed use, sources must provide documentation demonstrating
that (1) the pollutant characteristics of the ERCs and the proposed use are
compatible (i.e., same pollutant type and acceptable impact on ambient air
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quality) and (2) the use is compatible with the SIP. The preparation of this
documentation and associated engineering analyses is likely to furnished by
brokers as a technical service.
Summary
The functions performed by ERG brokers are likely to be more diverse than
those conventionally associated with the broker's role. Rather than limiting
their involvement to the actual search for and negotiation of transactions,
ERC brokers may become involved in a wide range of activities in all phases of
the banking and trading process.
2.3 LEGAL STATUS AND DOTISS OF BROKERS
As do brokers of any good or commodity, ERC brokers have a unique legal
relationship with buyers and sellers who use their services. The role of a
broker as an agent of a principal (a buyer or seller) is a fiduciary relation-
ship which is subject to the requirements of the law of agency. Under this
law, an ERC broker is free to accept or reject contract relationships with
potential principals. However, once a contract has been established, the
broker is required to meet the same high standard of conduct as the law imposes
upon attorneys, administrators and executors, guardians, bankers, public offi-
cials, and other persons vested with fiduciary obligations. ""
As an agent, an ERC broker owes the principal certain clear and specific
legal duties arising out of the fiduciary relationship: care and skill,
obedience, accounting, loyalty, and notice.' These duties can be briefly
summarized:
Care and Skill; An ERC broker must exercise a reasonable
degree of care and skill in transacting business on behalf
of the principal. The broker is legally liable for any
losses resulting from his or her carelessness or negli-
gence in arranging ERC transfers, creation, and use.
Obedience; An ERC broker must act in good faith and in
conformity with the principal's instructions and authority.
The broker is legally liable for any losses incurred by the
principal which result from any act which is outside the
scope of authority granted.
Accounting; An ERC broker must be able to report accu-
rately the status of any funds entrusted by the princi-
pal. In many states, fiduciaries are required by law to
deposit funds in' special accounts (trust or escrow) and are
prohibited under penalty of law from mixing this money with
personal funds. .
Loyalty; An ERC broker must always place the principal's
interest above those of other persons with whom the broker
is dealing. Information about the principal's financial
co-ndition, bargaining posture, or any other confidential
, rs
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facts that might harm the principal's bargaining position
must not be disclosed.
Notice; An ERC broker must- keep the principal fully in-
formed" at all times of all facts or information which could
affect the principal's business or purchase decisions. The
broker must also disclose any and all personal interests in
a transaction. In certain instances, a broker may be held
legally liable for losses resulting from failure to dis-
close such information.
There is an additional legal constraint on the way brokers must exercise
their responsibilities. In carrying out required duties, brokers must be
careful to ensure that no statements can in any way be interpreted as involv-
ing fraud. (Fraud refers to all deceitful or dishonest practices intended to
harm or take advantage of another person, including the concealment or nondis-
closure of important facts.) If any party suffers a loss because of a brok-
er' s misrepresentations, the broker can be held liable for damages.
Aside from these basic duties, few, if any, additional legal constraints
or requirements need be placed on the activities of ERC brokers. The nature
of other markets often necessitates additional control or oversight mechan-
ismslicensing, bonding, professional affiliationto help protect the gene-
ral public from dishonest or deceptive brokers. The complexity and sophisti-
cation ,of . the ERC market.is likely to .ensure against this problem, however,
because unqualified individuals would have a difficult time presenting them-
selves as skilled and experienced in ERC transactions. Moreover, the individ-
ual firms involved in ERC trades are likely to be quite sophisticated as well,
and 'therefore would be unlikely to engage a broker whose skills had not been
carefully studied and confirmed. In this sense, neither buyers nor producers
of ERCs can be considered members of the "general public" needing safeguards
against abuse at the hands of dishonest brokers. If this problem is anticipa-
ted, however, or if after a time it develops, rules requiring licensing or
bonding could be adopted as part of the banking and trading system.
2.4 THE ERC BROKER AS AGENT
The legal status of an ERC broker, according to the law of agency, is
that of a "special agent" authorized to represent the principal in one speci-
fic transaction or piece of business. As a special agent, a broker may be
retained by a seller to find a ready, willing, and able buyer, or by a buyer
to find a ready, willing, and able seller of ERCs. As a special agent, the
broker is not authorized to bind the principal to any contract or to consum-
mate a sales deal.Zr
Z/ln contrast, a "general agent" may sign contracts on behalf of a
principal and may thus bind the principal to obligations within the scope of
the agent1 s authority. A "general agent" must be specifically authorized to
represent the principal generally or in all matters concerning one aspect of
the principal's interest.
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A broker may be an agent either of a buyer or a seller of ERCs. The gene-
ral rule of law is that an agent cannot be "loyal" to different principals
with different interests in the same transaction. Most courts will allow a
broker to receive compensation from both the buyer and seller in a transaction
if there has been prior, mutual knowledge and consent of all the parties,
although some state courts have rejected this "informed consent" exception.
An agency relationship is created by agreement of the parties. When a
broker is retained to represent a seller, a contract- will be prepared which
describes the property to be sold, the broker's duties, and the compensation
for successful performance.- Similarly, when a broker is retained to represent
a buyer, an employment contract between the broker and the seller may be pre-
pared. These contracts do not guarantee that the broker will be able to find
a buyer or seller, but do obligate the broker to use reasonable effort to
carry out successfully the assumed agency duties. Contracts also bind princi-
pals to provide compensation to brokers in the manner spelled out in the
agreement.
2.5 COMPENSATION FOR BROKERS
The broker's monetary compensation is usually specified in the agreement
made with the firm engaging his or her service. Compensation often takes the
form of a "commission" or brokerage fee computed as a percentage of the total
amount of money involved in the..final transaction, though a flat fee or hourly
rate may be negotiated instead. Host sales commissions are payable when the
.sale is consummated. ' ..- ....
The economic rationale for using and compensating brokers reflects their
ability to reduce the costs of transacting a trade for their principals. To
work efficiently, markets depend on accurate information and informed traders;
brokers are a source of market information as well as a resource for locating
trading partners. Principals who choose to use brokers rather than to rely on
their own efforts at direct negotiation have obviously made a judgment that
the cost of the broker's commission is less than the cost of transacting the
trade without a broker. Where transaction costs are relatively high in tha
absence of broker involvement, there is a potential role for brokers to reduce
the costs of a trade while earning a commission for themselves.
Costs specific to the trading of ERCs include the cost of finding a ready,
willing, and able buyer or seller and the cost of applying for a transfer of
credits and preparing the necessary documentation. Clearly, the complexity of
the process and the difficulty of bringing together buyers and sellers of ERCs
indicates that transaction costs are sufficiently high to compensate brokers
for their services.
2.6 DEALERS AND BROKER-DEALERS
Special consideration needs to be given to dealers and "broker-dealers"
concerning their participation in ERC trading. In contrast to a broker who
effects business transactions for others, a dealer is someone who buys and
sells on his or her own account. A broker-dealer is someone who is both a
broker and a dealer. Broker-dealers are common in the markets for securities
and commodities, but less common in the real estate business.
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In an ERC market, a "dealer" would both buy ERCs for resale and sell ERCs
out of a purchased (or financed) inventory. Such purchases and sales would be
credited to the dealer's own account; the dealer would not be acting as an
agent for the buyer or seller. The dealer receives no brokerage commission
but relies upon a favorable difference between the prices at which the ERCs
are bought and sold (i.e., the "mark-up") for compensation. Any risk of loss
thus falls entirely upon the dealer.
As noted earlier, the law is designed to prevent agents from acquiring any
independent interest which might tempt them to act against the best interests
of their employers. However, considerable latitude exists for the exercise of
the functions of broker and dealer by the same person, provided "complete dis-
closure" is made.
For example, if employed to sell ERCs, a broker-dealer may not, without
complete disclosure to the customer, purchase them for his or her personal
account. Similarly, if authorized to purchase ERCs, the broker-dealer may not
supply them from a personal account without disclosure of this fact. A pur-
chase or sales transaction made without the required disclosure may be can-
celled at the will of the customer even though no actual damage was sustained
and the broker-dealer perpetrated no actual fraud.
. BUYING ERC OPTIONS "
Transactions involving options have become an established way of doing
business for a number of commodities similar to ERCs. Firms buy options on
land when they are uncertain about future expansion plans and want to minimise
their front end capital expenditures. Precious metals, grains, and many other
commodities are traded through the purchase and sale of options.
Why would firms and brokers want to get involved with ERC options?
Options offer several important advantages to ERC traders. Most impor-
tant, by buying an option for ERCs, firms can insure their availability with-
out incurring the significant capital costs often necessary to install addi-
tional pollution control equipment. In addition, just as options are critical
to firms assembling large parcels of land, firms might purchase ERC options as
they negotiate large offset transactions. .
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Summary
Although the expertise needed of ERC brokers and the tasks they will per-
form are likely to be quite diverse, there appear to be several types of or-
ganizations and individuals which easily could carry out some or all of the
functions likely to be needed or requested. In this sense, there already
exists a qualified pool of potential brokers which could easily meet the de-
mands of a new trading program, and in fact, several major offset transactions
have involved the services of a broker. Brokerage functions offer an attrac-
tive opportunity for engineering firms, industrial location firms, environmen-
tal consultants and related professionals to extend their current activities
into a potentially profitable new area.
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3. THE ROLE OF A PUBLIC AGENCY IN PRIVATE TRADING
Private trading of ERCs between individual firms is attractive because it
requires minimal attention or resources from the public sector. The little
public agency involvement that does occur can, however, enhance the effective-
ness of the private trading system by performing some relatively simple and
< inexpensive administrative tasks, and by filling gaps in service that might
i otherwise exist. The public agency's role can make the difference between a
i private trading program that serves a community well and one which is less
I able to meet the community's best interests.
j
| The public agency's role encompasses five specific activities:
(1) providing an information clearinghouse;
i
; (2) providing guidance about contracts with brokers;
(3) establishing a price disclosure mechanism;
i (4) acting as a broker (optional); and
(5) coordinating with other programs.
/ - In general,-.these activities provide participants in the, .trading system
with information and assistance that are not necessarily available otherwise.
Activities in support of the trading program could be performed by the air
pollution control agency but, because they are more directly linked to eco-
nomic assistance, they will generally fall within the domain of economic
development agencies or planning organizations. (See Exhibit 3-1)
3.1 PROVIDING AN INFORMATION CLEARINGHOUSE
j One concern of a trading program limited to private transactions is that
| parties will not have enough information to make the best possible trade.
I This lack of information could result in behavior (e.g. unawareness of less
j expensive ERCs, failure to bargain with all possible buyers or sellers) that
j limits the effectiveness of ERG trading and thereby unintentionally limits a
' community's economic growth. One of the most useful functions that can be
( performed by a public agency (e.g., Council of Governments, Economic Develop-
| ment Agency, Regional-Planning Association, etc.) is to supply the information
needed to improve ERC trading activities. Four general kinds of information
can be provided to parties engaged in ERC trading.
;
i
o List of brokers; The public agency can maintain a direc-
tory of brokers who are active in the ERC market. This
i directory will have updated information about how to con-
i tact brokers, whether they specialize in providing certain
j kinds of services, how long they have been brokering ERCs,
i a list of past clients, and other relevant information.
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- 20 -
EXHIBIT 3-1
-\
Industry Groups'
\
Inform Members '
\
DEVELOPING AN INTEGRATED
BANKING AND TRADING PROGRAM
\
Regulates System to
Protect Air Quality
Development
Agency
Promote Industrial
Growth; j
' A Provide Technical.1
v. / Regional
/ Planning Groups \
Encourage Trading /
Establishe Public/''
Goals
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- 21 -
List of potential ERC sellers: The public agency may peri-
odically publicize the names of sources holding ERCs in the
bank or undertake a study or survey to identify likely
sources for producing ERCs. These lists would be a valua-
ble resource to firms seeking to locate in the community,
or seeking to bubble as a means of compliance.
Financing information; The public agency may also provide
information or assistance to firms concerning the possible
ways of financing the creation or purchase of ERCs. A man-
ual could be prepared to highlight possible financing mech-
anisms, their applicability, and any application proce-
dures. This material should include information concerning
federal, state and local government programs as well as
private avenues of funding.
Necessary permit changes; ERC certification procedures,
and other regulatory requirements fall within the purview
of the APCA or other air quality regulatory organization.
Potential ERC traders should be directed to that agency for
information about procedural and other requirements for
using ERCs to satisfy regulatory requirements.
The information clearinghouse role supplies a missing dimension to private
trading and helps make it more effective. .Private trading can be further en-
hanced if guidance is provided concerning the nature of agreements made be-
tween brokers and ERC buyers and sellers. A discussion of this issue follows.
3.2 PROVIDING GUIDANCE ABOUT BROKERAGE AGREEMENTS
One very important decision that will be faced by producers or sellers
deciding to work through an ERC broker is. how to structure the brokerage
agreement. It is likely, at least during the initial stages of the program,
that the possible forms which a broker-principal agreement can take may not be
known or fully understood by many producers or sellers of ERCs. One key func-
tion which the public agency can perform is to provide guidance on the various
contractual options, pointing out their relative advantages and disadvantages.
In general, ERC buyers are likely to negotiate an agreement whereby they
pay the broker much as they would a consultanteither a cost-plus-fee ar-
rangement or a percentage of the value of the transaction. These agreements
are not very complicated to arrange and are of the type that most firms seek-
ing ERCs will have used frequently in other contexts.
The agreements available to the ERC producer are more complicated and may
be less familiar to such firms. A broker's inventory consists of ERC "list-
ings" obtained from prospective ERC sellers. A "listing agreement" consti-
tutes the contract of employment between the ERC seller (principal) and broker
(agent). Thus, when the broker has been retained by the seller, the ERC list-
ing agreement spells out the rights and duties of each party. Several differ-
ent kinds of listing agreements or employment contracts are commonly used.
Each has different implications for trading ERCs. The public agency can
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- 22 -
inform potential ERC sellers about these listing agreements and about the im-
plications of each kind of listing. The most common- listing arrangements
are described below, and their consequences for ERC trading are noted.
Open Listing; The seller retains the right to employ any
number of ERC brokers to act as agents simultaneously. The
seller is obligated to pay a commission only to that
broker who successfully produces a ready, willing, and
able ERC buyer. This contract option can, but does not
necessarily, achieve wide exposure of ERCs to firms need-
ing them. Under this option, attempts to sell ERCs are
limited only by the seller's own efforts in arranging for
brokers to handle offered ERCs.
Exclusive Agency Listing; Only one broker is authorized
to act as the agent for sale of the ERC. The ERC owner
retains the right to sell the ERCs without obligation to
the broker, unless the broker was responsible for the
sale. Efforts to sell ERCs are limited to the actions of
one broker and any private initiatives by the selling firm.
Exclusive Right to Sell. Only one ERC broker is appointed
as agent with the exclusive right to sell the ERCs in
question. The seller gives up the right to sell the ERCs
and must pay the broker a commission, regardless of who
actually sells the'ERCs. Prom the broker's standpoint',
this is the preferred contract optionthe broker is
assured of a commission'if the ERC changes hands. This
type of listing, however, limits sellers by requiring them
to give up for a time the right to sell its ERCs or to
hire another broker.
Net Listing. The broker agrees to pay the ERC seller the
net listing amount, and the broker is free to offer the
ERCs for sale at any higher price. The difference between
the net listing amount and the sales price is retained by
the ERC broker as a commission. This option creates a
conflict between the interests of the broker and the
seller; with the more usual percentage commission, a
higher selling price benefits both the broker and the
seller. But under a net listing, a higher price benefits
only the broker (and of course lessens the likelihood of
any sale).
Except for net listings; which are illegal in some states, all of the above
types of brokerage employment contracts can be used. A contract will generally
create an open listing unless specifically provided otherwise in the agreement.
3.3 ESTABLISHING A PRICE DISCLOSURE MECHANISM
Prices paid for ERCs traded privately may not be publicly-available
because (1) private trading does not take place in public, and (2) private con-
tracts may be drafted in a manner that obscures the price paid for ERCs even
if the contracts are made public. The lack of publicly available prices is a
i 36
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- 23 -
major disadvantage because public prices act as an important signal for poten-
tial buyers and sellers. Without knowledge of the prices from past transac-
tions, firms interested in buying and selling ERCs will lack the necessary
information to make a rational decision. It is possible, however, to overcome
this disadvantage by incorporating two alternative requirements as part of the
banking rule:
(1) an ERG transfer application, or
(2) a standard form of sales contract.
Either of these devices will accomplish the objective of public prices;
there should be no need to require both. Before either of these two price
disclosure strategies can be used, however, a basic question must be resolved:
Can price disclosure legally be required?
The legality of requiring price disclosure. Dnlike the auction and cen-
tralized systems for trading ERCs, private trading does not directly result in
publication of sales prices. It will be necessary, therefore, for price dis-
closure to be required by administrative rule. The rule should be part of the
banking system and require that price disclosure be made before ownership of
the ERCs is formally transferred on the banking registry. (Price disclosure
is required in other areas. For example, the prices paid for houses are
available to the public.) Only in cases where parties demonstrate that price
.disclosure ..would reveal., confidential business information would an exception .
from this requirement be reasonable.
ERG Transfer Application. The most straightforward means of getting
needed price information is to ask for it. The banking authority or any prop-
erty designated public agency can require the disclosure of sales information
as a condition of transferring ERCs on the banking registry. The trading
firms can be required to disclose the sales price and to supply a copy of the
transfer contract or sales agreement at the time the transfer is recorded. In
this way, price information would be public.
The disclosure requirement should cover all cash and non-cash (e.g.,
stock) compensation or benefit received by the seller as a result of the
trade. It still may be possible, however, for transfer agreements to be
drafted in such a way that the price paid for ERCs is obscured. The use of
special forms for sales contracts should be considered as a means of eliminat-
ing this problem.
Standard Forms of Sales Contracts. Most businesses are interested in
protecting certain confidential financial and commercial information. If a
firm involved in an ERG transfer is concerned about making public certain de-
tails of the transaction, the sales contract may be written so as to obscure
the actual price paid for the ERCs. As a result, the public agency might find
it difficult to determine the exact sales price in a given trade. The re-
quired use of a special form for sales contracts would alleviate this situa-
tion. '
A form for transfer of ERCs can be drafted by the public agency for use
by prospective traders. Many local real estate boards, for example, commonly
prescribe form contracts for real estate sales. The form could be simple and
straightforward, including:
) 37
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- 24 -
details of the transaction;
value of the compensation received for the ERCs; and
any protection provisions negotiated.
Details of the transaction might include a description of the ERCs pur-
chased. The value of the transaction should include monetary as well as other
1 forms of compensation. Protection provisions specified by the contact may
! include indemnification provisions, insurance requirements, or equipment
! performance bonding (in the case where the ERC purchaser installs pollution
j control equipment in a facility operated by the producer of the ERCs). In
! addition to providing a valuable- source of market information for future
participants in ERC trading, such a standardized contract form would ensure
the consistency and clarity of the formal record of ERC transactions.
3.4 ACTING AS A BROKER
I :
i In the past, public agencies have in several cases taken an active role
| in arranging offsets for firms seeking to locate in their communities. For
! example, in Pennsylvania, the State Department of Environmental Resources
arranged for the creation (by the State Transportation Agency) and prevision
of offsets to Volkswagen, enabling that firm to construct and operate a plant
dn-western Pennsylvania. . There are two brokering functions that public, agen- ,
ices are likely to perform:
. assisting private firms in identifying and, financing oppor-
tunities to create ERCs; '
subsidizing the purchase of ERCs as a means of inducing
firms to locate or expand in a community.
In both of these situations, the public agency may find it desirable to
directly influence the private trading process by performing the services of a
broker.
Although brokerage activities would significantly increase the role of
the public agency, such activity is not unprecedented. Economic Development
Agencies (EDAs) have always been actively involved in trying to attract new
industry to a community. The EDA promotes the economic well-being of a com-
munity by, among other things, arranging land, zoning, transportation, and in
this instance the offsets necessary to locate in a community.
Most public agencies would prefer having direct control over a supply of
ERCs to use to attract industry into an area, but this generally will not be
feasible. One likely source-, surplus emission reductions at municipal facili-
ties, will generally be limited in number and expensive to produce. Although
it may be possible to confiscate a portion of ERCs created by shutdowns or to
place a tax on the creation of all ERCs, such a policy is likely to have the
unwanted effect of reducing banking and trading activity and should be adopted
only after careful consideration of its legality and desirability.
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- 25 -
The same objective, providing ERCs to industry as a way to encourage eco-
nomic development, can be accomplished indirectly through a thriving ERG mar-
ket in which offsets are readily available for private purchase or through the
uae of public funds to purchase ERCs from the marketplace for donation to
j incoming firms. Public funds may be available for this purpose through the
! use of industrial development bonds and state and federal economic assistance
I programs.
I
i
j 3.5 .COORDINATING WITH OTHER PROGRAMS
;
J The public agency can coordinate private trading activities with other
i relevant programs in the community. Two areas that must be closely integrated
| are the trading and the banking programs, as illustrated in Exhibit 3-2.
Coordination with the Banking Program
i The public agency can help trading parties coordinate with the banking
i authority regarding requirements that must be satisfied before the formal
j transfer of ERCs on the banking registry can be made. Because the use of ERCs
to satisfy emission limits will be an important part'of most trades (i.e.,
purchasing ERCs to use in a bubble or to satisfy new source offset require-
ments) , the APCA must be involved in reviewing the proposed transaction. It
is essential that the public agency not make representations about the use of
ERCs.without prior consultation with the APCA.
As the first step, the parties submit either the required transfer con-
tract!/ of an equivalent application to the banking authority. The banking
authority must officially transfer ownership rights by cancelling ERCs, re-
registering the affected ERCs and/or re-issuing new ERG certificates. After
this has been done, the public agency may publish or make available to the
public the sales price for the ERCs traded and other relevant details based on
the disclosure rules which have been adopted. Finally, if the buyer decides
to use the purchased ERCs, it is up to the APCA to approve their use. If the
ERCs are used to satisfy emissions requirements, the bank will debit the
user's ERC account accordingly.
Coordination with Other Trading Mechanisms
A community may use a trading system that includes both private and public
sales as described in Chapter 1. If so, the private approach will be used only
in some trading situations, and coordination should be maintained with other
kinds of trading activities. Potential producers and users of ERCs should be
kept informed of trading possibilities outside the private sphere. For ex-
ample, if an out-of-state firm contacts a public agency about SRCs for a
transfer contract and special form should expressly state that
the contract is "contingent" on official approval by the banking authority.
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-26 -
EXHIBIT 3-2
PROGRAM ELEMENTS AMD INTERRELATIONSHIPS
Trading Program
Banking Program
o Trading Authority
o Trading Rules &
Mechanisms
o Promotion
o Approval of Trades
o Coordination
o Information
o Banking Authority
o Certification & Registration
of Emission Reduction Credits
o Re-registration of Traded Credits
o ERC Tracking & Accounting
o Coordination
o Information.
Air Pollution Control Program
o Air Pollution Control Authority
o Confirmation of Emission Reductions
o Monitoring and Enforcement
o Permit Issuance and Modification
o Air Quality Modeling
o Technical Services
o Coordination
o Information
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- 27 -
particular pollutant, it should be able to provide the firm with information
about possible sources of the needed ERCs including the existence of brokers
and any public trading avenues.
Another aspect of the coordination should involve joint publicity and
promotional efforts. The availability of ERCs and the operating of banking
and trading should be publicized in a uniform fashion. The promotional activ-
ities of the banking authority, other trading organizations, individual brok-
ers, and other local organizations (e.g., EDA, Chamber of Commerce) can be
combined to form a comprehensive presentation of the ERC trading activity and
support available within the community.
Although many of the functions performed by the public agency are de-
signed to facilitate private trading using brokers, the information and guid-
ance will also be of use to ERC producers and buyers who choose not to use a
broker1s services. The services performed by the public agency can provide
participants in private trading with assistance which would not otherwise be
available.~ In so doing, the effectiveness of the private- trading option is
enhanced without requiring a large commitment of public resources. Once the
services to be provided by the public agency have been identified and the
necessary information assembled, only minimal administrative activity will be
needed, as Section 4 describes.
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4. ADMINISTERING PRIVATE TRADING
This section summarizes the administrative support required for the on-
going activities of the public agency involved in promoting trading activi-
ties. Although the public agency has fewer responsibilities under the private
trading system than it would in either the auction or central trading systems,
it could perform at least five Important functions:
(1) to serve as an information clearinghouse;
(2) to provide guidance on agreements with brokers;
(3) to disclose price information;
(4) to serve as a broker; and
(5) to coordinate with other relevant programs.
These functions were discussed in Section 3. The administrative support
needed for these five responsibilities encompasses personnel, financing, and
publicity. This Chapter describes each of these issues.
j 4.1 STAFFING
| ' ' ' : ' , ' . .' ''' '''
! A trading program based on'private brokers should require little staff
| time from the agency which has assumed trading responsibilities. Staffing
j responsibilities are primarily to provide information and to coordinate trad-
| ing activities with other relevant programs and offices. A very limited staff
j probably will be adequate to meet these responsibilities. A program director
i will be required, although this position is very unlikely to be full-time. In
addition to the director, it is. likely that only one other full- or part-time
staff member will be needed to perform the information clearinghouse functions
(maintaining the lists of available ERCs, potential buyers, and interested
brokers) and the general administrative and clerical duties. If the agency
opts to serve as a broker of ERCs, additional staff may be required.
In general, the program should seek some mix of the following skills and
experience: contacts with and knowledge of the area's business community,
familiarity with federal and state clean air legislation and regulations, and
public relations, promotional skills and experience.
4.2 FINANCING
Financing is needed only for administrative functions associated with
operating a private trading program. The responsible public agency's finan-
cial needs should be quite limited, but can vary depending on the types of
services provided by the agency. Generally, the more duties that are assumed,
the greater will be the financial need. Any brokering duties taken on by the
public agency, however, should be self-supporting and should not impose any
additional demand on the agency's financial resources. Manuals on both public
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- 29 -
and private funding opportunities to support ERG funding have been developed
by EPA's Controlled Trading Project Team and should be consulted for specific
sources of financial aid for administrative duties related to ERG trading.
4.3 ARRANGING ON-GOING PUBLICITY EFFORTS
A successful trading program depends upon a good publicity effort to in-
form and interest potential participants. Both an initial effort to develop
interest in the program and on-going information activities are necessary. An
effective publicity campaign will include general information dissemination,
technical assistance for potential ERG buyers and sellers, and a marketing
effort to encourage active participation in the program.
o General information dissemination should focus on acquaint-
ing sources and organizations with the ERG trading program
and how they can benefit by using it. Ideally, much of the
neccessary dissemination will have occurred through public
participation in the design of the program. Nonetheless, a
follow-up to this public involvement should identify likely
participants and develop an information strategy to inform
them of trading opportunities. This could involve a. stan-
dardized packet of information, briefings, or some combina-
tion of the two. At a minimum, the information should ex-'
. ,,. plain the mechanics, and advantages of ERG trading. Potenr
tial users of an ERG trading program include local emitting
sources, those organizations which, could be instrumental in
attracting new sources into the area, pollution control
financing agencies and companies which are considering
locating in the area.
o Technical assistance should be available to potential users
of the trading program. Potential buyers and sellers will
have specific questions about how they can participate in
the ERG trading program. The agency should be able to sup-
ply detailed information to these participants as part of
their information, clearinghouse role.
o Promotional efforts will probably be an integral part of
the agency's publicity strategy. In starting the trading
program it may be necessary to take the initiative in
developing community interest. The trading program's use-
fulness to.businesses seeking to expand, relocate, or plan-
ning for expansion should be emphasized and participation
encouraged.
In summary, the administrative support needed to run a private trading
program includes personnel, financing, and publicity activities. Although the
personnel and financing requirements are much less for private trading than for
either of the other two systems, the publicity and information dissemination
responsibilities are at least as important as in the other systems and are
crucial for the success of private trading.
-------
CASE HISTORY
-------
ONE BROKER'S EXPERIENCE
prepared by
Stuart Rupp
California Environmental Technology
Richmond, California .
,. for ;.
The Brokers' Conference
January 26, 1981
This paper describes one firm's experience with brokering
emission reduction credits. From the firm's early involvement
through its contract negotiations, the paper discusses the steps
taken, problems encountered, and alternative strategies. The paper
includes a draft contract and a list of useful air pollution terms.
-------
ONE BROKER'S EXPERIENCE
STUART RUPP
CALIFORNIA ENVIRONMENTAL TECHNOLOGY
RICHMOND, CALIFORNIA
HOW I BECAME INVOLVED
When emissions offset and banking regulations were first pro-
mulgated in the San Francisco Bay Area our firm saw a potential
business opportunity. At that time, two years ago, C.E.T. was
already established as an industrial consulting firm. We had
extensive experience assisting industries with their environ-
'mental management programs. Emissions' offsets and reduction
banking credits were' a logical extension of our business.
We first evaluated the potential offsets in the Bay Area.
Then we contacted the companies which had the largest quantity
of offsets at the lowest reduction costs. Trade associations
provided us with information about several companies which were
potential offset sources. These associations helped us advertise
by informing their -membership about our services. All the pro-
spective sellers we contacted were uninformed about the offset
concept and the value of their emissions. At first they were
incredulous. Sell pollution? But after hearing a thorough ex-
planation they were very enthusiastic.
Agency agreements .were set up with the sellers and we began
contacting prospective buyers. To locate prospective buyers we
used>informatio"n from business publications and conversations with
-------
members of the business community. The contacts were made; and
we were in business.
BROKERING '
Emission reduction credit brokers provide industry with a
valuable service. The broker will locate emission reduction
sources (offsets), negotiate the contracts, and expedite the per-
mit procedure, all resulting in profits for the client. Brokers
assist new industry in starting operations within a community
while protecting the community's interest in clean air. Both
the public health and the local economy will improve.
TYPES OF INVOLVEMENT
The ERG broker may act as agent for either the purchaser or
seller of emissions offsets. When representing either party the
broker has the same responsibility. making a successful trans-
action.
The bases of the ERG transaction are the types and quantities
of pollutants which are to be sold. This can be determined by
first referring to the local air pollution control district's
(APCD) source emissions inventory. Possible reductions are cal-
culated using various abatement methods. The approximate value
of the offsets is the sum of the reduction costs plus seller's
profit. The final price will depend on market demand and:the ne-
gotiating efforts of the parties. Emission reductions must be
profitable. For the buyer there must be a return of investment.
The seller must have an increase of profits.
-2-
i 4G
-------
A prospective seller may be reluctant to offer his offsets
for sale because the concept is new and not a common industrial
practice. It is up to the broker to instruct the seller on how
the system works. A well prepared broker will carefully explain
the ERG concept, and present cost and profit estimates. Once the
prospective seller is educated, profit will be the inducement to
sell.
Increases in operating or production costs may concern a
prospective ERG seller. If the capital gained from an ERG sale
is invested in more efficient abatement or process equipment
there will be a long term increase in profits. It is the broker's
job to show the seller how he or she can gain the maximum benefit
from an ERG sale.
Compensation for a broker's services can be either a fixed
hourly rate or, when representing a seller, a commission based on
a percentage of the selling price of the ERC's. A commission
arrangement will usually produce a substantially higher compen-
sation than a fixed hourly fee because of the high risk invloved
in all ERG transactions. Not only must a willing buyer be found
but the entire sale is contingent upon the proposed new source
obtaining the required air pollution operating permit. A broker
will spend a great deal of time and incur substantial expenses
in closing a transaction. He or she must find the offsets, find
a prospective buyer, negotiate the contracts, help prepare the
permit application, and carry the application through the permit
-3-
-------
review procedure. Therefore a commission must be commensurate with
the effort, expenses, and risk involved.
Both buyer and seller will benefit by using an ERG broker.
Because of a broker's expertise and negotiating skill, a buyer
will make the best investment and a seller will enjoy the highest
profit. A broker also allows the parties to an ERG transaction
to remain anonymous until final negotiations. By being anonymous
a buyer can prevent extraordinary sellers' profits when a major
new source requires a large number of ERC's from a limited market.
A seller can benefit from anonymity when the prospective buyer is
a large company with sophisticated engineering and legal resources.
When representing either a buyer or seller of ERC's the broker
has a fiduciary duty to his client. Situations may arise where
the broker will receive compensation from both parties. In such
a situation the broker must make full disclosure to both, parties
in order to avoid a breach of fiduciary duty. Because the broker
will provide each party with valuable services, it is doubtful
either party will object to a dual agency.
FINDING OFFSETS
A broker's success will depend on his or her ability to locate
emissions offsets. Locating .offsets requires imagination and
creativity as well as skill and diligence.
Never overlook small sources. Often the large, more con-
spicuous emissions sources accumulate offsets for their internal
use. Study the area and learn about all the industries. A street
by street inspection of an industrial area may reveal several
-4-
) 03
-------
previously unknown offset sources. The local Chamber of Commerce
and industrial development organizations can provide information
about the industrial activities in an area.
When an offset source is located, contact that particular
industry's trade association for information about similar oper-
ations in the area. Plant managers are very knowledgeable about
similar or competing operations. Whether or not a new industry
locates in an area may depend upon the availability of a large
number of ERC's. Therefore a small offset source can benefit
by helping to locate other offsets in the area.
Emissions from sources already controlled can often be reduced
below regulatory limits. These excessive reductions are market-
able offsets. For example, water base coatings can be used instead
on solvent base systems. Excessive reductions resulting from this
process change can be used as offsets. <
Non-point sources are another source of offsets. A heavily
traveled unpaved road produces a lot of particulate. Paving the
road can cause a reduction of particulate which can be used as
an emissions offset.
Mobile sources can also provide offsets. Converting a
fleet of gasoline or diesel powered vehicles to LPG will result
in a permanent, marketable emissions reduction.
A broker must be imaginative. Look to every source of air
pollution as a potential source of emissions reductions.
-5-
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THE CONTRACT
After preliminary agreements are made between the buyer and
seller of emissions offsets the contract must be negotiated.
The contract must state all the terms and conditions of the ERC
sales agreement. Both parties stand to suffer losses if the con-
tract is not complete or fails to correctly state their intentions.
Lengthy contracts should be avoided. A long, highly tech-
nical document may intimidate a party to the transaction or
cause substantial legal expenses just to interpret the document.
The best contract is clear and direct.
The buyer should make the seller's operating permits con-
ditional upon the emissions reductions. This will prevent the
buyer's permits from being revoked if the seller increases emis-
sions from his or her operations. If the seller's operations do
not require a permit, an agreement must be drafted giving the
APCD the power to limit the seller's emissions below the reg-
ulatory limits. These assurances are formalized with a third
party beneficiary contract; the APCD is named as beneficiary
of the agreement with the power to enforce the contract.
The buyer should seek a single transaction for the purchase
of the ERC's. Agreements requiring the buyer to provide the
seller with fuel, maintenance, or other services should"be
avoided. Costs of long term commitments are unpredictable and
may result in future losses for the ERC buyer.
Future operations of a new source will depend on the terms
of the emissions offset contract. The document must be carefully
drafted to fully protect the interests of the parties.
-6-
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THE PERMIT APPLICATION
Acceptance of the air pollution operating permit application,
including the offsets, is the last step of the ERG sales trans-
action. The broker oust see that the application is complete
and meets all the criteria fora.new source permit. All operating,
emissions, and offset data must be accurate.
A friendly working relationship with the APCD is essential.
Antagonism between the broker and the APCD staff will only harm
the client. APCD engineers are very knowledgeable about emis-
sions control technology. They can offer helpful suggestions for
complying with the new source review regulations.
Data presented in the permit application must accurately
reflect actual operating conditions and emissions. Exaggerated
numbers only invite delays and litigation.
The permit.application must, show an .overall air quality
benefit. This is easily demonstrated with direct emissions re-
ductions in close proximity to the proposed new facility. How-
ever distant offsets will require mathematical modeling to show
an air quality benefit. Modeling is expensive and controversial,
and sometimes the results are unpredictable. If a model is re-
quired, use a model approved by the EPA. You must make sure the
input data is correct, particularly the discretionary and inter-
pretive data. The success of a model may depend on stack height
or an interpretation of wind patterns.
Private environmental protection organizations can stop a
project if their interests are not considered. A local plan-
ning agency will deny an application for a land use permit,
-7-
-------
even though an air pollution permit has been granted, if the com-
munity is adamantly opposed to a proposed new facility. Without
a land use permit the issue of offsets is moot. It is advisable
to meet with local environmental groups and gain their support.
Aesthetics or wildlife habitat are often the issues of contention.
If the company proposing to build the new facility promises to
purchase wetlands to be dedicated as a wildlife sanctuary, or if
the new facility is built with an aesthetically pleasing design
the objections of the environmental groups may be satisfied. It
is important to consider and mitigate the total environmental
impact of a new facility.
Delay and litigation can be eliminated with proper plan-
ning. Prior to submission the permit application should be
reviewed by both broker and applicant. Any anticipated prob-
lems can be resolved and the permit processed without delay.
BEING A BROKER
ERG brokering is a new business. Both government and
industry are promoting it as a way of satisfying environmental
regulations and stimulating industrial growth. A person willing
to acquire the necessary knowledge and skills can look forward
to financial success as well as contributing to the environmental
health and economic wealth of the nation.
r-o -8-
-------
EMISSIONS OFFSET SALES AGENCY AGREEMENT
;1. This agreement is made by and between
j herein called the Principal and California Environmental Technology, 102 Washington
i Avenue, Richmond, California, herein called the Agent.
i
j2. The operations of the Principal's business at
j produce any or all of the air contaminants of hydrocarbons, sulfur oxides, nitrogen
i oxides, particulate, and carbon monoxide. A reduction of any or all of these air
j contaminants may result in a marketable emissions offset.
i
:3. In consideration of the mutual covenants and conditions contained herein the
{ parties ,. Principal and Agent, agree as follows:
i
a. The Principal hereby appoints California Environmental Technology as Agent for
the sale of offsets and sale of options to purchase offsets with the exclusive
and irrevocable right to sell.
b. The Principal shall pay to the Agent as compensation for services a fee of:
c. The Agent shall not accept offers for the Principal. The Agent shall obtain
and present written offers to the Principal for acceptance by the Principal.
d. The Agent shall notify the Principal in writing of all offers to purchase the
offsets and all offers to purchase options for the offsets.
e. The term of this agreement shall be for '"'' days, beginning
and continuing thereafter until terminated in writing by either of the parties.
i f. The Agent shall not assign this contract without written consent of the Principal.
i.
| g. The Agent may represent all parties to a sale of the offsets and collect compen-
' . sation or commission from both of them provided there is full diclosure to each
i of the Principals of such dual agency.
;
:
! h. If within 180 days of the.termination of this agreement the offsets or options
! for the purchase of the offsets are sold to anyone with whom the Agent has
negotiated prior to final termination of this agreement the Principal shall
; pay to the Agent the compensation specified in subparagraph b, provided the
Principal received the names of the prospective purchasers, in writing, from
the Agent prior to the final termination of this agreement.
: i. In consideration of the above, the Agent agrees to use due diligence in the
performance of his obligations under this agreement.
Principal: Agent:
California Environmental Technology
102 Washington Avenue
Richmond, California 94801
(.415) 233-9156
:Dated: Dated:
-------
AIR POLLUTION TERMINOLOGY
COMPILED BY:
CALIFORNIA ENVIRONMENTAL TECHNOLOGY
RICHMOND, CALIFORNIA
ABATEMENT DEVICE: equipment used to reduce air pollutant
emissions
AQCR: Air Quality Control Region
AQMA: Air Quality Maintenance Area
AQMP: Air Quality Maintenance Plan
BACT: Best Available Control Technology
BUBBLE: a concept developed to allow some .plant.operations
to exceed emissions limits'if the total emissions
from the plant do. not exceed the calculated emis-
sions, when all operations are emitting pollutants
at the emissions limits; excessive emissions
and excessive reductions are aggregated as if
the plant was in a bubble
CFR: Code of Federal Regulations
CTG: Control Technology Guidelines (EPA)
EIR: Environmental Impact Report
EIS: Environmental Impact Statement
ERG: Emission Reduction Credit
LEAR: Lowest Achievable Emission Rate
MODELING: a mathematical procedure for determining the
air quality impact of an air pollution source
NAAQS: National Ambient Air Quality Standards
NESHAPS: National 'Emission Standards for Hazardous
Pollutants
-------
NONATTAINMENT AREA (NA): an air quality control region
where the NAAQS are exceeded
NSPS: New Source Performance Standards
NSR: New Source Review
OFFSET: an emission reduction from an existing source
used to reduce the air quality impact of emissions
from a new source
POLLUTANTS/AIR CONTAMINANTS:
CO - carbon monoxide
HC - hydrocarbons; organic chemical compounds
NOx - nitrogen oxides
Ox - photochemical oxidant
organics - hydrocarbons
ozone - 0^ an allotropic form of oxygen
particulate - airborne solid or liquid particles
TRS - total reduced, sulfur
TSP - total suspended particulate
SOX - sulfur oxides
VOC - volatile organic compounds
PSD: Prevention of Significant Deterioration
RACT: Reasonably Available Control Technology
SIP: State Implementation Plan
-2-
-------
MARKET ANALYSIS
-------
MARKET ANALYSIS OF EMISSION REDUCTION CREDITS
Prepared by
Michael E. Lukey
Glenn T. Reed
Brian D. Hillis
Engineering-Science
7903 Westpark Drive
McLean, Virginia 22102
for
The Broker's Conference
January 26, 1981
ABSTRACT
Is the market for emission reductions credits (ERCs) in a given area
sufficient to support a broker's services? Controlled trading is a new,
fast developing business in which brokers who act now have the opportunity
to earn a substantial return on their investment. These returns can be
achieved by buying and selling ERCs, by performing emission reduction
audits, by helping clients to arrange bubbles, and by performing other
related services that can save their clients considerable sums of money.
The purpose of this paper is to describe a methodology that brokers can
use to determine EEC supply and demand in a given area and to develop the
information they will need to market their services aggressively.
-------
MARKET ANALYSIS OF EMISSION REDUCTION CREDIT SUPPLY AND DEMAND
Michael E. Lake?
Glenn T. Reed
. Brian D. Billis
Is the market for emission reduction credits (ERCs)in a given area
sufficient to support a broker's services? Through its controlled trad-
ing program (i.e., offsets, the bubble policy, and banking) the U.S. En-
vironmental Protection Agency (EPA) has provided a general regulatory
framework that has lead to the creation of an ERC market. ERC banks
have been established in a number of states and localities. A limited
amount of controlled trading of ERCs has occurred. These facts do not,
however, prove that a sufficient market for ERCs exists in a specific
' state or locality. A market > analysis is, therefore, the first question
facing potential brokers before deciding to commit scarce capital and
other resources to ERC trading activities .
Engineering-Science (ES) conducted a market analysis for Louisville,
Kentucky. Based upon this analysis, a general methodology, the resource
i - needs, and the time requirements for an ERC market analysis were identi-
i f ied. Although some of the techniques used in this analysis were speci-
; fie to conditions in Louisville, the methodology used for this case study
can be applied by brokers contemplating involvement in other geographic
; areas to determine how best to structure their brokerage services to suit
the particular needs of an area.
i
i MARKET AREA SELECTION
i -
i A potential broker must select the area in which to offer his or her
\ services. Although the selection of a specific area may be dependent upon
factors such as location unique to the individual broker, other character-
istics can be identified that will be important determinates of whether
of not a viable brokerage business can be developed in a particular area.
: The following are some general factors that will affect the selection of
i an area for establishing an ERC brokerage business:
o Existence of an ERC bank. EPA's controlled trading program is a
new regulatory reform that 'has been developing rapidly throughout
the nation. ERC banks have been established in Louisville, Ken-
tucky; Portland, Oregon; and San Francisco, California. Many
other areas are working to establish banks.
-------
o Amount of existing pollution. If there are few emitting industrial
facilities in an area, ERG creation would be extremely difficult.
Thus, the area selected should already have a significant indus-
trial base.
o Age of existing industrial base. An industrial base that consists
of older industry that has retrofitted or must retrofit control
equipment is more likely to provide a supply of ERCs than one that
consists mostly of newer well-controlled facilities.
o Rapid industrial growth. Obviously, an area that is experiencing
rapid industrial growth is a likely area in which to establish an
ERC brokerage operation because ERCs will be needed as emission
offsets to support that growth.
o Industrial growth limitations. Air pollution control regulations
need not limit industrial growth, but, in nonattainment areas and
areas where consumption of the Prevention of Significant Deterior-
ation (PSD) air quality increments is limited, the controlled trad-
ing of ERCs can overcome these limitations to industrial growth.
The potential broker must weigh each of these factors when selecting a mar-
ket area, but should understand that an area need not rank high on all of
these characteristics to support an ERC market.
.The selection of -Louisville as a study area is illustrative of how - >
these factors can be considered. Louisville was selected for the follow-
ing reasons: ....
o The Jefferson County Air Pollution Control District (APCD), which
is a joint pollution control agency for the City of Louisville and
Jefferson County, was the first agency to establish an ERC bank.
The Louisville bank has had more deposits and withdrawals that any
other bank.
o Louisville has a substantial industrial base dominated by the auto-
motive assembly, large appliance, synthetic rubber, and chemical
industries. In addition, electric power generation is. the major
source of particulate and sulfur dioxide emissions.
o Louisville's industrial base is fairly old. The synthetic rubber
and chemical industries were built shortly after World War II.
The automotive assembly and large appliance industries are more
recent but are nonetheless more than ten years old. Even these
newer industries, however, are faced with new air pollution con-
trol regulations adopted in 1979.
o Industrial growth has not been rapid in Louisville during the past
decade. Yet,, some of the large industries in Louisville, such as
B.F. Goodrich, and Ford, have recently undertaken modernization and
expansion of their existing facilities.
o Growth in Louisville will be limited because Jefferson County is
a nonattainment area for particulates, sulfur dioxide, carbon
-------
monoxide, and ozone. Recognizing that the controlled trading of
ERCs is an important method for an area to overcome the growth
limitations caused by a nonattainment problem, the Jefferson
County APCDS established an ERC bank.
Other areas may have a greater potential to support EEC brokerage
services because they are stronger than Louisville in certain fac-
tors. Houston, for example, is experiencing very rapid industrial
growth and is a nonattainment area. Many oidwestern and eastern
cities might adopt ERC trading as a means of encouraging modern-
ization of older industrial facilities. Brokers should make a
quick assessment of the potential demand for his or her services
in a particular area before undertaking a more detailed analysis
aimed at identifying specific services and clients likely to en-
gage a broker in a particular locality.
GENERAL METHODOLOGY
Although the specific analysis will depend on the types of services
the broker plans to offer, a general methodology for conducting a market
analysis of the supply and demand for ERCs can be divided into the follow-
ing steps:
o Obtain necessary data. A site visit is essential to a detailed
" market'analysis although much of the information needed can be'"
obtained prior to a visit. This information can also enable the
broker .to screen the area to decide whether further analysis is
warranted.
o Determine potential ERC supply. Supply is one side of the equa-
tion defining a viable market. Without a potential supply of
ERCs, brokers will be unable to successfully complete a transac-
tion.
o Assess ERC demand. The most difficult part of the analysis will
be quantifying demand, but a number of possible measures of de-
mand will be detailed in this paper.
Although the methodology consists of three steps, all three are some-
what interdependent and may be undertaken concurrently. Determining the
ERC supply and assessing demand are the two most important steps and are
the ones upon which brokers should focus their efforts.
Using this methodology, brokers will be able to answer a number of
questions critical to the eventual success of their business venture.
These questions include the following:
o Do existing pollution control rules and regulations allow for the
creation of an adequate supply of ERCs?
o What restrictions are placed on who can create, own, and use ERCs?
o Is there a sufficient potential ERC supply that can be obtained
at a reasonable cost?
-------
o Do existing industries in the area need ERCs to babble or expand?
o Will new industries want to build in the area? Will they need
ERCs for offsets?
o What will be the approximate cost of creating ERCs and the likely
market price at which they can be sold?
These questions are oriented primarily towards brokers who would assist
firms in purchasing and selling ERCs. The first step in addressing these
and related questions is to develop a detailed understanding of the envi-
ronmental and economic characteristics of targeted locality.
SITE VISIT
A market analysis requires a significant amount of information con-
cerning existing rules and regulations, emissions reductions required by
the State Implementation Plan (SIP), current emissions and air pollution
control technology, industrial growth, existing ERCs in the registry, etc.
Much of this informaion can be obtained prior to a site visit. Before
visiting the potential market area, the broker should obtain as much in-
formation as possible to determine if brokerage services can be adequately
sustained. An initial screening of this information should provide tne
potential broker with enough data to determine if the area is worth addi-
tional analysis. The techniques for this screening will be basically the
same as those used in.the detailed market analysis. There are some spe-
cific questions, however, that can be asked during the screening that
could identify that there is no need to proceed. The following are some
of these questions:
o Has an ERC bank been established? If not, does the local agency
have plans to establish one? Controlled trading will be more
difficult if there is no bank, but the bubble policy could pro-
vide a basis for some brokering services.
o Are there any ERCs listed in the registry? If so, who owns them?
ERCs listed in the registry are obvious indicators of a potential
supply.
o Have there been any SRC transactions? Were brokers involved in
these transactions? Prior transactions are an obvious indication
of a potential for a broker to enter the market.
o Has the SIP been approved by EPA? If the SIP has not been ap-
proved, a moratorium on growth may be in effect.
o Is there a nonattainment problem in the area or are PSD incre-
ments available? Unless there are limits on growth imposed be-
cause of air quality considerations, the market may be very li-
mited.
Some of these questions can be answered quickly by contacting the local
control agency. At this point, the broker can decide to continue the
i co *
-------
analysis by visiting the area to collect additional information, conclude
that the market potential is too limited, and/or select another area that
may be more promising. The broker should re-member, however, that a pre-
liminary screening may be inconclusive and a site visit is essential be-
fore the potential, of an area can be completely evaluated.
Types of Information
To save «»"» and money the broker can obtain the following types of
preliminary information by telephone or through the mail:
o The State Implementation Plan (SIP)
o State and local regulations pertinent to controlled trading
o The emissions inventory
o Industrial growth projections
o A summary of EHCs in the bank
o Topographical and planning maps
t
Each of these types of information can be effectively used in the later
steps of determining potential supply and assessing demand. The following
sections explain in 'depth the' sources for obtaining this information,' the
specific data and its uses, and potential problems or limitations of each
type of information. .
State Implementation Plan
Each state is required by the Clean Air Act (CAA) to submit a SIP
to EPA. The SIP details the specific emissions reductions that the state
proposes to obtain in order to attain and maintain National Ambient Air
Quality Standards (NAAQS). To date, EPA has established primary NAAQS
for total suspended particulates , sulfur dioxide, carbon monoxide, ozone,
hydrocarbons, nitrogen dioxide, and lead. Although the NAAQS define ac-
ceptable air quality, it is the responsibility of the states to obtain
sufficient emission reductions to ensure that these standards are attained.
To accomplish this objective, each SIP will contain a summary of the emis-
sions inventory, regulations for specific sources and categories of sources,
and the projected growth in emissions that will not jeopardize reasonable
further progress (RPP) towards attaining the NAAQS. Because ERCs are emis-
sions reductions beyond those required by the SIP, the SIP defines the
baseline by which controlled trading is bounded. Copies of the SIP can
be obtained from the state air pollution control agency. In some cases,
state agencies have delegated responsibilities for the SIP to local air
pollution control agencies. The Air Pollution Control Association (APCA)
publishes annually a directory of state and local agencies with each agen-
cy's address, telephone number, and directors. Care must be taken, how-
ever, to ensure that the latest version of the SIP is obtained because
SIPs change frequently as new regulations are adopted or as old regula-
tions are changed.
-------
Local Regulations
Some state or local control agencies like the Air Pollution Control
District (APCD) of Jefferson County, which is the local agency in Louis-
ville, have written regulations or policies that pertain specifically to
controlled trading. Such regulations establish the regulatory framework
for controlled trading in a specific area and define who can bank, what
qualifies as an ERG, who owns them, what restrictions are placed on their
use, etc. The Jefferson County APCD, for example, has a written policy
establishing the ERC bank, but has no specific bubble regulations. Louis-
ville's banking rules, however, are not included in the SIP. In Kentucky,
the Department of Natural Resources and Environmental Protection (DNREP)
was responsible for preparing the SIP. DNREP reviewed the Jefferson Coun-
ty APCD regulations to ensure that they were as stringent as the State's
own. Thus, the banking regulations are not specifically part of the SIP,
but are incorporated by reference. Thus, a quick check with the state
or local agency is necessary to ensure that all of the regulations have
been obtained, including those in the SIP and those only referenced in it.
TJT"* ssions Inventory
Emissions inventories include a wealth of data on existing point
sources of air pollution in a given area. The information in the emis-
sions inventory will provide the basis for much of the broker's market
analysis. Key information that can be gained by reviewing an inventory
includes the following: '" ' "" ---
o The difference between a source's allowable and actual emissions
may indicate which sources are likely to be able to create ERCs.
o The type of control device currently used may indicate that it
can be replaced with a more efficient one which would create an
ERC.
o Shutdown facilities can be identified easily from an updated in-
ventory by looking at a facility's compliance code.
The inventory will be a broker's main source of information for iden-
tifying firms likely to participate in ERC transactions. Although there
is wide variance in state .and local inventory systems, most include the
following information for each point source:
o Name of the company.
o Location of each emission point in Universal Transverse Mercator
(UTM) grid coordinates.
o Address of the plant.
o Name of the plant's air pollution professional or plant manager.
o Type of process.
o Type of control equipment.
-------
o Efficiency of control equipment.
o Allowable and actual emission rates.
o Compliance status.
Depending upon the inventory system, other -useful data may also be avail-
able in the emissions inventory.
The emissions inventory for state and local areas can be obtained
from a number of sources. EPA'3 National Air Data Branch (NADS) in Re-
search Triangle Park, North Carolina, maintains the National Emissions
Data System (NEDS). NEDS is a computerized emissions inventory system
with data for the entire country. Figure 1 is a copy of a NEDS report
for a specific emission point. State agencies are required periodical-
ly to submit data to EPA Regional Offices for inclusion in NEDS. Unfor-
tunately, NEDS may not be as good an inventory as those maintained by
the individual states because it often is not updated as frequently as
the states' data. Because EPA does not collect the data directly, it
relies upon the states to ensure that data in the system are correct and
inaccurate data is often not removed quickly from NEDS. It is difficult
to separate bad data in NEDS from that which is good. Therefore, a bro-
ker should use NEDS data with caution and discuss its currency with know-
ledgeable local officials.
States also maintain an emissions inventory of their own. These in-
ventories vary in quality but are generally superior to NEDS. Many states
use the Emissions Inventory System/Permits and Registration (SIS/PSR), a
computerized data handling system developed by EPA for use by the states.
Figure 2 shows a copy of the EIS/P&R printout for air emission point in the
Louisville inventory. EIS/P&R is similar in many respects to NEDS with re-
gard to the type and format of information that can be stored in the system
and, at a Mnl""ir», contains all of the information in NEDS. In addition,
it is flexible enough to allow the state to include information like the
projected emissions for the source, and it permits retrieval and summariz-
ing of the data in various formats. Some states have developed new and
very useful reporting formats. For example, both Kentucky and EPA Region
IV have programs which allow plotting of point sources with brief summaries
of emissions data. Since the location of partieulate and sulfur dioxide
ERCs is important to determining whether they can be used by a specific
source seeking to bubble or offset emissions, this type of report can be
very useful to brokers. Data processing personnel in the state or local
agencies can provide the broker with a description of the various reports
available from the agency's inventory system. If the analyst has access
to a computer with an installed 3IS/P&R system, the inventory could be ob-
tained on a magnetic tape and the broker could then generate his own re-
ports. _
Industrial Growth Projections
Industrial growth projections are essential for quantifying the de-
mand for ERCs. ERG demand will arise from two types of situations: ex-
isting firms that wish to expand or bubble and need ERCs to offset the
additonal emissions that will result and from new industry moving into
\ CO ,
-------
) Csl a ENGINEERING-SCIENCE
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Illl. .. .
ui'tin iriHi Ht> ,,..<:ri,.,. run/ NtumiN PFSI«» SIIIFUR »SH
.U'lE l» III I 1. Ill |g Pl'Ul'SS PilF COHUNI CnNIENI
SO. 107 U< AI ' ill OOu 0| 79 I.S/,7 .oa J.O
r.oimIOn<H/»
?SglUOPI""J{foS»«i NF^S,00
'«!:| a-" 11' "if
81.? 3.*i (1) C«U
0977.1 218) I]) C«U
1490.7 U.I. (]> C»|C
?«.6 M.». Ill CHC
HFtl CONF SOURCE
lONIfNI COOt CODE
tHJJSjgN s«S^R
17.000 1
I. 296
U'lo! s
1 300
HFtl C1HF SOURCf
CDNIENl CODE CODE
mission ASH/
r>clOR suiruR
17 tOO
600 000
i ooo
o
-------
the area. Industrial growth projections provide a basis for estimating
ERC demand that results from new and expanding industrial growth. Pro-
jections are normally extrapolations from the existing industrial base
using particular assumptions about the national, state, regional, and/or
local economy. Industrial growth is projected in terms of number of em-
ployees or earnings. In many projection series, key industrial groupings
identified by the first two digits of the SIC code are projected separate-
ly. It is important for the broker to obtain projections segregated by
two-digit SIC because some industrial groupings tend to have greater air
pollution problems and, thus, need ERCs more than others.
Industrial growth projections can be obtained from various sources.
The SIP may contain some projections. These projections will normally
be those developed by local planning agencies in response to program re-
quirements directed by the federal government. More recent and detailed
projections may be available from the planning agencies and other organi-
zations such as the Chambers of Commerce. One particularly useful source
of projections is the U.S. Bureau of Economic Analysis, which publishes
a series called OBERS which are commonly used in a variety of economic
planning activities by the federal government. OBERS projections are
based upon specific assumptions about the national economy. Projections
for Standard Metropolitan Statistical Areas (SMSAs), which are the small-
est areas for which specific OBERS projections are given, are disaggre-
gated from the projections for the national economy. Thus, the quality
of OBERS projections decreases as the size of the area becomes smaller.
Most local planning agencies, however, project employment trends for
their local area. The Louisville and Jefferson County Planning Commission
has employment projections for major industrial categories. These cate-
gories .are designated by the first two digits of the four-digit SIC code.
Louisville's projections are based on a questionnaire survey of local in-
dustry. Thus, expansion plans of local industry are reflected more than
growth from new industry. Table 1 shows the industrial growth rate pro-
jections for Louisville obtained from the Louisville and Jefferson County
Planning Commission. Although initial contacts by letter or telephone
may be sufficient to obtain growth projection data, these data may be ob-
tained best during a visit to agencies likely to have these data. There
may be conflicting sources of growth data, and the broker may not be able
to judge the quality of the data except through discussions with person-
nel responsible for developing these projections.
ERC Registry
To determine the current supply of ERCs, the broker should obtain a
copy of the current ERC registry from the agencies responsible for adaiini-
stering the ERC bank. Table 2 is a copy of the current ERC registry. It
includes the following information:
o Name of the depositor.
o A personal contact for the depositor with a telephone number.
o The ERCs banked for each depositor by pollutant.
r**
(.."L>
-------
TABLE 1
PROJECTED GROWTH RATES BY 2-DIGIT SIC (PERCENT)
Low
SIC
20
21
22
23
24
25
26
27
28
29
30
32
33
34
35
36
37
38
39
Industry Group
Pood
Tobacco
Textiles
Apparel
Lumber
Furniture
Paper
Printing
Chemicals
Petroleum
Rubber
Stone
Primary Metals
Fabricated Metals
Machinery, Nonelectric
Electric Machinery
Transportation
Instruments
Miscellaneous
1973-
1985
-10.5
-3.2
-22.4
26.6
-18.3
-0.1
15.0
-5.4
5.7
-10.3
46.1
31.3
21.6
11.4
20.9
54.7
77.6
23.7
-9.9
1985-
2000
-17.5
9.6
-14.4
16.8
-14.3
11.6
12.6
10.9
6.9
13.9
42.2
4.5
14.3
12.1
7.7
35.5
13.0
20.2
-2.0
Medium
1973-
1985
-7.2
0.3
-19.2
31.2
-15.3
3.5
19.2
-2.0
9.6
-7.4
51.4
36.1
26.1
15.5
25.3
60.4
84.1
28.2
-.6
1985-
2000
-14.1
14.1
-10.9
21.6
-10.3
16.2
17.2
15.4
11.2
19.0
48.1
8.7
18.9
16.7
12.1
41.0
17.6
25.0
1.9
High
1973-
1985
-4.4
3.4
-16.8
35.2
-12.8
6.6
22.8
1.0
12.9
-4.4
56.1
40.2
29.9
19.0
29.1
65.3
89.7
32.1
-3.7
1985-
2000
-11.4
17.8
-7.7
25.5
-7.9
19.9
20.9
19.1
14.3
22.3
52.7
12.2
22.8
20.4
15.7
45.6
21.3
23.9
5.2
Source: Louisville and Jefferson County Planning Commission (1979).
67
11
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TABLE 2
JEFFERSON COUNTY, KENTUCKY
EMISSIONS BANK STATUS REPORT*
(July 31, 1980)
Pollutant Tons /Year
Depositor
B.F. Goodrich Company
| Logan Company
\ General Electric
; International Harvester
Ford Motor Company
] Philip Morris
Unallocated
1
; Totals
i . .
Contact
w.c. Holbrook
R.C. Hunt, P.E.
Keith Moser
J.F. Mavri
A.M. Twilley
Tom Scott
A.P.C.D. -
Phone Number
216-524-0200
502-587-1361
502-452-5678
502-367-3226
313-323-2845
304-271-2474
502-587-3327
TSP SO->
417.1
22.0 36.0
197.0
329.0
41.2 464.3
15.0- 101.0
1021.2 601.3
voc
687.7
..
70.0
348.0
343.0
0.7
, _ _
1449.4
; a Interested parties can also contact: M.T. DeBusschere, P.E., Air Pollution
j Control District at 502-587-3327, or Stan Bowling, Louisville Area Chamber of
j commerce at 502-582-2421.
12
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The registry in Louisville also includes the name and telephone number of
personnel at the agency and at the Louisville Area Chamber of Commerce who
interested parties can contact. Mote that unallocated EPCs listed in the
registry belong to the Jefferson County APCD.
The ERC Registry is an important source of information for brokers
interested in finding EBCs for clients seeking to expand or to utilize
the bubble policy. It also provides brokers with a sense of the market
for creating ERCs.
Topographic and Planning Maps
It is generally a good idea to obtain maps of an area before under-
taking any type of field reconnaisance. The U.S. Geological Survey (OSGS)
publishes 7 1/2' topographic maps that provide substantial information.
Large industrial complexes can be easily identified on these maps. Most
importantly, because these maps also use the OTM coordinate system, which
most emission inventories use to locate point sources, they can easily be
used for showing the location of emission sources. Other maps, particu-
larly planning maps showing present and future land use patterns, ^*n be
obtained during the site visit. These maps provide an indication of where,
because of zoning regulations, new industrial growth is likely to occur.
Stops to Make on a Site Visit
,.. After collecting-background information, a broker examining the fea-
sibility of entering an area to provide services will want to make a site
visit to complete his or her market analysis. The purpose of this visit
is to learn more about the regulations, the emissions inventory, and the
community, and to meet with key individuals responsible for administering
the controlled trading program. At a minimum, the analyst should visit
the following agencies:
o Air pollution control agency. The control agency is responsible
for regulating controlled trading as well as the overall air qual-
ity management program. Normally, agency personnel will have an
intimate knowledge of air pollution sources and their ability to
create and use EPCs.
o Planning agencies. Local planning agencies prepare industrial
growth projections, are involved in the transportation and land
use planning and are generally involved in the interrelationship
between air quality and planning. They also are the responsible
local agency for zoning.
o Chamber of Commerce. As the representative of local industry,
the Chamber of Connerce often has information on industrial de-
velopment sites and is most aware of the needs and problems of
local industry.
o Industrial development agencies. These agencies will have infor-
mation on major areas where development may occur. They also act
as the primary group involved in attracting new industry to an
area and in developing programs to retain existing firms.
13
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o Industrial bonding authorities. Financing will be an important
factor in obtaining ERCs and can be an important service for bro-
kers to provide. Industrial development revenue bonds, which are
administered by these agencies, may be a useful financing mecha-
nism.
The air pollution agency should be visited first because agency personnel
can usually direct the analyst to specific personnel in the other agencies.
In Louisville, all of the agencies in this list were very cooperative and
provided considerable useful information.
Not surprisingly, the local air pollution control agency has a wealth
of information useful to a potential broker. Mot only does the agency re-
gulate air pollutant emissions, but it is the agency responsible for estab-
lishing the controlled trading regulations. Prior to visiting the agency,
the broker should review the agency's regulations and be prepared to ask
any questions necessary to clarify particular points. The agency will al-
so be able to identify any modifications in the emissions inventory that
have not been incorporated into the latest published report. Because agen-
j cy personnel inspect sources routinely, they should be aware of any likely
' ERG suppliers and also be able to identify firms who may have a demand for
ERCs to bubble or to offset expansion. All local and state agencies re-
quire new sources to obtain construction permits. Thus, the agency would
also have information about recent growth. The most important information
that a broker can obtain from an agency may be personal contacts from whom
j . . further information can be gained. Local control agency personnel are also
j the people with whom the brokers will eventually be dealing when'arranging""
1 for certification.and.evaluating proposed uses of ERCs.
Local planning agencies normally have a number of specific functions.
Some of these functions include the following:
o Preparing a comprehensive growth plan.
o Planning for transportation to serve the needs of the community.
o Reviewing and processing rezoning applications.
o Maintaining zoning maps and files.
o Reviewing and processing building permits.
In some areas, these functions may be split between several planning agen-
cies or other governmental entities. For example, in Louisville, the Ken-
tuckiana Planning and Development Agency is responsible for transportation
planning, and the Louisville and Jefferson County Planning Commission has
control of all of the other planning functions.
The local planning agencies can provide the broker with industrial
growth projections,- current population, employment, transportation, and
land use data; and' detailed maps depicting current and future land use
patterns. Industrial growth projections are an important factor in pre-
dicting ERG demand. Current land use maps and data can be used in con-
junction with the emissions inventory to identify and locate potential
70
14
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sources of supply. The projected land use maps can be used in assessing
and locating potential new growth areas that may generate ERC demand.
Together with current land use maps, these maps will also help the broker
to relate ERC supply and demand spatially for pollutants such as particu-
lates and sulfur dioxide which is important because ERC use must not de-
grade air quality. This will be dependent upon the location of the sup-
plier relative to the user for these pollutants. Other types of informa-
tion that the planning agencies can provide, such as population and hous-
ing characteristics, will enable the broker to assess, in a general way,
the area's attractiveness to new industry.
The Chamber of Commerce is a good source of general information about
the local economy because it is the representative of all of the industry
in the area. In Louisville, the Chamber was able to provide useful infor-
mation including detailed maps on industrially zoned development sites.
The Chamber was quite helpful in providing general data such as value of
goods and services produced and sold, local labor market characteristics,
recent development activity, employment by local industry, and tax rates.
The Chamber in Louisville currently acts as a liaison between the air pol-
lution control agency and local industry for disseminating information
about the controlled trading program.
Industrial development agencies are charged with the responsibility
of promoting industrial development. In Louisville, there are several
agencies at the city, county, and.regional level with this responsibility.
In addition, the Riverport Development Authority is responsible specifi-
cally for promoting development at the Riverport Industrial Park. Devel-
opment personnel can provide information on recent developments and on
current development plans. They know the types of firms interested in
moving to the area. Often,, they have developed a comprehensive program
to entice firms to their area. They also are aware of the problems and
needs of existing industry with regard to air pollution. Normally, how-
ever, they are reluctant to discuss the specific plans of individual
firms.
ERC financing may be an important issue for firms contemplating an
ERC transaction. Industrial review bonds may be an important source of
capital for financing ERCs. Bonds may be issued by a number of different
local governmental agencies in Louisville. One such agency, Office of
Economic Development (OED) for Jefferson County, was contacted in Louis-
ville. OED provided a list of recent bond issues by the Jefferson Coun-
ty Fiscal Court (see Table 3). Industrial revenue bonds are intended to
promote industrial development in the area. They can be used to finance
a wide variety of projects although there are restrictions on their use
with regards to the total investment of which the bonds are part. In
fact, many recent issues in the Louisville area have supported commer-
cial development. Bond issues have been rather small, except for recent
issues for Stauffer Chemical Co. and Phillip Morris. The largest recent
issue by the Fiscal Court was $3,000,000 for Drum Engineering Company.
Bonds are not normally issued for public sale but are bought by banks
and other financial institutions immediately upon issue. In fact, the
County would probably not issue bonds unless a buyer was already avail-
able. Banks in Kentucky.are limited in size by state laws prohibiting
branch backing, but no one contacted in Louisville felt that these
15
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a'
TABLE 3
. SUMMARY OF RECENT INDUSTRIAL REVENUE
BOND ISSUES BY THE
OFFICE OF ECONOMIC DEVELOPMENT
JEFFERSON COUNTY FISCAL COURT
Job Creation Data
Court
Date
7/24/79
10/1/79
11/1/79
2/26/80
4/8/80
4/8/80
4/22/80
6/24/80
7/30/80
8/19/80
8/19/80
8/19/80
9/9/80
9/23/80
Bond Applicant
Name
Altamil Corp.
Jaggers Equip., Co.
Ennis Business Forms
K6R Corporation
Industrial Belt &
Supply
Bun ton Co., Inc.
Lacy Diversified, Inc.
Manning Equip., Ind.
Snider Bolt & Screw
Stauffer Chemical Co.
Philip Morris
Drum Engineering Co.
S.W. Jeff. Skateland
Cincinnati Elec. Equip
Size of
Issue
$ 500,000
220,000
1,000,000
2,000,000
250,000
475,000
1,000,000
1,400,000
600,000
1,000,000
1,000,000
3,000,000
550,000
. 250,000
ft Jobs/
Years
25/2
6/1
30/2
16/3
5/2
50/2
6/1
50/2
10/3
29/3
26/3
8/3
Annual .
Payroll
$300,000
48,000 :
325,000
225,000
100,000
750,000 :
75,000 .;
800,000
150,000
435,000
\
95,000 '
160,000
Capital/
Job
$ 20,000
36,666
33,333
125,000
50,000
9,000
166,666
28,000
60,000
103,000
21,000
31,250
Job
Capital/ Security
Payroll $ Enhanced
$ 1.67
4.58
3.08
8.89
2.50
.60
14.29
1.75
4.00
154
3,850
6.90 9
5.79
1.56
Nature of Business
Operates fabricating &
truck equipment; acts
as installing facility
Railroad car seats
Business form distribu-
tion
Scrap metal
Conveyor belts mfg./
supply /di s tr ibut ion
Lawn care equipment
mfg. & distribution
Waste paper disposal
Truck body manufacturer
Bolt & screw warehouse,
sales & distribution
Chemical products raft.
plant
Tobacco products
manufacturers
Mfg. & distribution of
pumps
Rollerskating rink
Electric motor distrib.
& repair
-------
TABLE 3Continued
SUMMARY OF RECENT INDUSTRIAL REVENUE
BOND ISSUES BY THE
OFFICE OF ECONOMIC DEVELOPMENT
JEFFERSON COUNTY FISCAL COURT
Job Creation Data
Court
Date
10/14/80
10/28/80
10/28/80
11/12/80
11/12/80
Bond Applicant
Name
Byck Bros. & Company
L&L Enterprises
Vulcan Land Co.
Eduplay , Inc .
A. Arnold & Son
Size of
Issue
2,100,000
1,000,000
1,600,000
2,500,000
600,000
1 Jobs/
Years
49/3
50/3
80/1
10/3
Annual
Payroll
421,000
i
830,000
800,000
115,432 :
Capital/
Job
42,857
32,000
31,250
60,000
Capital/
Payroll $
4.99
1.928
3.125
5.198
Job
Security
Enhanced
211
38
38
300
30
Nature of Business
Ladies fashion apparel
Land developers/indus-
trial park
Auto exhaust pipe mfg.
Health care/aged
Moving & storage
-------
limits would seriously affect financing of ERCs or industrial development.
The following conclusions can be drawn concerning ERG financing using in-
dustrial revenue bonds:
o Bonds may be in some circumstances be used to finance the purchase
or creation of ERCs.
o The amount of financing of ERCs through bonds would be limited by
the rules for their issuance. Projects for smaller firms are more
likely to be financed through bonds.
o Negotiation with banks and other bond purchasers should be under-
taken prior to issuance to ensure that there will be a buyer for
the bonds.
Thus, the broker should consider industrial revenue bonds as a potential
source of ERG financing but should contact local bonding authorities for
assistance in identifying the potential and method for tapping this source
of capital.
ESTIMATING THE SUPPLY OP ERCs
The next step in the market analysis is to determine the potential
.ERC supply, i.e. to identify firms likely to create ERCs for each pollu-
tant, the manner in which they will be created, their costs, and quantity.
In order, order to determine .the potential supply of ERCs, the following
steps are necessary: . ,
o Review local regulations. This review should concentrate on iden-
tifying any restrictions or creating ERCs and the level of control
required on existing sources.
o Define the controlled trading baseline. Since ERCs must be emis-
sions reductions beyond the limits in the SIP, it is important to
determine those limits.
o Analyze existing ERCs in the bank. The broker should analyze
banked ERCs to determine if any are available to be traded.
o Identify ERCs available from plant shutdown. Plant shutdown can
be a major source of ERCs.
o Quantify ERCs available from further controls. ERCs can also be
obtained.by installing more efficient control equipment.
o Consider the potential for obtaining ERCs from small point sources,
area sources, and mobile sources. In many areas, pollution from
these sources constitute a large percentage of total area emissions.
These steps can be.undertaken using only the information discussed pre-
viously without contacting specific industries. The overall purpose of
these efforts is to get a general sense of the quantity and likely sources
of ERC supply.
18
-------
Local Regulations
The local air pollution control regulations will establish the regu-
latory framework within which controlled trading will occur. Important
considerations in reviewing the regulations include the following:
o Ownership of ERCs. Unless ownership rights to ERCs are clearly
defined in in the banking regulations, a market may not be viable
because of the legal uncertainty. For example, both a firm and
the state may claim the right to credit from shutdowns.
o Rules for the creation of ERCs. EPA has allowed state and local
agencies significant latitude in permitting or disallowing par-
ticular ERC creation mechanisms, e.g., plant shutdowns and cur-
tailments, fuel switches, etc.
o The role of plant shutdowns in ERC 'creation. Shutdowns can be
-the most plentiful source of ERCs, but some agencies may not
grant credit for reductions from shutdowns because they had al-
ready been counted in the design of the attainment strategy for
the SIP.
o Time limits and discounting. Some banking programs may limit
the usefulness of ERCs to a specific time limit or may provide
;.-.. M ,for discounting in situations where additional..controls will.be
needed to attain the standards.
. o Existing controls. Local regulations will,define the level
of air pollution emission controls that existing sources must
achieve. As a result of the changes in 1977 to the CAA, these
control levels will be defined as reasonable available control
technology (RACT). But what is defined as RACT can vary signi-
ficantly across communities.
o Further controls. Some local agencies may have imposed more
stringent controls on existing industry or required controls on
previously uncontrolled emission sources as a result of the 1977
amendments to the CAA. In particular, VOC sources which in many
areas of the country were not controlled are now required to in-
stall RACT as a result of many of the 1979 SXP revisions. Nor-
mally, agencies allow sources which must install new controls
a period of time defined as a compliance schedule within which
to institute the required controls. Because these sources are
required to put in controls, and may at the same time create
surplus reductions, they are likely clients for a broker.
In reviewing the state or local regulations, the broker needs to identify
factors that may limit his or her ability to provide services to clients.
In general, simple regulations that provide for the consistent and perma-
nent creation and use of ERCs will further the ERC market and provide a
favorable climate within which the broker can operate. Complexities such
as requiring offsets-for indirect emissions or confiscating ERCs after
only a few years can significantly limit the potential market and there-
fore restrict the activities of brokers.
75
19
-------
Genuine Emissions Reductions
Since ERCs must be emissions reductions beyond those necessary to
attain the NAAQS, the broker must establish the controlled trading base-
line to determine if potential ERCs are genuine. Many of the services
provided by brokers will involve the determination of whether a poten-
tial reduction qualifies as an EEC. Emission reductions which cannot be
considered genuine ERCs include the following:
o Plant shutdowns and other reductions that have been counted in
the SIP towards achieving reasonable further progress (RFP).
o RACT controls on categories of VOC sources that are scheduled to
be imposed in the future.
o Paper reductions that can be created by redefining allowable
emissions.
The SIP will provide the broker with the necessary information to deter-
mine the acceptability of emissions reductions for the purpose of banking
and trading.
The RFP section of the SIP is the most important portion for the
broker to review in order to establish the controlled trading baseline.
Each SIP contains an RFP curve which demonstrates emission reductions,
that must be achieved by the agency each year until the standards are
met. The RFP curve for VOC emissions in Jefferson County is shown in
Figure 3. . Table 4 summarizes the VOC emission reductions needed in Jef-
ferson County in order to attain the ozone NAAQS. Although reductions
from plant shutdowns have not been counted in the Kentucky SIP, some
states have estimated that a percentage of the emissions will be elimi-
nated through shutdown and count these reductions towards RFP. In these
cases, ERC creation through plant shutdown would be limited to those re-
ductions in excess of the amount required for RFP. Kentucky has correct-
ly, however, taken credit for reductions resulting from the imposition
of RACT on VOC source categories that are not regulated in the 1979 SIP.
These regulations are being developed now and will become effective dur-
ing the 1979-1987 period. The source categories due to be regulated are
listed in Table 5. Daily reductions from these source categories in ex-
cess of RACT controls will qualify to be banked.
Finally, most SIPs are based on actual emissions rather than allow-
able. Because allowable emissions in most areas are based upon the as-
sumption that all sources operate continuously unless otherwise restric-
ted, paper reductions are possible for many firms by simply redefining
allowable emissions as actual. In many cases, this redefinition could
result from simply accepting permit conditions restricting hours of op-
eration. If the SIP is not based on allowable emissions, no credit can
be obtained through such paper reductions. Brokers will probably have
to discuss the SIP process with the local agency personnel in order to
properly interpret and define the controlled trading baseline to ensure
that potential ERCs are genuine.
7G
20
-------
FIGURE 3
Reasonable Further Progress for VOC Emission
in Jefferson County
1976
1987
77
21
ENGINEERING-SCIENCE
-------
TABLE 4
SUMMARY OF VOC EMISSION REDUCTIONS FOR
JEFFERSON COUNTY
JEFFERSON COUNTY HC EMISSION REDUCTIONS (TONS/YEAR)
1976 1982 1987
Uncontrolled VOC Emissions 72,730 77,010 81,340
RACT 0 8,320 17,320
Federal Motor Vehicle Cont. Program (FMVCP) 0 17,790 27,980
Mandatory Vehicle I/M Program 0 2,210 3,730
Transportation Strategies 0 1,470 1,080
Controlled Emissions 72,730 47,220 31,230
Emissions Necessary to Attain the
Standarda 44,365 44,365 44,365
Additional Reductions Needed to
Attain the Standard4 28,365 2,855
78-
22
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TABLE 5
VOC SOURCE CATEGORIES THAT WILL BE CONTROLLED
AFTER EPA PUBLISHES ADDITIONAL CONTROL TECHNOLOGY GUIDELINES
Pharmaceutical Manufacture
Rubber Products Manufacture
Paint Manufacture
Vegetable Oil Processing
Graphic Arts (Printing)
Flat Wood Products
Service stations, Stage II
Organic Chemical Manufacture
Process Streams
Fugitive (Leaks)
Wood Furniture Manufacture
Architectural and Miscellaneous Coatings
Organic Chemical Manufacture
Waste Disposal
Storage and Handling
Natural Gas and Crude Oil Production
79
23
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ERCs Listed in Banking Registry
The summary of ERCs listed in the registry should be reviewed. All
ERCs in the bank should be considered tradeable. Yet, some ERCs may be
difficult.to obtain. In Louisville, a few small industries have banked
ERCs. These ERCs may be obtained more easily for trading because the own-
ers are less likely to need them than larger firms with expansion plans.
Similarly, the Jefferson County APCD owns a limited number of ERCs in the
bank. APCD regulations allow these ERCs to be auctioned publicly. Thus,
they should be considered a readily available supply of ERCs. The analy-
sis of the ERC bank should also include a review of the past use of banked
ERCs. B.F. Goodrich, for example, has already used a substantial portion
of their ERCs to modernize their plant. They may, therefore, have no fur-
ther immediate use for their remaining ERCs and may be willing to sell
all or part of their remaining account. International Harvester traded
ERCs to a company as part of a subcontract agreement. Thus, a quick re-
view of paat ERC transactions may give indication of a firm's willingness
to sell its ERCs. Current ERCs in the bank, however, must not be consi-
dered as the only or main supply of ERCs for the broker. Brokers will
want to actively work with their clients to create low-cost ERCs.
Plant Shutdowns and Curtailments
If plant or process shutdown and curtailment are eligible sources
of ERCs, they may represent the easiest and cheapest supply of ERCs. The
industrial base of most cities, such as Louisville, is constantly shifting
as older industries are replaced. Firms shutting down a facility will of-
ten be quite willing to divest themselves of ERCs in order to raise capi-
tal for modernization of its plant. In Louisville, the APCD has already
identified a number of shutdowns that have produced ERCs which could be
banked. These shutdowns are listed in Table 6. A 09 code in the compli-
ance status field of the EIS/PSR system indicates a shutdown. By keying
on this code, the system can cull the shutdowns from the inventory and
produce a printout showing just those sources. Thus, using this method,
brokers can be easily and quickly identified.
Short of a total shutdown, firms may be able to create ERCs by cur-
tailing operations. Ford Motor Company, in Louisville, created a substan-
tial amount of ERCs by reducing their operations to one shift rather than
two. To create an ERC from a curtailment, sources will have to impose
permit limitations on their operating hours. Brokers can assist their
clients in documenting previous hours of operation (i.e., to establish
the baseline) and in developing an acceptable and enforceable compliance
plan that allows the air agency to determine its future level of produc-
tion.
Identifying ERCs from Additional Controls
The next step is to quantify ERCs that may be created by installing
more efficient air pollution control devices. Most major sources in non-
attainment areas are already using reasonably available control technol-
ogy (RACT). Generally, it would be quite expensive sources to use more
efficient controls such as best available control technology (BACT) or
lowest achievable emission rate (LAER) technology. BACT is defined as
80
24
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8
to
in
TABLE 6
POTENTIALLY BANKABLE EMISSIONS SUMMARY
Company Name
Uarshaw .
Jefferson Concrete
Jefferson Concrete
Precision Metals
NST Metals
Peerless Manufacturing
Cohart Refractories
Monitor Cabinets
Philip Morris
International Harvester
Foundry
Logan Company
Louisville Cooperage Plant #3
Miller's Concrete
Flexible Materials, Plant 82
National Distillery
Hill & Hill
Henry Bickel
Campbell Tobacco
Murphy Manufacturing Co.
Old Boone Distillery
Texaco, Inc.
Kentucky Concrete Pipe
Tube Turner
I.D.
No.
86
100a
252a
17 7a
755a
50
154a
171
97
118
123
218a
229
158
24a
35a
763a
166a
222
107a
227
Allowable Emissions
(t'py)
TSP
4 '>
268
184
14 !' :<
' v
. ' ,;
5' ' " ' ' ,
169
352.5+
4.' . '.,-
14
58
7 :
149
47 :i
15
5
40
90
9
SO,
0
0
0
2
557
4
8
417
101
.
104
7
"^
Actual Emissions
(tpy)
TSP
0
0.5
1.5
1.0
0
3.1
2.0
5.3
925.0
2.9
3.8
1.1
0.2
10.0
2.8
14.7
1.0
0.2
0
<0.1
2.0
so2
0
0
0
1.7
0
0
0
55.5
0
0
0.3
0.1
40.0
0
52.1
0
1.0
0
neg.
0
THC
0
0.3
0
0
0.2
82.6
0
0
0.6
0
0
0
0.6
0.1
3.4
6.7
256.0
3.6
neg.
19.0
Complete shutdown with company gone out of business or out of county.
-------
the most efficient control equipment technically and economically feasible
for new major sources seeking to construct in PSD areas. LAER is defined
as the most stringent emission limitation in any SIP or achieved in prac-
tice by a similar source. LAER must be achieved by new major sources lo-
cating or expanding in nonattainment areas. Cases where sources may in-
stall more efficient controls than RACT include the following:
o Retrofit of BACT or LAER on major sources.
o Change in production processes to reduce emission.
o Additional control of smaller sources.
o Fuel switch or change in other inputs.
It is difficult to specify techniques for identifying such cases because
the decision as to whether the creation of ERCs through installation of
further controls must be made on a case by case basis.-
The CAA requires that states impose RACT on all sources that have a
significant impact upon air quality in a nonattainment area. A signifi-
cant air quality impact has been defined by EPA as 1 ug/m3 annnual aver-
age, 5 ug/3 24-hour average, or 25 yg/m^ 3-hour average concentration
for particulate and sulfur dioxide as determined'through air quality
dispersion modeling. States have defined RACT differently in the 1979
SlPs. For VOC sources, EPA issued Control Technology Guidelines (CTGs)
for specific categories of sources. The'states used these CTGs to write '
regulations defining RACT although variances may have been granted .for.
specific categories based on economic considerations. For other pollu-
tants , RACT in some EPA regions was determined on a case-by-case basis.
In other cases, the existing regulations were reviewed to determine their
stringency. In any case, the emissions limitations imposed in a SI? ap-
proved by EPA consistute RACT for all of the sources in the area.
EPA determines LAER and BACT on a case-by-case basis during the new
source review process. EPA has, however, established a clearinghouse
which publishes a compendium of BACT/LAER determinations. The brokers
will want to consult this publication in order to compare RACT as de-
fined for the sources in his or her market area with these different
technologies. In some cases, the cost differential between RACT and
BACT or LAER may not be great. The DuPont synthetic fibers plant in
Waynesboro, Virginia, for example, chose to use baghouses on its coal-
fired boilers rather than electrostatic precipitators (ESPs) because
the company estimated that the cost of baghouses and ESPs were compar-
able and felt that baghouses would be a more reliable control technol-
ogy for this particular application; Baghouses are generally recognized
as BACT and LAER technology for coal-fired industrial boilers. As a.
result of the installation of the baghouses, ERCs were created. If a
source is not currently using RACT but may be required to do so by 1987,
it may be cheaper for the source to install BACT or LAER technology and
create ERCs for trading. To quantify the potential for such ERCs, the
inventory should be reviewed to identify sources that will have to in-
stall RACT and compare the cost differential between RACT and BACT or
LAER.
82
26
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Smaller sources in the area may be using inefficient control equip-
ment that may be accepted as RACT. For example, woodworking plants com-
monly use cyclones. Instead baghouses might be used to control these
sources without a large expenditure of money. Candidate sources of this
type can be identified in the emission inventory by reviewing the com-
puter codes for control equipment. Cyclones in the inventory are gene-
rally coded as high, medium, or low efficiency. The Guide for Compiling
a Comprehensive *&*ssion Inventory (EPA Publication No. APTD-1135) con-
tains basic guidelines for the use of the NEDS system. Many of the codes
in APTD-1135 are also used in EIS/PSR and other inventory systems used by
states. Table 7 lists the codes for control equipment. The inventories
will also indicate the control efficiency used on individual processes.
In some cases, sources employing control equipment such as ESPs, which
may be capable of achieving high efficiencies, may not be attaining the
maviTnnm reduction possible. The broker should be able to identify such
sources which might be controlled more effectively by reviewing both the
control equipment codes and control efficiencies.
The emissions inventory should also be examined to identify sources
achieving a higher, efficiency with their control equipment than is neces-
sary to meet the requirements of the SIP. For example, sulfur dioxide
emissions from Louisville Gas and Electric Company's coal-fired power
plants are limited by the SIP to 1.2 Ib/million Btu. Recent stack tests
indicate that the company's emissions are actually ranging between 0.6
and 0.9 Ib/millipn Btu. If the utility was willing to accept permit con-
ditions limiting allowable emission to a level less than the current SIP
.limit, a sizable quantity .of ERCs would be created. The emissions inven-
tory could be used to- identify possible cases where actual emissions are
less than allowable because-of better performance of control equipment
than expected. To make this initial determination, brokers should exa-
mine the emissions inventory to identify the method used to calculate
the actual emission rate for particular sources. The EIS/PSR system
has codes to indicate whether actual emission rates are based on emis-
sion factors or stack test data. Data for sources that have lower ac-
tual emissions than allowed could be reviewed to determine if the data
are based on source tests and therefore represent a likely source of
ERCs. The local agency, would also be a valuable source of information
for identifying this type of ERC supply.
Another method of creating ERCs is process modifications. Sometimes,
it is more cost effective to control air pollution by modifying the pro-
cess rather than installing control equipment. VOC emissions from sur-
face coating operations can often be controlled effectively by convert-
ing to water based coatings. ERC creation from process modification is
difficult to determine without detailed knowledge of the process. Nor-
mally, process modification as a control technique would be limited to
VOC sources. EPA has published control technology guidelines for cer-
tain VOC source categories. Some of these source categories can be con-
trolled by process modification and, thus are likely candidates for the
inexpensive creation of ERCs.
Improvements in control technology occur every year. Brokers should
be in the forefront of control technology innovation because these improve-
ments often represent a low cost means of creating ERCs. EPA is a valuable
83
27
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TABLE 7
.CONTROL EQUIPMENT IDENTIFICATION CODES
Identification Nun^er Control Device/Method
000 No Equipment
001 Wet Scrubber - High Efficiency
002 Wet Scrubber - Medium Efficiency
003 Wet Scrubber - Low Efficiency
004 Gravity Collector - High Efficiency
005 Gravity Collector - Medium Efficiency
006 Gravity Collector - Low Efficiency
007 Centrifugal Collector - High Efficiency
008 Centrifugal Collector - Medium Efficiency
009 Centrifugal Collector - Low Efficiency
010 Electrostatic Precipitator - High Efficiency
011 Electrostatic Precipitator - Medium Efficiency
012 Electrostatic Precipitator - Low Efficiency
013 Gas Scrubber (general, not classified)
014 Mist Eliminator - High Velocity
015 Mist Elijninator - Low Velocity
016 Fabric Filter - High Temperature
, 017 Fabric Filter - Medium Temperature
018 Fabric Filter - Low Temperature '
.019 . Catalytic Afterburner . .
020 Catalytic Afterburner with Heat Exchanger
021 Direct Flame Afterburner
022 Direct Flame Afterburner with Heat Exchanger
023 Flaring
039 Catalytic Oxidation - Flue Gas Desulfurization
040 Alkalized Alumina
041 Dry Li mestone Injection
042 Wet Limestone Injection
043 Sulfuric Acid Plant - Contact Process
044 Sulfuric Acid Plant - Double Contact Process
045 Sulfur Plant
046 Process Change
047 Vapor Recovery System (including condensers,
hooding/ and other enclosures)
048 Activated Carbon Adsorption
049 Liquid Filtration System
050 Packed-Gas Absorption Column
051 Tray-Type Gas Absorption Column
NOTE: These code numbers are used in the NEDS and EIS/P&R computerized
emissions inventory data handling systems to identify the type of
devices/methods used to control emissions from each source.
28
-------
source of information on control technology developments. For example,
i EPA publishes a summary of industrial boiler applications of flue gas
1 desulfurization. Another series of publications addresses control tech-
1 nology developments in specific industries such as the metallurgical in-
dustry. Host EPA publications dealing specifically with control technol-
ogies are published by EPA's Industrial Environmental Research Laborato-
ries. EPA publications are readily available from EPA, the Government
Printing Office, and the National Technical Information Service (NTIS).
NTIS publishes a Quarterly Abstract Bulletin of EPA publications. Pri-
vate sources of information include individual vendors, the Air Pollu-
tion Control Association (APCA), and the Industrial Gas Cleaning Insti-
tute. Most of the major vendors usually exhibit at APCA's annual meet-
ings. APCA also sponsors a number of specialty conferences each year.
The Journal of the APCA publishes articles periodically on innovations
in control equipment. Informing clients of new technologies and expanded
applications of existing eqiupment in an important service brokers can
I
provide
As part of the market analysis in Louisville, particulate sources
with emissions greater than 40 tons/year were examined. Emissions from
utilities were not included in the analysis. The analysis was limited
to these sources for the following reasons:
o Time savings in the analysis can be achieved by limiting the num-
ber of sources on the inventory that is examined. A 40 ton/year
. -limit would catch most major -sources .likely to supply ERCs., . , .
o Most of the large industrial boilers which would be controlled by
baghouses would be included. . Since the cost differential between
baghouses and ESPs for industrial boilers is marginal and bag-
houses can routinely achieve a greater efficiency, these sources
are likely ERC creators.
o Utility boilers would be far more expensive to control and be-
cause of size considerations are more likely to be controlled
better already.
o Sources included in the analysis account for 16% of the total
point source emissions in Jefferson County. Utility boiler emis-
sions constitute 41% of this total.
o ERC creation from smaller sources may be more difficult.
o Sources in this size range are more likely to take advantage of
controlled trading options. In fact, some of these sources have
already created ERCs which have been entered in the registry.
Thus, they area already familiar with the program.
Thus, an initial analysis of these sources can provide a useful measure of
ERC supply for particulates in Louisville.
The supply of particulate ERCs from these sources would be liaitad
because the weighted average control efficiency is 98.3%. It was possi-
ble however to identify a few sources which might be more effectively
85
-------
controlled to produce ERCs. Table 8 shows the results of this analysis.
LAER technology and control efficiencies indicated in Table 8 are based
upon a comparison of ths control technology and efficiency needed by the
sources (as stated on the inventory) and that technology and efficiency
that has been applied to similar sources or categories of sources. Note,
however, that such'technology may not be applicable to the specific sources
in Louisville, but is indicative of the type of controls that could be po-
tentially applied to produce ERCs. Controlling these sources further is
likely to be quite expensive because centrifugal collectors or low effici-
j ency wet scrubbers would be replaced by baghouses or electrostatic preci-
| pitators. Thus, this analysis only provides the boiler with a first cut
I at estimating the potential ERC supply.
Conducting an Emission Reduction Audit
One particularly important service brokers could provide for their
clients is to analyze their control strategies to determine the costs
and feasibility of producing ERCs. As part of their marketing efforts,
brokers will want to assist firms in conducting emission reduction audits.
Such an audit would consist, in general, of the following steps:
o Review control technology. The auditor would consider whether
more efficient control equipment or techniques are available for
processes within the plant.
. , - o Estimate costs for..alternative controls... Cost is an important ......
consideration in. deciding whether to install more efficient con-
j . trol equipment. .Engineering cost analyses would be a major ef-
1 fort in the audit.
o Determine availability and costs of financing. Brokers can assist
firms in raising the necessary capital and in analyzing whether
this use of its funds satisfies the firms investment hurdle.
o Analyze internal bubble opportunities. In addition to creating
ERCs for external trading, the audit should identify opportuni-
ties for the source to bubble its sources internally.
To firmly establish the ERC supply, the broker must improve the informa-
tion available by working with potential suppliers to obtain the results
of emission reduction audits.
Emission reduction audits are, in fact, one of the most useful ser-
vices that brokers can perform their clients. They are particularly use-
ful to sources who must install additional controls to meet RACT require-
ments, are undergoing a shift in production lines, are modifying or ex-
. panding, or are undergoing other physical or product alterations. During
the market analysis, the broker should identify firms that might benefit
from an audit and promote this service to these clients. In addition to
increasing the supply of marketable ERCs, the brokers should be able to
profit by identifying specific measures that the client can undertake
that will yield- significant cost savings.
86
30
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TABLE 8 -
POTENTIAL SOURCES OF PARTICULATE BRCs IN LOUISVILLE
Possible Application of LAER
Existing Conditions
. ' Actual Emissions Efficiency
(tons/year). (percent)
B. F. Goodrich
Ralston Purina
Airco Carbide
International Harvester
B. F. Goodrich
Department of Sanitation
Stauffer Chemical Co.
Ford Motor Co.
E. I. DuPont
Rohn & Haas
American Standard Iron
Foundry
E. I. DuPont
Ashland Oil
TOTAL
78.6
76.5
74.2
82.6
48.6
86.6
477.0
45.5
63.4
268.7
115.7
84.3
78.3
75.0
76.6
92.5
1824.0
Uncontrolled
Uncontrolled
Uncontrolled
73
75
86.7
90
90
92
93
97.5
97.5
97.5
98
98
99.9
Process
Coal Boiler
Grain Transfer
Carbide Production
Coal Boiler
Gray Iron Molding
Coal Boiler
Incinerator
Coal Boiler
Coal Boiler
Coal Boiler
Coal Boiler
Coal Boiler
Coal Boiler
Iterm Sand
Coal Boiler
Oil Cracking
LAER
Efficiency
(percent)
99.9
99.9
99.9
99.9
99.0
99.9
99.9
99.9
99.9
99.9
99.9
99.9
99.9
LAER Possible EEC a
Emissions Created
(tons/year) (tons/year)
< 0.1
< 0.1
0.3
0.7
47.7
0.5
0.8
3.8
4.6
3.4
3.1
~
3.8
92.5
161.0
78.5
76.4
82.3
~
85.9
429.3
45.0
62.6
264.9
111.1
80.9
75.2
~
72.9
0
1465.0
87
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Other Potential Sources for Creating ERCs
The last step in assessing ERG supply is to consider the potential
for obtaining ERCs from small point sources, area sources/ and mobile
sources. These sources are likely to emit significant quantities of pol-
lution in many areas. For example, mobile sources are generally the pre-
dominate sources of VOC emissions.
There are a number of problems in trying to create ERCs from these
sources. Emissions from these sources are very difficult to quantify
and would be difficult to certify as permanent. Ownership of ERCs from
these sources might also be questionable. As a result of these problems,
care must be taken in trying to develop ERCs from these sources.
Industrial process fugitive emission and open dust sources are other
potential sources of ERCs. Fugitive emissions are those emissions from
industrial processes like rock crushers, coke oven door leaks, and so
forth, that are not emitted from stacks but are emitted to the open air.
Open dust emissions sources include material storage piles, reentrained
dust from paved roads, unpaved roads, and so forth. Open dust and fu-
gitive sources have not normally been well controlled in the past and,
therefore, these emissions may be quite large and often have a signifi-
cant impact upon air quality near a facility. In those situations where
these emissions can be effectively controlled by a firm, they offer a
potential source of particulate ERCs. The use of these ERCs may be li-
mited, however, because the air.quality impact of aL,like. quantity of ._...
ERCs from fugitive emissions and those from sources with stacks would
differ markedly because of differing dispersion .characteristics. More-
over, controls on open dust and from roadways have frequently been in-
cluded by states in the design of their attainment strategy and there-
fore may not always qualify for credit.
ANALYSIS OF DEMAND FOR ERCs
Even though there may be an abundant supply of a commodity, there
can be no market for that commodity unless there is a demand. Demand
and supply, however, are dynamic processes rather than static and finite
givens. Brokers should not only try to estimate existing demand, but
should pursue aggressive marketing activities to create the demand. This
is a new market and brokers must convince firms that significant cost
savings can be realized through the use of ERCs to satisfy permit re-
quirements.
Estimating Existing Demand
The following tasks, described below in more detail, will provide a
useful measure of ERC demand:
o Examine local regulations to identify limits on ERC use. In ad-
dition to the ERCtbanking regulations, rules governing offsets
for new source emissions, EPA's bubble policy, and PSD must be
reviewed. ERC demand will be dependent upon how ERCs can be
used to meet these control requirements.
88"
-------
o Identify the potential for bubble policy applications. A major
use of ERC3 will be for bubbles. The bubble policy offers an
opportunity for existing sources to exercise greater flexibility
in reducing their costs of meeting emissions limitations.
o Project expansion of existing industry. Most ERCs used in Louis-
ville, to date, have been used to offset emissions when firms
modernize or expand existing facilities.
o Identify areas and types of new growth. Although new growth in
nonattainment areas will be emphasized, controlled trading can
also be used in PSD areas.
o Locate areas of demand and consider area specific supply. Parti-
culate and sulfur dioxide ERCs in a specific location may not be
used to meet demand in another area because no air quality bene-
fit would result.
Examine Local Regulations to Determine Potential Uses of ERCs
The extent to which ERCs can be used for controlled trading depends
upon local regulations. These regulations establish the limitations on
the use of ERCs to:
o Offset increased emissions in nonattainment areas.
o Meet current and future more stringent regulations through the
use of bubble policy. .
o Avoid consuming or violating increments in areas subject to PSD
regulations.
Emission Offsets
A major use of ERCs is to offset increased emissions from expansion
of existing or new plants. Host major metropolitan areas throughout the
country are designated nonattainment for one or more pollutants. Jeffer-
son County is a nonattainment area for TSP, sulfur dioxide, ozone, and car-
bon monoxide. Since the Kentucky SIP, like most SIPs, does not require
emissions reductions more than necessary to attain the standards in order
to accommodate growth, any new or modified major sources of these pollu-
tants will have to obtain offsets. Louisville regulations define major
sources and major modifications as those with potential emissions more
than 100 tons/year at continuous operation without control equipment or
actual emissions more than SO tons/year with control equipment at contin-
uous operation. These threshold limits are important because they define
the threshold used to determine whether the new or modified sources will
need to offset emissions. To date, all of the ERCs withdrawn from the
bank in Louisville have been used to offset expansions of existing plants.
Bubble Policy Applications
Another major use of- ERCs is to reduce the cost of controlling ex-
isting sources subject to stringent emissions limitations by applying
89
33
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EPA1 s bubble policy. In general, the bubble policy states that a source
can selectively control processes within a facility as long as the overall
emissions limitation for the facility as a whole is met. Thus, it is as
if a bubble were placed over the facility and consideration given only to
the impact of the emissions from the facility outside the bubble and not
to air quality directly within the bubble. Although commonly thought of
as involving only emissions points within a single facility, the policy
allows emissions points from more than one facility to be included in the
bubble. This policy is a keystone of EPA's regulatory reform program be-
cause it provides industry an opportunity for greater flexibility in meet-
ing regulatory requirements.
Normally, a bubble must be approved as a SI? revision. Recently, SPA
has approved New Jersey's generic bubble for VOC sources which requires
only state issued permit limitations. The generic bubble rule substanti-
ally reduces the time required for approval. New Jersey has estimated
that the generic rule will greatly increase the number of bubble policy
applications. Louisville does not have a bubble regulation at all. Thus,
any bubble proposed in Louisville would have to be subject to negotiation
with the local agency and approved by EPA as a SIP revision. The Camnon-
wealth of Kentucky has incorporated the bubble policy into their regula-
tions. These regulations specify, however, that a SIP revision would be
required. Although Jefferson County has not adopted a bubble policy, Ken-
tucky's regulations could provide a basis for applying the bubble policy
in the County.
Avoidance of PSD Increment Consumption
The PSD regulations specify tnaytmrpn air quality increments which
cannot be exceeded by a new major source locating in an area where pre-
sent' air quality is better than the NAAQS. There are two cases in which
a source might be prevented from constructing in a PSD area. In the
first case, other sources that were constructed in the area earlier may
have consumed all of the available air quality increment. SIP revisions
which loosen emission limitations for existing sources also consume PSD
increments. The other case is where the existing air quality, although
better than NAAQS, is not sufficiently better than the standards to al-
low consumption of the PSD increment without violating NAAQS. A source
is never allowed to violate NAAQS even though its impact may be less
than the PSD increments. In each of the cases, ERCs could be used by
firms to avoid creating a PSD violation by offsetting emissions from a
proposed new facility.
The Jefferson County APCD designate the entire County as a nonattain-
ment area although air quality in the rural portion of the County is bet-
ter than the NAAQS. Maps showing areas of Jefferson County where severe
air pollution problems exist are included in the County's comprehensive
plan. Figure 4 shows problem areas for sulfur dioxide. .Although the
APCD has indicated that new sources applying for permits will be reviewed
on a case- by-case basis, because of this nonattainment designation, use
of ERCs to increase PSD increment in the Louisville area will be limited
at least until 1987 when all NAAQS, including secondary standards, are
due to be attained.
90
34
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Sulfur Dioxide Problem Areas
-------
Potential Bubble Policy Applications
To estimate demand for EBCs, brokers will want to consider separate-
ly the potential for use of EBCs in each of its regulatory contexts. The
first step is to identify the potential applications of the bubble policy.
This step can be accomplished by reviewing the emissions inventory and
regulations to identify the following types of sources likely to bubble:
o Sources that must meet new emissions limitations as a result of
recent SIP revisions requiring more stringent controls.
o Facilities with a multitude of individual processes with widely
varying marginal control costs.
o Sources currently burning oil that may convert to coal or natural
gas.
o Two or more sources in close proximity or under common ownership
that may find it more cost-effective to enter into a bubble be-
cause of varying costs of control.
Brokers can quickly identify firms that may benefit from applying
the bubble policy by reviewing the SI?, which will normally list specific
sources or source categories that must implement further controls. Each
SIP must also have a section discussing the economic, energy, and social
effects of new regulations. In most areas, new-regulations requiring
more stringent emissions controls apply to sources of VOC. The Kentucky
SIP identifies the specific categories of VOC sources for which new emis-
sions limits were established in 1979. This list is given in Table 9.
Kentucky based these regulations generally upon the Control Technology
Guidelines (CTGs) issued by EPA. The Kentucky SIP also identifies the
following impacts for each VOC source category:
o Cost of control per ton of reduction.
o Energy demand.
o Problem areas in implementing the regulations.
This information from the Kentucky SIP is given in Tables 10 and 11. Ma-
jor elements of the Louisville economy, such as automobileassembly and
large appliance coating, will be affected. The automobile assembly and
large appliance coating industries in Louisville are good examples of po-
tential users of the bubble policy for the following reasons:
o Each industry emits large amounts of VOCs that are presently un-
controlled, but are required by the 1979 SIP to be controlled at
RACT levels.
o There are only a few sources in each category. These sources.
Ford and General Electric, are very large and have a multitude
of individual emission points.
92
36
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TABLE 9
VOC SOURCES REQUIRED TO INSTALL RACT BY 1979 KENTUCKY SI?
1. Asphalt Paving (401 KAR 63:025)
2. Solvent Metal Cleaning (401 KAR 61:095)
3. Large Appliance Surface Coating (401 KAR 61:110)
4. Metal Furniture Coating (401 KAR 61:105)
5. Automobile and Light Truck Surface Coating (401 KAR 61:090)
6. Service Stations (transport unloading into storage tanks. Stage I,
401 KAR 61:085)
7. Petroleum Liquid Storage (401 KAR 61:050)
8. Petroleum Liquid Loading, Terminals and Bulk Plants (401 KAR 61:055
and 401 KAR 61-f£§6-) - -
9. Magnet Wire Coating Operations (401 K&R 61:100)
.10. Sources Using Organic Solvents (401 KAR 61:060)
11. Fabric, Vinyl, and Paper Surface Coating (401 KAR 61:120)
12. Can Coating (401 KAR 61:125)
13. Coil Coating (401 KAR 61:130)
14. Petroleum Refining, Miscellaneous Sources (401 KAR 61:135)
15. Dry Cleaning (Local Agency Regulation)
Kentucky Administrative Regulations (KAR).
S3
37
-------
TABLE 10
RACT CONTROL COSTS FOR VCC SODRCS CATEGORIES
RACT Category
Paper Coating
Automobile Assembly
Metal Furniture Coating
Large Appliance Coating
Solvent Degreasing
Refinery Vacuum Systems
Gasoline Terminals
Gasoline Bulk Plants
Stor age Tanks ' ' ' ' ". '----. ;.
Service Stations ....
Cutback Asphalt
Cost Per Ton
of Reduction
5
51
$
$
$
$
$
$
,- $
'f :
$
520-680
,550-2,660
126
320
105
5
188
300
' *)C£ '. - -
256 :
95
17C
Energy
Demand3
+12,900
-1-87, 000b
-1,300
-5,120
+300
-48,600
-33,750
-1,500
4 £' rtlVfV '
IO,OOU
-9,500
-1,800
a Equivalent barrels of oil, positive (+) means additional
energy required, negative (-) indicates savings.
k 87,000 if CTG strictly adhered to, deviation from CTG may
be less but is technology dependent.
c First year cost, no cost in following years.
94
38
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TABLE 11
PROBLEM AREAS IDENTIFIED IN APPLYING RACT TO VOC SOURCES
RACT Category
Problem Area
Paper Coating
Automobile Assembly
Metal Furniture Coating
Large Appliance Coating
Solvent Degraasing
Refinery Vacuum Systems
Gasoline Terminals
Bulk Plants
Storage Tanks
Service Stations .
Cutback Asphalt
Wide variation in type and cost of control
Technological limitations on topcoat formula-
tions
Quality control of various colors
High solids technology unproven commercially
None
None
Requires coordination throughout marketing
system
Severe economic Impact on small operations
Availability of equipment
.Older stations have higher retrofit costs,
also dislocation during installation is a
concern
Cold weather application, storage time limits
95
-------
o There is a wide difference in the cost of RACT. The Kentucky
SIP estimates that the .average cost per ton of VOC emission re-
duction from large appliance industry is $320 and that for the
automobile assembly ranges between $1550 to $2660/ton. .
o Each of the two major firms affected by these requirements has
ERCs in the registry.
Thus, a broker in Louisville might initially target any marketing efforts
toward demonstrating the potential cost savings through use of a bubble
to meet these recently imposed RACT requirements.
A broker in Louisville might focus in Ford's and General Electric's
facilities and identify specifically how they might save money by using
the bubble to satisfy VOC requirements. Table 12 shows a summary of RACT
and LAER costs and levels of control for these VOC categories. The emis-
sion reductions indicated for each plant are based on earlier reviews by
ES of the control technology to achieve both RACT and LAER. Both compan-
ies have VCCs in the registry. Ford has 343 tons/year, and General Elec-
tric has 70 tons/year. Ford could possibly meet its RACT requirements
(i.e., 1084 tons/year) with the following methods and costs:
o Ose the 343 tons/year in the ERC registry at no direct cost.
o Purchase the 70 tons/year of ERCs from General Electric at half
-. the-cost Ford-would incur to-control a ton,-but at twice, the ..
costs General Electric would incur to further reduce its emis-
. . sions. The total price would be $54,250. :
o Pay General Electric $775/ton to generate the 322 tons/year of
ERCs that could be obtained if General Electric controlled at
LAER levels rather than RACT. The total cost to Ford would be
$249,550.
Ford would have only 349 tons/year of emissions reductions to obtain from
its own plants at a total cost of $734,645. Ford could realize a savings
of $1.3 million. General Electric would save $300,000 or 3/4 of the cost
of implementing RACT by selling its excess ERCs to Ford. This, analysis
should not be considered definitive because many assumptions underly it,
but it is illustrative of the kind of analysis and bubble policy scenarios
that a broker can undertake to promote controlled trading to clients.
Other bubble candidates will be more difficult to identify. Fuel
conversion bubbles are now particularly likely with the increased avail-
ability of natural gas. Some brokers might want to specialize in this
particular type of bubble policy application. Applications of the bubble
for sources that have a multitude of processes with varying marginal costs
could not be readily^ identified by the broker without a thorough under-
standing of control technologies and costs. Similarly, whether two or
more sources could combine in a bubble would be based on internal cost
considerations of each facility to which a broker would generally nor be
privy. Brokers will want to work with their clients to carefully eval-
uate these bubble possibilities.
36
40
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TABLE 12
CONSIDERATION OF CONTROL OPPORTUNITIES IN THE LARGE APPLIANCE
AND AUTOMOBILE ASSEMBLY INDUSTRIES IN LOUISVILLE
a Based upon general analyses of control technologies performed by Engineering-Science
in 1978-79.
h Assume $2105 which is the midpoint of the range of control costs given in the SIP.
' !
Alternative Control
Levels.
. Plant
General Electric Co.
Ford Motor Co.
Assembly Plant
TOTAL
Uncontrolled
Emissions
1825
1295
3120
RACT
Emissions8
458
211
669
LAER
Emissions9
136
* 63
199
Alternative Control
Costs
RACT
($ Million)
0.44
2.28b
2.72
LAER
($ Million)
0.54
2.59b
3.13
-------
<*
Expansion of Existing Industry :
The second major element in ERC demand' is the requirement to offset
emissions from new or expanding sources locating in a nonattainment area.
In order to estimate EEC demand from this requirement, industrial growth
projections are needed. This methodology can be based on general employ-
ment trends for the region. The first step is to determine the emissions
per employee for each 2-digit SIC category. Emissions in the inventory
can be grouped according to 2-digit SIC and divided by the number of em-
ployees in the particular SIC. Although emissions per employee can vary
widely between plants within the SIC, the number of employees is general-
ly a good estimate of the magnitude of a sources emissions. The inven-
tory must first be corrected to reflect IAER emission rates. IAER emis-
sion rates can be determined on the basis of individual Standard Classi-
fication Codes (SCCs) based upon generally available data from the BACT/
IAER clearinghouse. It is necessary to use IAER emission rates because
sources expanding in a nonattainment area must use LAER technology. With
the emissions per employee per 2-digit SIC and projected growth in employ-
ment, the EEC demand can be estimated .
The technique outlined above can be illustrated using the VOC emis-
sion inventory for Louisville. Table 13 is a summary of the uncontrolled,
actual, and IAER emission rates for each 2-digit SIC. The growth rate in
emissions is also shown in 'the table along with the emissions that must
be offset. To limit this analysis to a manageable size, this .analysis
only considers sources with actual emissions greater than 40 tons/year. '
Even if smaller sources expand, they are not likely to increase emissions
sufficient to trigger new source review, and therefore would not have to
obtain offsets. Negative growth rates were not used in this analysis be-
cause declining industries would normally be expected to generate SRCs
rather than consume them.
Identifying Sources Likely to Locate in an Area
The next step is to identify new industrial growth that may require
ERCs for offsets. The Louisville Chamber of Commerce had some very use-
ful information for this purpose. One type of information was the loca-
tion of sites that had already been zoned for industry. A map of these
sites is shown in Figure 5. In Louisville, there are two major industrial
parks that are being developed. Riverport is located along the Ohio River
south of LG&E's Cane Run Power Plant. The Riverport Development Authority
was contacted in order to identify the. type of industry that might be lo-
cating there. A significant portion of development in Riverport will pro-
bably be warehousing and light assembly because the Authority has estab-
lished a Foreign Trade Zone. The other area, Station Park, is near down-
town Louisville and is part of the urban renewal effort. Only warehous-
ing and light industry is planned for this area. Thus, ERCs are not like-
ly to be needed to offset development in Station Park and part of River-
port. Other industrially zoned areas are owned by existing industry and
may be used at least in part for their own expansion. Each area where
industrial development may occur should be analyzed. The broker should
assume a proportion that may be given to grassroots industry. For example,
assume that' 50% of Riverport will be developed by grassroots industry re-
quiring offsets. The LAER emissions determined above can then be divided
42
-------
TABLE 13
PROJECTED EMISSIONS .REQUIRING OFFSETS BY 1985
Uncontrolled Actual LAER Additional Emissions
Emissions Emissions Emissions Growth Rate ' That Must Be Offset
SIC ft SIC Name (tpy) (tpy) (tpy) (Percent) : (tpy)
25 Furniture & Fixtures Mfg. 243 243 . 25 +1.8 25.5
26 paper & Allied Products
Mfg. ' 606 606 61 +9.6 67.0
27 Printing & Publishing 375 107 ; 38 -1.0
28 Chemicals & Allied Produts 6403 3304 119 +4.8 125.0
C0 29 Petroleum & Coal Products 677 314 .. 38 -3.7
CO 33 Primary Metal Industries 1117 1117 38 +13.0 43.0
34 Fabricated Metal Products 1610 1610 128 +7.8 138.0
35 Non-Electrical Machinery
Mfg. 615 615 67 +12.7 75.5
36 Electric & Electronic
Equipment Mfg. 3205 3205 178 +30.2 232.0
37 Transportation . 1384 1384 68 +42.0 96.0
803.0
-------
H
c
c
2
O
8
S
o
m
Location of Industrial Sites in Louisville
M
-------
! by the total acres of existing industrial usage to provide an estimate
I of ERCs per acre needed for industrial development. This method is based
! on the assumption that new industry will have the same characteristics as
existing industry. This assumption is rather gross, but is reasonable
given the fact that similar industries tend to aggregate in a particular
area. Sectors of the local industrial base that are projected to decline
can be discounted in this process.
A broker will want to identify specific firms likely to move into an
area so that the firm can advertise its services by direct mail. Likely
candidate's firms may emerge from conversations with development agency
personnel but, normally, these people will be rather discreet concerning
particular "hot leads." Instead, the broker should rely primarily on the
following techniques:
o Consider the existing industry in the area. Generally if particu-
lar firms in an industry have selected an area, other firms in the
same industry might also find the area attractive.
o Determine who supplies major firms in the area. Suppliers often
move to be near their major clients.
o Find out from the local development agencies about firms that have
b Review the planning agency's: growth projections to" identify indus-.
trial sectors that are projected to grow.
o Develop business contacts with industrial realtors and industrial
location specialists in the area.
With these techniques, the broker can identify a large number of firms
i that could be contacted as potential clients. The possibility of obtain-
i ing ERC brokerage services in an area could be a positive impetus for a
; firm to locate to a particular area.
i Analysis of the Location of ERC Supply/Demand
For particulate matter and sulfur dioxide, the location of ERC sup-
ply and ^"IMTI^ is an important consideration because dispersion character-
istics will determine whether a particular ERC supply can be used to off-
set or bubble emissions from a source in a different location. ERCs from
a plant in one end of the county may not be used to offset or in a bub-
ble with emissions in another part of the. county because these ERCs will
generally not result in an air quality improvement in the area where the
new emission sources will impact. EPA is currently developing guidance
so that simplified modeling analyses can be used to identify whether ERCs
can be applied in particular situations. This guidance will limit cases
where detailed modeling is required and, therefore, make it easier to
trade. But in those cases where detailed modeling analyses may be neces-
sary the broker must recognize the importance of location in determining
the adequacy of supply and demand. Brokers should locate on maps likely
areas where ERCs will be needed. Existing sources in close proximity
to these areas can then be reviewed to determine if the supply in these
101
45
-------
areas will be sufficient. The map in Figure 6 was prepared by the Jeffer-
son County APCD to locate ERG suppliers that could meet demands generated
by facilities locating in Riverport. It is illustrative of the type of
analysis necessary for particulate and sulfur dioxide. This step will
complete the demand assessment portion of the market analysis.
Steps to Generate ESC Demand
Although the methodology outlined above is an attempt to quantify
supply and demand, the broker should not consider any numbers derived
from these exercises as definitive. Rather, brokers should consider the
market analysis to be qualitative; they can and should take a number of
steps to stimulate the creation of a market. Specific actions brokers
may pursue to encourage firms to buy and sell ERCs include:
o Obtain changes where necessary in local SIP regulations to facil-
itate the creation or use of ERCs.
o Purchase ERCs from current owners.
o Negotiate options to purchase ERCs from potential suppliers.
o Conduct an emissions reductions audit for potential producers of
ERCs.
o Review firms compliance strategies to determine potential cost
savings by using ERCs.
o Publicize services through direct mail and other forms of adver-
tising.
Particularly in the early stages of market development, many firms
may not be aware of the potential for profit by generating ERCs. Brokers
must not only ask firms if they are interested in buying and selling ZRCs,
but must inform them that the possibility exists. Active, aggressive mar-
keting is the only way to overcome the skepticism that is a natural obsta-
cle in any new market.
The extent to which brokers will participate in any of these efforts
depends upon their role and the price of ERCs. Price and potential sav-
ings for firms will be important considerations in whether a viable SRC
market can exist and whether a broker can realize a reasonable profit.
The analysis of controlled trading opportunities between Ford and General
Electric in Louisville, however, demonstrates that substantial savings to
clients can be realized. If the broker were.to ask for 10% of the savings,
the commission in this case would be $160,000.
RESOURCES HEEDED FOR A. MARKET ANALYSIS
Much of a market analysis J.ike that undertaken by ES of the Louis-
ville area, can be 'performed for $5,000 to $10,000. The resources that
a broker may have to invest in a market analysis will depend upon the
102
46
-------
FIGUBE 6
Potential ERG Sources near Riverport Industrial Park
Riverport Industrial Park
AMERICAN SYNTHETIC
RUBBER
BOROEN
CAMPGROUND FILL CO.
CANE RUN
E.I. DuPONT
EXXON
KOCH
SCOTT
SOUTHERN MATERIALS
STAUFFER
103
47
ENGINEERING-SCIENCE
-------
level of analysis that he wishes to perform. . The following elements com-
prise the resources needed for a market analysis:
o Manpower will be the largest cost.
o Specific skills are required for the type of analysis performed
in Louisville, but each broker should try to trailer the analysis
in accordance with his own skills.
o Direct costs include travel expenses, material costs, telephone
expenses, computer timesharing expenses, and so forth.
o Time is money so that brokers should develop a schedule.
To provide the potential broker with information to define the re-
source needs for a market analysis, the Louisville analysis is used as
an example.
Manpower
Approximately 250 manhours was required to complete the Louisville
market analysis. The division of labor by specific categories is outlined
in Table 14. Specific functions of these personnel at ES are:
o Principal - plans and directs analysis, assigns personnel to pro-
! ject, and reviews performance. . . . .
| o Supervising. Engineer or Scientist - gathers information, analyzes
j data, and directs lower level personnel.
i
I o Associate Engineer or Scientist - assembles and processes data,
j ' prepares summaries, and writes reports.
o Draftsman/Technician - processes data and prepares figures.
o Secretary/Typist - types reports, letters, etc.
Skills '
Skills needed to perform a similar analysis would be the following:
o Legal/Regulatory. The broker should be familiar with controlled
trading regulations and air pollution control regulations.
o Control Technology. To identify control technology options avail-
able for creating ERCs, the broker should be able to identify
alternative levels of control that can be applied to different
sources and processes. In general, this knowledge can be obtained
by reviewing EPA and other publications to identify control effi-
ciencies associated with RACT, BACT, and LAER. The broker does
not have to be an engineer or be able to design control equipment.
For example, a broker should know that electrostatic preci?itators
are LAER, but need not know exactly how an ESP works.
1C4 48
-------
TABLE 14
MANPOWER REQUIREMENTS FOR MARKET ANALYSIS
Labor Category
Manhours
Principal
Supervising Engineer or Scientist
Associate Engineer or Scientist
Draftsman/Technician
Secretary/Typist
Total
25
70
110
25
20
250
105
49
-------
o Financial/Control Cost Estimation. The broker must be aware of
the costs associated with controlling sources and processes at
different control levels.. This information can also be obtained
from EPA and other publications..
o Emissions Inventory. Since most of the information used in the
analysis will be from the emissions inventory, the broker must be
familiar with inventory systems and data, especially NEDS and EIS/
P&R.
These skills should not be taken as limitations on who can become a broker.
There are many potentially profitable roles for brokers in the controlled
trading process. Brokers without the specific skills identified above can
easily develop sufficient expertise. Moreover, the Louisville market anal-
ysis focused primarily on control aspects of creating and using EECs. Bro-
kers could, however, be more highly specialized. For example, a broker
with tax or legal skills could handle only the financing or sales agree-
ments.
Other Direct Costs
The major other direct costs for the analysis may be travel expenses
if the broker is not located in the area that he is analyzing, other
-costs include printing,, telephbna,-materials and supplies, computer time-
sharing, etc.. Estimates of .other direct costs for the Louisville analysis
are given in Table 15. Travel expenses include two round-trip airline tic-
kets from Washington, D.C. to Louisville and rental of a car for five days.
Meals and lodging are based on a $35 per .diem'rate for ten days. Materials
purchased include a copy of the inventory ($50) and maps, etc., from the
planning agency ($10). Brokers who do not use computer systems to summa-
rize data will have to budget for more manpower.
Time
The schedule for the Louisville analysis is shown in Figure 7. In
general, a broker can perform a market analysis within one to two months.
This type of schedule would allow the broker to obtain all of the infor-
mation necessary and make any determinations that are useful. '
SUMMAR?
One of the first steps a broker will want to take before entering a
market is to analyze the area. This market analysis should consist of
the following steps:
o Visit the area. Gather information on the emission inventory,
regulations that govern the creation and use of ERCs, SIP, new
more stringent emissions limitations that are being imposed on
industry, industrial growth projections, etc.
o Estimate EBC supply. ERCs can be created by plant or process
shutdown or curtailment, using BACT or LAER technology rather
than RACT, or modifying the process to minimize emissions.
-------
I
i TABLE 15
ESTIMATES OF OTHER DIRECT COSTS
Category Estimate ($)
Mileage 100
Printing 100
Telephone 100
Meals and Lodging 350
Materials and Supplies 100
Travel Expense 575
Computer Timesharing 150
Total 1,475
107
51
-------
108 52 ENGINEERING- SCIENCE
Schedule and Manpower Estimates for Market Analysis of Louisville
TASK
1.0 GATHER PRELIMINARY DATA
2.0 VISIT THE AREA
3.0 PERFORM SCREENING ANALYSIS
4.0 ESTIMATE ERC SUPPLY
4;l Review regulations
4.2 Identify shutdown
4.3 Estimate ERCs available
from further control
5.0 IDENTIFY ERC DEMAND
5.1 Review regulations
5.2 Identify potential
users of the bubble
policy
5.3 Project ERCs needed for
plant expansion
5.4 Identify ERC requirements
for new growth
WEEKS AFTER INCEPTION OF ANALYSIS
1
2
.
3
r
mmm
mtmm
4
BBBK
5
ffiMMnwn^noM
^^^^H^^^^^W
EjJHjrfl
6
TOTAL
MANHOURS
10
40
10
100
90
250
-------
Another source of supply for the broker is EHCs that are already
in the registry.
o Identify and quantify ERC demand. ERC demand will arise from the
potential uses of ERCs. ERCs can be used to offset increased
emissions from expanding or new industry in nonattainment areas,
to reduce the need through application of the bubble policy to
install new control equipment to meet new regulations, and to
avoid consuming available air quality increments or violating
NAAQS in PSDareas.
The market analysis is an initial step brokers might take to help them
decide whether or not to offer particular services if any in an area.
This analysis will also provide important information for brokers to use
in aggressively marketing their services.
There are many roles for brokers in the controlled trading program.
This is a new, fast developing business in which brokers who act now have
the opportunity to earn a substantial return on their investment. These
returns can be achieved by buying and selling ERCs, by performing emission
reduction audits, by helping clients to arrange bubbles, and by performing
other related services that can save their clients considerable sums of
money.
109
-------
FINANCING EMISSION REDUCTION
CREDITS
\o
-------
information on financing emission reduction .credits is contained
under separate cover in two documents: Private Financing Manual
for the Creation and Purchase of Emission Offsets and Public
Financing Manual for the Creation and Purchase of Emission Offsets.
Both are available from EPA at:
U.S. Environmental Protection Agency
Controlled Trading Project (PM-223)
Information Request
401 M Street, S.W.
Washington, D.C. 20460
110
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OPTIONS TRADING
i
\\OOL,
-------
BROKERING OPTIONS
prepared by
John S. Hoffman
Office of Planning and Evalution
EPA
for
The Brokers' Conference
January 26, 1981
Options, that is the selling of the right to buy a product
within a specified time at a given price, is a method used in
many industries for reducing risks both for producers and buyers.
Four types of options exist in emission reduction credit (ERC)
markets, reflecting various regulatory strategies in the life of
an ERC. This paper describes all four types and analyzes the
advantages and disadvantages of each.
The viewpoints expressed in this paper do not
'necessarily represent EPA1s views
111
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Birth of a New Business Opportunity
A revolution is taking place in the way states control air
pollution. Dozens of local and state air agencies have developed
or are developing CONTROLLED TRADING SYSTEMS. These systems will
set up markets in surplus "emission reduction credits" (ERCs):
that is, reductions in pollution beyond those mandated by the State
Implementation Plan. These credits can give firms discretion in
how to comply with air pollution requirements. Instead of always
requiring a company to meet regulatory emission limits by purchasing
control equipment, controlled trading allows firms to purchase
and use ERCs as long as the net effect is to comply with their
obligations. Thus, under controlled trading firms will be able
to produce surplus emission reductions and stand to make a
profit selling ERCs. Firms with higher than average control
costs will be able to reduce costs by purchasing and substituting
ERCs for more expensive equipment. And firms seeking federally
required new source construction permits will find it easier to
purchase ERCs for use as offsets, thus maintaining air quality
in the face of growth.
Cost Savings Possible With Controlled Trading Are Large and Unrealized
The cost savings of Controlled Trading are enormous. A
DuPont study estimates that within its own plants over $80,000,000
could be saved by producing less expensive surplus emission
reductions from some pieces of equipment as substitutes for more
expensive reductions from other pieces of equipment.1
This estimate is derived from an econometric model designed by
M.T. Maloney and Bruce Yandle.- They used data collected by
M.T. Kittleman and R.B. Akell, two DuPont Company engineers.
For more information see M.T. Maloney and Bruce Yandle,
"Bubbles and Efficiency", in Regulation, May/June 1980, p.
49-52.
-------
j
Arraco Steel Company is anticipating saving between $12 and
14 million at its Middletown, Ohio facility by controlling emission
points not required under the Ohio State Plan instead of ones that
are presently mandated.2
In California a utility is seeking to buy new, less polluting
production equipment for installation at some low volume emitters
in order to use the resulting ERCs to offset the new emissions
from a facility expansion.3
While numerous examples of other realized cost savings
exist, only a few of the tens of thousands of sources that could
potentially engage in Controlled Trading have done so. It takes
time for a new market to develop. At present few firms understand
or realize how to capitalize on their opportunities.
Existing Lags Represent an Enormous Opportunity For Brokers
Brokers ready to creatively overcome the obstacles now
associated with controlled trading will capture those markets.
A variety of different services and activities can be provided
to firms to help them take advantage of cost saving and profit
making opportunities. Assisting firms to develop, purchase or
sell ERCs is the most straightforward service that brokers can
undertake. Brokers can facilitate the legitimate trading of
this commodity by assuring that the surplus reductions have been
Figures are from an ARMCO presentation held June 17, 1980 at
the Middletown facility. EPA.regional and headquarters
personnel were present along with officials from the State
of Ohio.
Personal communication
113
-------
bound into an "enforceable" form by a State agency under a rule
that is part of its State Implementation Plan. .
One major drawback, however, exists to producing and holding
a fully perfected ERG. Firms are likely to incur sizeable up-front
costs when undertaking control actions that produce ERCs. These
costs may be very high. Holding an ERG without selling or using
it also incurs costs. Risks are further increased because ERG
markets are new and price information about the worth of ERCs is
scarce or non-existant. Finally, as a "product", ERCs are outside
the traditional product area of the firm, and are dependent on
new laws. They also do not produce a physical entity with
a salvage value. These attributes tend to raise many suspicions
about ERG production. ManycompaniW simply will not recognize
the worth of a "piece of paper" until the market begins to pay
for it. In combination with today's high interest costs, this
factor makes it difficult for ERCs to compete for scarce capital
which decreases the odds of investment in ERCs.
Securing large amounts of money for speculative investments
will be difficult, especially if knowledgeable advocates of ERC
production are unavailable to assist firms. Brokers, by being
knowledgeable advocates and experts, can overcome many of these
obstacles, making the brokering business attractive for those
who understand its workings. Options represent a valuable tool
for reducing risk, and should be considered by every broker.
Options as a Means For Reducing Risk
Options, that is the selling of .the right to buy a product,
within a specified time at a given price, is a method used in
many industries for reducing risks both for producers and buyers.
-------
For producers, options can serve several functions: price protec-
tion, deferral of production costs, elimination of need for
up-front captial.
For buyers, options provide similar benefits. Less front
end money is needed to secure ERCs, holding costs can be eliminated,
and the risks of buying something unneeded can be avoided.
Because of these advantages, option agreements between firms
will often be easier to "sell" than ERCs. Options can play an
important role in the development and penetration of many ERG
markets.
Kinds of Options in ERC Markets
Four kinds of options exist in ERC markets, reflecting
various regulatory stages in the life history of an ERC.
The most valuable option is a fully'perfected ERC. A fully
perfected ERC is one that the state has already approved and
credited to its books, and in which the company has changed its
compliance agreement, installed necessary equipment, and reduced
pollution.
The second most valuable kind of option is for a partially
perfected ERC. A partially perfected ERC is one in which a
company has made a proposal which the state regulatory agency
has accepted and has bound the source to the proposed compliance
agreement, but in which the source has not yet made the actual
reduction. Until the reduction is made it cannot be used nor
If a Major SIP revision is required because of a failure to
achieve Reasonable Further "Progress or to attain ambient
standards or because of a revision in ambient standards,
then the rights associated with ERCs must be adjusted
according to one of several allowable methods.
115
-------
fully protected from regulatory changed Firms that agree to
a compliance agreement (including a schedule of compliance) for
creating an ERC can be given protection from regulatory changes
for a limited period of time, but not indefinitely. The partially
perfected ERC option is not as valuable as the fully perfected
I one because it cannot be used until the.producer fulfills his
! control agreement.
i '
| A third kind of option is the fully qualified proposal with
i
1 a compliance offer (by the Regulatory Authority) which the source
! has not bound itself to accept. Thus, a Regulatory Agency quali-
fies and quantifies a proposal and makes a compliance offer to the
i source. The source can or cannot take the offer as it sees
1 ''-
fit. Such offers themselves can specify time limits in advance
on how;long they are good, but such offers must be subject to
j termination by the Regulatory Agency without any rights being
i
I assigned by the source. Consequently, the qualified ERC option
i
represents a real offer for an ERC that has no guaranteed life.
j it is less valuable because it is subject "to being lost" if
j the state so declares.
i
A fourth kind of option is/ the pre-qualified ERC. This
is an option to buy the rights that would accrue if a particular
action qualifies an ERC. The option would be sold before the
producer actually qualifies the possible proposal with the state
reviewing agency. Thus, the option's future as an ERC would be
contingent on the actions, by the state. No "objective" assessment
of its size or characteristics would be possible.
Advantages and Disadvantages of Each type of Option
Fully perfected ERC options guarantee buyers the right to
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use the ERC (or its adjusted nominal value)5 with the time period
allowed by the contract. Such options would provide total security
for the buyer; he or she would know that the ERC would be there
if and when he or she needs it. For sellers, such options are
an attractive way to balance or even exceed holding costs by
using repeated option sales. For buyers facing deadlines, the
postponement of which would be expensive or illegal, this kind
of option represents the kind of security needed (see Table 1).
partially perfected ERCs would provide almost the same benefit
to buyers, except in the situation in which the buyer exercised
the option, but the seller refused or failed to keep its contract
and put on control equipment. In such a case no ERC would exist,
and the. buyer .would .be. unable to go forward with the planned
project using -that ERC. The buyer could seek legal damages,
including any penalties included in the options contract for
failure to fulfill the terms of that contract. However, as in
all such disputes, the value of such legal rights depends on
many factors, including the capability of the non-fulfilling
party to pay damages. Thus, in cases where the failure to have
an ERC exposes a firm to large risks, this type of option may be
unacceptable.
Options on qualified ERCs that are unperfected, would guarantee
purchasers an opportunity to gain an ERC, if the State takes no
intervening action to require actions that eliminate the ERC in a
One method of accomodation to major SIP revisions is to
rollback the value-of the ERC (in tons per year) the average
rollback of all sources. For example, if total emissions in
an area must be reduced 15%, a 100 ton per year ERC would be
reduced to 85 tons'"per year.
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TABLE I
KINDS OF OPTIONS
Definition
Protection Prom
Regulatory Change
Readiness For Use
Fully Perfected
ERC
Reduction has already
been made and certified
by the state. The firm
is legally bound to a
conpliance agreement.
High
High
partially
Perfected
ERC
Reduction has not been
made, but the source
has agreed to a compliance
schedule and the state has
assessed the proposed
reduction. '..-
Limited
Medium
Fully
Qualified
ERC
P re-
Qualified
ERC
No reduction has been made
nor has the source agreed to
adhere to a compliance schedule
that has been established by the
state based on its evaluation of
the magnitude of the proposed :
reduction.
No reduction has been made nor .
has a compliance schedule been;
set up by the state.
118
Very low
Low
Extremely low
Extremely
low
-------
regulation.6 Ordinarily states will not want to take such
actions nor would they be forced to do so. However, some cases
exist. For example', if an area does not make Reasonable Further
Progress (RFP) or does not achieve the National Ambient Air Quality
Standards (NAAQS) on time, the SIP would have to terminate such
offers.
Options in this qualified but unaccepted class have the
distinct advantage that buyers also know what the option represents
if it can be successfully exercised. Since the hard work of qua-
lifying, quantifying and developing a compliance agreement for a
i proposal has been successfully completed before the producer
commits 'itself to spend money on controls, this type of option
j . .is a,.very .good...compromise between financial, risks and risks
associated with not having a viable ERC.when needed. This type
of option is almost as good as an ERC at s fraction of the up-front
cost and risk. Its drawback is a small but real exposure to
regulatory loss.
A fourth kind of option is one for a pre-qualified proposal,
in which a seller agrees to submit a proposal and sell any resulting
ERCs. The buyer has no guarantee of what it is buying under this
option. This may not prove to be a problem provided the buyer
is seeking the option without a specific project deadline in
mind or if the price is low enough. Since the producer need not
spend any money, the risk to it is small, especially if the
contract calls for the purchaser to bear costs associated with
For example, a new s'tate regulation could require the reduction
that would have been used to create an ERC. Unless the source
has committed to the change before such an action, no rights
exist for an ERC.
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8
the development and/or implementation of the proposal. This
sort of option can be particularly successful for transactions
that involve replacing out-of-date process equipment and in
which the risks of not qualifying the proposal are neglible.
The risks for a buyer of not having a viable ERG will necessarily
be substantially higher than other.options, but the financial
i '
i .
| exposure of this type of option may be sufficiently less than
! other options or ERCs themselves. In,some instances it could be
a best buy.
Finding Sellers and Buyers
i
i Deciding how to approach firms for producing, selling,
purchase of options requires several things. One must assess the
j needs of the firm, who in the firm can best assess those needs,
and who can make decisions. More than the environmental section
must be involved. The planners and financial experts for the
corporation must also be included.
Various obstacles can exist to gaining needed data. Firms
may prefer not to reveal information about their activities.
Or, they may want confidentiality agreements. Access to the
best level of management may be difficult to obtain. Hassled
line managers may prefer to avoid more hassles, despite the
potential for reasonable or even large profits available with
options. . In approaching new or existing clients it is critical
that all these possibilities be considered in advance and that
methods be used to involve the critics and get their acquiescence.
A good presentation must involve every decision-maker in the
firm that could stop the project.
-------
Closing on an agreement may be the most difficult phase of
the process. Someone in the firm needs to take responsbility,
someone who probably is unfamiliar with all the dimensions of
the proposal. Consequently, it is critical to involve supporting
parts of the organization in the proposal, so that their endorse-
ment is visible to the person or committee making the decision.
"Shuttle diplomacy" may be useful in bringing buyers and sellers
together as long as it reduces risk and is used not opportunis-
tically to inflate prices. Caution should always be exercised
in every negotiation. The key to any successful transaction is
development of trust and confidence. Options provide a viable
mechanism for reducing upfront risks thus improving the saleability
of ERCs. Brokers who use options as a tool of risk reduction
will often succeed-.on what otherwise would be barren ground.
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TAX IMPLICATIONS OF BROKERING
-------
TAX CONSIDERATIONS RELATED TO THE FINANCING,
CREATION, BANKING, AND USE OF ERGS
Prepared by:
Peter H. Winslow
--.=--.-v-:E.-, P> -Baker-' . -;.-- ...,-..
Scribner, Hall, Thornburg and Thompson
1875 Eye Street, N.W..
Suite 700
Washington, D.C. 20006
January 1981
122
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TABLE OF CONTENTS
Page
I. Introduction 1
II. Role of Brokers Related to Tax Issues 3
III. Scope of Paper 4
IV. Definition and Relevance of Tax Terras 5
V. IRS Offset Rulings ' 9
Ownership of Pollution Control Facility 10
Deduction for the Payment of Operating and
Maintenance Expense 11
Subsidy Payments Taxable to the Source
Reducing Emissions 12
Other Taxable Income of the Source Creating
the ERG . 13
VI. Significant Tax Issues 14
Tax Benefits Available to a Source
Creating an ERG 16
Financing Issues 19
Administrative Costs Relating to the Creation
and Banking of an ERG 2.2
Banking of *an ERG 23
Sales of ERCs 24
Use of an ERG in an Operating Permit , 26
Government Subsidies and Grants of ERCs 27
Leasing Transactions 28
VII. Conclusion 29
Exhibit 1
Relationship of-Tax Issue to ERG Trading
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Tax Considerations Related to the Financing,
Creation, Banking and Use of ERCs
I. Introduction
Controlled trading of emission reduction credits (ERCs)
| offers firms new opportunities to significantly reduce their
j costs of meeting air pollution control requirements. Under
j this program, firms now have the option of reducing their
I control costs by purchasing surplus emission reductions from
I other firms, by exceeding current control requirements at one
] point source in return for relaxing controls at another (i.e.,
! use of the bubble policy), or by selling surplus emission
j reductions to other firms. With a controlled trading system,
| firms are no longer locked into a rigid regulatory program
| . requiring the installation of specific control equipment at
! each point source. Controlled trading permits each firm to
dev.elop a compliance strategy consistent with the exigencies
of its own business and planning goals.
A key element of an effective controlled trading program
is ERC banking. A banking system enables more cost-effective
compliance with control requirements by allowing firms to
receive and store credits for' reducing'I'tftei'r' emissions beyond
required levels of control. In areas with banking programs, a
firm now has an incentive to initiate emission reductions
beyond current requirements when it is economically feasible
to do so. Credit for the surplus emission reductions can then
be banked providing cost-savings through future sale or use at
another point source (e.g., in a bubble or to accommodate
plant expansion), or to use in the event SIP standards are
later revised.
With the added flexibility of being able to buy and sell
emission reduction credits, a number of different options are
available to firms in developing their compliance strategies.
Most importantly, these options have significant profit and
loss implications affecting emission control costs and the
financial well-being of the firm. For example, in a number of
recent bubble applications firms anticipate a savings of more
than $5 million. Savings for the seventy bubble applications
currently in the regulatory process are estimated to average
$2 million.
In evaluating decisions to create, purchase, bank, or use
ERCs, firms will want to carefully evaluate their costs and
potential savings in each transaction. Tax consequences play
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an important part both in the firm's initial decision to
create an ERG and in determining its use.
IRS treatment of various ERG transactions will affect
their financial desirability.- For example, there can be a
significant difference in the cost and therefore desirability
of creating an ERG where industrial development bonds are used
as a means of financing the installation of control equipment,
instead of using debt-financing from private sources.
Although a firm is entitled to a tax deduction for its
interest payments in a private financing, transaction, these
interest deductions will not compensate for the burden of
interest payments at high commercial rates. In comparison,
industrial development bonds can be sold at lower rates
(because interest income on such bonds is tax-exempt when
received by bondholders), with the savings passed on to the
firm which reduces emissions.
Tax implications not only can influence the method of
financing ERCs selected by a firm, but they also can influence
the way in which this commodity is used once it is created.
; For-instance, a firm that-.creates.-surplus reductions with- the
aim of selling the credit may achieve significant tax savings
.by banking the ERG and holding it for more than one year .
before it is sold to avoid^paying higher taxes on a short-term
profit. Further savings through deferral of tax liability can
result if the negotiated ERG sales agreement is structured as
. an installment contract.
Through negotiation and careful tax planning, applicable
tax benefits and burdens can be distributed among firms
participating in an ERG transaction in the most desirable
fashion. Where tax results may be in doubt, however, securing
a private letter ruling from the IRS as to the tax
consequences may be an essential consideration in structuring
an ERG transaction.
The types of tax issues firms will want to consider in
j evaluating ERG transactions include the following:
i
i o Can tax-exempt industrial development bonds be used
i to create a surplus emission reduction or purchase
I an ERG?
i
i o Does pollution control equipment used to create an
j ERG qualify for 60-month rapid amortization?
I o Can the costs of purchasing an ERG be amortized?
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o Will proceeds from the sale of ERCs be taxed as
long-term capital gains?
o Will a firm be taxed on government grants made to
subsidize the cost of creating or purchasing an
ERC? . ;
These and related issues are addressed in this paper.
II. Role of Brokers Related to Tax Issues
Because tax considerations play a key part in any
financing arrangement or transfer agreement, brokers will want
to be able to advise their clients of the tax consequences
that will result from the various ways in which an ERC
tranaction can be structured. For example, from the
standpoint of the firm creating ah ERC, a broker can assist in
evaluating the alternative methods of financing the emission
reduction, such as by using industrial development bonds,
leasing pollution control equipment, or soliciting government
grants or subsidies. Decisions also,>will. have to ,be made as «-;
to the most desirable way of using or disposing of an ERC
after .it is created. '. ;' ." :'. ... ' ' '.-.-. .- ...'
Brokers also will provide advice to firms needing to
purchase ERCs for use in a bubble, as offsets in a
nonattainment area, or for investment. A prospective
purchaser may engage a broker to locate an appropriate seller
(i.e., the creating firm, dealers or a government agency) and
to negotiate a favorable transfer agreement. As with
control equipment financing transactions, tax considerations
can determine the best way of funding the acquisition of an
ERC. Potential purchasers will want to compare ERC leasing
arrangements to the use .of debt-financing.
Brokers also may wish to act as dealers by buying,
selling and trading ERCs on their own account. Tax
consequences can determine the structure and timing of a
broker's own ERC transaction.
Whether or not a firm participates in a banking and
trading transaction- will depend on its ability to reduce its
costs of meeting pollution control requirements. An important
part of the brokerIsi role will be assisting firms in reducing
these costs. Because of the significance and complexity of
the tax consequences of ERC transactions and because of the
many alternatives available for structuring these
-------
4
transactions, the services of brokers knowledgeable in tax
matters will be particularly helpful in maximizing the
benefits of ERC banking and trading.
III. Scope of Paper
This paper will discuss the key tax issues relating to
ERC transactions. The paper has three parts. The first
presents the basic tax terms and outlines their importance in
ERC transactions. The second examines the tax consequences in
a major offset case which occurred as a private transaction
outside the context of a structured banking system. Although
the offset case discussed is probably atypical, it is
important because it is the first ERC transaction in which the
IRS has ruled on the tax consequences. The IRS ruling
demonstrates the tax complexities that can occur, particularly
where a market in ERCs has not been established.
The last part of the paper will identify and discuss
important tax issues relevant to ERC transactions and to the
creation, banking, and use of ERCs. The discussion of the
relevant tax issues is in a question and answer format.
Readers are. cautioned that other than the offset case
discussed in the second part of this paper there is no
established precedent in the tax law for dealing with
transactions involving ERCs. The IRS has not had an
opportunity to examine the most important issues. With
respect to most issues, existing IRS rulings and regulations
provide little direct guidance. Consequently, reliance by
firms on any specific tax treatment of a proposed ERC
transaction may not be advisable in the absence of an IRS
private ruling.
It also must be borne in mind that each individual ERC
transaction will differ, depending on the circumstances. In
. addition, applicable state banking and bubble rules can vary.
Therefore, tax results may differ significantly even in
similar circumstances.
In examining the tax issues relating to ERC transactions,
care should be taken to distinguish between those issues
affecting pollution control equipment which may be purchased
to create an ERC and those affecting the ERC. For tax
purposes, an ERC will' be treated as a separate valuable
commodity, distinct from the equipment. These two assets will
have different tax characteristics requiring independent
consideration.
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The discussion of tax consequences in this paper
represents a preliminary analysis of the issues. The
conclusions are tentative and subject to IRS review. A more
detailed analysis of the relevant issues will soon be
available from EPA's Controlled Trading Program.
IV. Definition and Relevance of Tax Terms
Before examining the tax implications of specific types
of ERG transactions, it is useful to outline the basic tax
concepts that must be considered in evaluating the tax
consequences of these transactions.
Tax-Exempt Industrial Development Bonds
Interest received by bondholders on qualified industrial
development bonds is not taxed. The greatest potential for
industrial development bond financing is with large issues
(e.g., over $10 million). But, large issues can only be used
for the purpose of constructing "air pollution control
facilities" and therefore exclude process changes and
pollution prevention equipment. Major tax questions that
arise with large, .issue,; industrial, development bond financing
concern the type of equipment that qualifies as an "air
pollution control facility" and whether the creation of a
valuable ERG will preclude this type of financing.
Investment Tax Credit
Taxpayers can claim a ten percent investment tax credit
for qualified investments in business property. For 1981, the
total credit can equal the first $25,000 of tax liability,
plus 80 percent of the excess over $25,000. The credit only
applies to depreciable, tangible personal property used in the
taxpayer's trade or business. The availability of an
investment tax credit for the acquisition of pollution control
equipment may ease the financial burden of creating an ERG.
The purchaser of the ERG will not be entitled to an investment
tax credit for its capital outlay, because the ERG 'is
intangible property.
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-6-
Depreciation or.Amortization
A depreciation or amortization deduction is available for
business or investment property that has a limited useful life
of more than one year. Certain accelerated depreciation
methods allowing disproportionate deductions in early years
are available for tangible business property, such as
pollution control equipment. Straight-line amortization
usually must be taken for intangible property, such as an ERC,
with a limited useful life. How ERCs are-defined in state
implementing rules (e.g., whether they must be used within a
specified period of time) may determine whether ERCs can be
amortized while banked. Once withdrawn from the bank and used
in a permit, amortization deductions for the costs of an ERC
may be available over the life of the operating facility.
60-Month Rapid Amortization
In lieu of claiming a depreciation deduction, a firm may
elect to amortize a portion of the cost of a certified
pollution control facility over a 60-month period. If the
facility is-financed by tax-exempt- industrial development
bonds, the election of 60-month rapid amortization potentially
results in a reduction in the investment tax credit available
. ; to the firm. .The tax/benefits of each alternative must be
weighed to determine whether rapid amortization is desirable.
Capital Asset
Gain realized on the sale of a capital asset can be
accorded favorable tax treatment. Capital assets do not
, include (1) stock in trade or inventory, (2) property held
i primarily for sale to customers in the ordinary course of
1 business, and (3) depreciable business property. The primary
factor in determining whether an ERC is a capital asset is the
owner's motive in holding it (i.e, for investment or for sale
to customers). A banked ERC may constitute a capital asset.
Although pollution abatement equipment generally will not be a
capital asset, long-term capital gain treatment still may
result when it is sold to the extent gain is greater than
prior depreciation deductions. An ERC held by dealers for
sale to customers will not be treated as a capital asset.
Consequently, a dealer's profit realized on the sale of an ERC
will be ordinary income, rather than capital gain.
Long-Term Capital.Gain
Gain on the sale of capital assets generally is
tax-favored only if it is held for more than one year. Gains
on the sale of capital assets held for a shorter period are
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-7-
treated as short-terra capital gain potentially taxable as
ordinary income. The period of time during which an ERG is
banked before it is sold may determine whether favorable long-
term capital gain treatment will occur.
Basis or Adjusted Basis
Basis and adjusted basis are key factors in determining
the amount of the depreciation deduction as well as the gain.
or loss upon a disposition of property. The.'original basis of
property is its purchase price or cost, whether paid in cash
or in notes or other debt instruments. Basis also includes
commissions or other expenses connected with the purchase.
While property is held, basis is adjusted by increasing it for
all expenditures related to the property chargeable to the
capital account and by reducing it by depreciation or
obsolescence deductions. In ERC transactions, a tax basis
must be established for the pollution control equipment used
to achieve an emission reduction, as well as for an ERG that,
is created or purchased. The basis will determine the -amount
of depreciation or amortization deductions for the abatement
equipment and the ERC.' An 'import ant "basis -question is' whether
any costs incurred in achieving a surplus emission reduction
should be allocated to the basis of the ERG, or whether ali of
these costs are included in the basis of the pollution control'
facility.
Loss Deduction
A loss deduction is available where a firm decides to
dismantle, abandon, or sell its plant or machinery. The loss
will be determined by the adjusted basis of the plant or
machinery. To support a claim for a deduction there generally
is no requirement that the firm entirely terminate business
operations or refrain from replacing the abandoned property.
A loss deduction can occur where an ERG is created by a source
shut-down, the replacement of out-moded pollution.control
equipment, or a change in an industrial process. A loss also
could result if SIP revisions result in the forfeiture of a
banked ERG. Firms will want to determine how profits from the
sale of ERCs created by cutbacks and shutdowns will affect
their claim for a loss deduction.
Contributions to Capital
Contributions to the capital of a corporation generally
are not taxed to the corporation. Contributions to capital
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-8-
can be made through government grants or subsidies. Such
grants qualify for tax-free treatment if (1) the grant becomes
part of the working capital of the corporation, (2) it is not
compensatory, (3) it is bargained for, (4) it will benefit the
corporation, and (5) it may contribute to the production of
additional income of the corporation. In the context of ERC
transactions, contributions to capital may come in the form of
government subsidies made for the purpose of reducing
| emissions to create ERCs or government grants of ERCs made as
an inducement to firms to locate in an area or to retain
existing firms. Firms will want to know under what
circumstances government subsidies and grants will be
j tax-free and what consequence tax-free treatment will have on
j other tax benefits available (e.g. depreciation deductions).
{ Rental Deduction
j In a leasing transaction, the leasee obtains a deduction
i for rental payments and the owner of the property includes the
j rental payments in taxable income. A leasing transaction can
j occur for both pollution control equipment and for an ERC that
is created by the emission reduction. A rental deduction is
I not available if the lessee's payments result in the
I.,. -..-.,. acquisition,.of an--ownership interest.-in. the. property.. .The ,,-..;
j primary tax consideration for firms engaging in a leasing
j : -.. transaction is to. make sure that the IRS will not . .
; recharacterize the.arrangement as a sale.
i Capital Expenditure
] A capital outlay made to acquire property that has a
! useful life of over one year is not deductible as a business
j expense. Instead, the expenditure is capitalized and becomes
j part of the basis of the property acquired. Tax recognition
i of the expenditure is accorded through depreciation deductions
i during the useful life of the property. Firms will want to
know which expenditures incurred in an ERC transaction must be
captalized. Expenditures for the acquisition of pollution
control equipment and ERCs generally will be treated as
capital expenditures, while costs incurred in operating and
maintaining pollution control equipment will be deductible on
a current basis as ordinary business expense.
The concepts described in this section highlight the main
tax issues facing firms contemplating ERC transactions.
Although the majority of these issues have yet to be resolved,
the next section,-.which presents the IRS ruling in a major
offset case, provides some useful insight into the important
considerations in resolving some of these unanswered issues.
131
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V. IRS Offset Rulings
At present, the IRS has not ruled on most of the issues
involving the creation, banking and use of ERCs. However, in
two related rulings, Rev. Rul. 79-264 and Letter Ruling
7950049 , the IRS considered the tax consequences in a
transaction where a new source seeking an offset finances an
emission reduction on the premises of an unrelated party.
The facts of the IRS rulings probably do not represent a
typical offset transaction and did not involve ERG banking.
The rulings are nevertheless important because they are the
first legal precedent dealing with the tax aspects of an
offset transaction.
The underlying facts in the rulings apparently were based
on the aborted SOHIO offset transaction. In 1976 SOHIO
initiated permit negotiations for the construction of a marine
terminal, petroleum-storage facility, and oil pipeline
terminals in Long Beach, California. SOHIO proposed to obtain
. required .off sets, .from a. .number. ,of, sources includin.g .Southern..,,...,,.,
California Edison through the installation of a scrubber arid
combustion temperature controls on its electrical generating
unit. The proposed offset transaction called for SOHIO's
payment of approximately $78 million to the utility for the
construction, installation, and operation of the control
equipment which SOHIO would own.
In 1979, SOHIO abandoned the offset transaction citing
project killing delays in government permit procedures and the
likelihood of protracted legal challenges to the arrangement.
By providing a reservoir of approved ERCs readily available to
new or expanding sources, one of the goals of an ERG banking
program is to reduce regulatory delays and to increase legal
certainty, the two main problems encountered by SOHIO.
Revenue Rulings represent the IRS's application of the law
to a hypothetical set of facts that may have been derived and
abstracted from an actual case. Revenue Rulings are published
by the IRS in the Cumulative Bulletin and generally may be
relied upon by all taxpayers. A letter ruling issued by the
IRS involves the facts of a particular situation and can be
relied upon only by the taxpayer to which it is issued.
Copies of private letter rulings with identifying facts
deleted may be obtained from the IRS upon request.
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The SOHIO offset transaction is unusual in that SOHIO
would have reimbursed Southern California Edison for its costs
in reducing emissions and would have retained ownership of the
scrubber installed at the utility's plant. Another unique
aspect of the transaction was that the installation of the
scrubber would not have effected a cost savings for the
utility or reduced its cost in achieving compliance with
ambient air pollution control standards. In a typical ERG
transaction where a banking program has been established
the existing firm will initiate its own emission reduction,
retain ownership of the control equipment and possibly satisfy
control requirements in addition to creating .an ERG.
The aborted SOHIO offset transaction raises tax questions
concerning:
o Which firm is treated as the owner of the pollution
control equipment for depreciation, rapid
amortization, and investment tax purposes?
o Does the company with the existing source (Southern
California Edison) recognize taxable income on the
transaction?
o Which company is entitled to a deduction for expenses
incurred in operating the control equipment?
These issues were addressed by the IRS in its rulings.
Ownership of Pollution Control Facility
The SOHIO offset transaction could have been structured .
so that either company would be considered the owner of the
control equipment acquired to achieve the emission reduction.
Establishing ownership is important because it determines
which company is entitled to the investment tax credit and
rapid amortization or depreciation deductions. In cases not
involving ERG transactions, the company that bears the
economic benefits or burden of any increase or diminution in
the value of the property generally will be considered its
owner by the IRS.
In Rev. Rul. 79-264 and Letter Ruling 7950049, the IRS
listed the following factors as controlling in its ruling that
the new source financing the emission reduction would be
considered the owner of the control equipment. (S (SOHIO) is
the company seeking.offsets through emission reductions on E's
premises):
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o S possessed legal title to the scrubber;
o S had a contractual duty to pay for all of the capital
investment in the scrubber;
o S had the responsibility to pay maintenance and
operating costs;
o S had the duty to pay taxes .levied on the scrubber;
o S bore the risk of loss if the scrubber was destroyed
or condemned;
o S bore the risk of diminution in value of the scrubber
due to obsolescence or exhaustion;
o S enjoyed the benefits of the scrubber throughout its
entire useful life; and
o the scrubber satisfied pollution abatement conditions
imposed, on S..and^ was an ancillary activity relating to
the operation of S's new source.
Any alternative transaction outside of the banking
process that contemplates a continuing relationship between
the parties must be carefully structured to ensure that the
company that is intended to benefit from the depreciation or
amortization deduction and investment tax credit will be
recognized by the IRS as the owner of the property.
Rev. Rul. 79-264 and Letter Ruling 7950049 provide
guidelines for companies to follow in a private offset
transaction to secure IRS recognition of the firm seeking an
offset as the owner of the control equipment. As stated
earlier, ownership of the pollution control facility by the
firm seeking an offset is unusual. With a banking system
firms able to create surplus reductions can evaluate their own
tax benefits independently of the ERG purchaser.
Deduction for the Payment of Operating and Maintenance
Expense
In its rulings, the IRS recognized the business necessity
of obtaining offsets to operate in a nonattainment area. It
ruled that a new source is entitled to a deduction for the
cost of operating and maintaining control equipment used to
create an offset on the premises of an existing source. The
factual pattern in the rulings involved ownership of the
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-12-
abatement equipment by the new source, rather than the source
that created the emission reduction. If ownership is retained
by the existing source, however, the new source nevertheless
should be able to deduct its costs in reimbursing the existing
source for its operating and maintenance costs.
In the IRS rulings, the actual cost of reducing emissions
(i.e., acquiring and installation of the scrubber) served as
the purchase price. The facts of the rulings indicate that
the existing source did not obtain an economic benefit from
the transaction. With ERG banking this will not be the case.
Since market factors and not just costs will be the primary
influence on the purchase price of an ERC, a firm creating a
surplus emission reduction can sell its ERC at a profit. This
profit-making potential will inject additional tax
implications into a firm's decision as to how to best use an
ERC it has created.
tc
Subsidy Payments Taxable to the Source Reducing Emissions
.In its rulings, the IRS has not been consistent in its
treatment of the existing source receiving payments from a new
source subsidizing, the cost of achieving a surplus emission,
reduction; In Rev. Rul. 79-264, the IRS ruled that to the
extent the recipient of the subsidy payments acts as an
independent contractor in the construction, operation, and
maintenance of the abatement equipment:
o it must include in gross income any reimbursement
payments received from the new source; and
o it may deduct all ordinary and necessary expenses
incurred in constructing, operating and maintaining
the equipment.
The IRS reached a different result in Letter Ruling
7950049. It ruled that the recipient:
o will not realize income to the extent reimbursements
received from the new source do not exceed
expenditures;
o will not be entitled to deductions for expenditures to
the extent that, it has a right to reimbursement.; and
o will be entitled to a deduction for expenditures only
to the extent they exceed reimbursements.
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While the different approaches of Rev. Rul. 79-203 and
Letter Ruling 7950049 do not have much effect where
reimbursement and expense payments occur in the same taxable
year, the tax consequences can be significant if payments are
paid or accrued in different taxable years. For instance,
significant expenses could be incurred for which reimbursement
payments are received or accrued the following year. Under
the approach of Rev. Rul. 79-203, the company could receive a
tax benefit through the mismatching of the deduction and
income items, i.e., a deduction in the earlier year and
recognition of income in a later year. Under the approach of
Letter Ruling 7950049, no such tax benefit is available.
Other Taxable Income of the Source Creating the ERC
A firm that receives subsidy payments to finance the
reduction of emissions may receive many incidental benefits
from the transaction. These could include:
o satisfaction of SIP requirements imposed on the "
recipient;
o production economies; and
o income from the sale of byproducts.
In its rulings, the IRS stated that the recipient of
the benefits presented above did not realize taxable income
from the installation and use of. control equipment on its
premises. Six reasons were given for this conclusion:
(1) the recipient had no duty to reduce air pollution;
(2) if the recipient's facilities became subject to air
pollution regulations, replacement of the abatement equipment
would have been necessary to satisfy those regulations;
(3) the equipment did not increase the production or
capacity of the recipient;
(4) the equipment did not effect an increase in revenue
or any cost savings to the recipient;
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(5) the equipment did not increase the useful life of
the recipient's facilities; and
(6) title and beneficial ownership of the equipment
remained with the source providing the subsidy payments.
The possible implication of these rulings is that the
recipient of subsidy payments may realize gross income if one
or more of these factors is absent. Such a potential result-
is underscored in Letter Ruling 7950049 which states that no
opinion is expressed as to the tax consequences to the
recipient in a situation where the control equipment satisfies
any duty to reduce pollution imposed on that company.
It is difficult to understand why the IRS considers these
factors significant. It may be true that installation of the
equipment can economically benefit the recipient of subsidy
payments by reducing its costs in complying with pollution
regulations or by increasing its operating capacity, but these
benefits will be realized through greater profits in the
future. The appropriate time to tax these economic benefits
is when those profits are realized, not'when the indirect
benefits are conferred. This aspect of the IRS rulings
creates a degree of uncertainty in a SOHIO-type offset
!''. -transaction in the more typical case where the existing source
i receives an economic benefit in addition to reimbursement
! payments for the cost of creating a surplus emission
i ' reduction.
VI. Significant Tax Issues
This part of the paper will discuss in a question and
answer format the major tax issues that arise with respect to
ERCs. It is divided into eight sections dealing with-tax
aspects of typical ERG transactions. The tax issues discussed
in these sections occur at various stages of the banking and
trading process. See Exhibit 1. It is important to keep in
mind that the tax issues may affect ERG buyers and sellers
differently at each stage of the process.
o Tax Benefits Available to a Source Creating an SRC:
Various tax benefits are available to a firm that
undertakes to reduce emissions. Where emission
reductions are created by a plant shutdown or
curtailment .a .firm may be entitled to a loss deduction
for its unrecovered costs in the abandoned plant or
process. Where reductions are achieved through the
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EXHIUIT 1 .
Relationship' of Tax Issue to EfC Trading
CRI-'ATING ERCS CERTIfYING ERGS BANKING ERCS SM£ OF ERCS ' USING ERCS
use o£ accelerated depre- determination of tax basis of availability of airortiza- capital gains vs. ordinary availability of
elation ERC tion deduction income amortisation de-
use of 60-month rapid treatjnent of administrative ' lease vs. sale arrangements duction
amortization expenses as capital expendi- treatment of government
availability of investment tures :: grants of ERCs
tax credit
selection of source of funds to
finance purchase of control equip- : ,
rncnt (e.g., industrial develop-
ment bonds or loans) ..
tax treatjnent of operating ' -
an3 maintenance expenses ' '
availability of loss
deductions :
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| purchase and installation of pollution abatement
i equipment, tax benefits in the form of accelerated
depreciation or rapid amortization deductions or the
investment tax credit may be derived as a result of
the firm's expenditures. Section 1 considers whether
the creation of an ERG will have an impact on these
tax benefits.
o Financing Issues; Section 2 discusses the major tax
considerations where an emission reduction is funded
by another public or private financing source, such as
through tax-exempt industrial development bonds or by
loans. '
o Administrative Costs Relating to Creating and Banking
an SRC; Section 3 deals with the tax treatment of
administrative costs in qualifying and certifying an
ERG. .These costs are to be distinguished from the
expenditures incurred in actually reducing emissions
which are considered in Section 1.
o Banking of an ERG; Section 4 discusses whether an ERG
can be amortized during the period it is banked.
p Sale of ERCs; A sale of an ERG has tax consequences
to both the purchaser and seller.. The purchaser will
. . need to know whether tax benefits are available for
his cost of acquisition. The seller may recognize
taxable income on the transaction. Section 5 explores
these issues.
o Use of an ERG; After an ERG is used and incorporated
into an operating permit, it loses its status as a
marketable commodity. Section 6 considers whether the
cost of acquiring an ERG can .be amortized after it has
been used.
o Government Subsidies and Grants of ERCs; Section 7
considers the tax consequences to a business that
receives a grant of an ERG or government subsidies to
reduce'pollution. ERG grants most likely will occur
where a governmental agency (e.g., an industrial
development agency) seeks to entice a business to
locate in a nonattainment area or to retain an
existing firm threatened with closure due to pollution
control requirements.
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. o Leasing.Transaction; Depending on the applicable
banking and trading guidelines, firms may want to
lease rather than purchase ERCs. An ERG leasing
transaction could be beneficial where a firm needs an
emission reduction for only a short duration during a
transitional, start-up, or winding-down period. In
addition to the leasing of ERCs, control equipment
leasing may be a means of financing the creation of
surplus emission reductions. Section 8 considers tax
issues relating to leasing transactions.
1. Tax Benefits Available to a Source Creating an SRC
To illustrate the potential tax benefits of reducing
emissions through the purchase of control equipment, source
shutdown, or process change, it is helpful to provide a
representative example. A large industrial company operates a
manufacturing process in a nonattainment area. For sometime
the company has used a baghouse to reduce emissions of
particulates resulting from the coal combustion. This process
satisfies current SIP requirements for the existing facility.
The company is considering adding on'a electrostatic
precipitator to further reduce particulate emissions
significantly below current requirements. The company is
aware that emission reductions are scarce in its geographic
area .and a new or existing source would be willing to pay a
considerable price for an ERG to enable it bubble or to locate
in the nonattainment area.
The company1s decision to adopt the new method for
reducing emissions has many potential tax ramifications:
o the company may claim an investment tax credit for the
cost of acquiring the new electrostatic precipitator;
o when the new equipment is placed in service, the
company can claim a depreciation deduction;
o if the electrostatic precipitator qualifies as a
pollution control facility, the company, in lieu of
claiming a depreciation deduction, could elect
60-month rapid amortization;
o the company can deduct the costs of operating and
maintaining-the new equipment; and
o if the baghouse is abandoned or sold for its scrap
value, the company may be entitled to a loss deduction
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-17-
for its uncovered costs incurred with respect to the
baghouse.
In determining whether to incur the expense of acquiring
the new electrostatic precipitator and creating an ERG, the
company would take these tax advantages into account. This
section considers whether the creation of an ERC will have any
adverse impact on these tax benefits.
Will the investment tax credit, depreciation or elective
rapid amortization for the cost of a pollution control
facility be available if an ERC is created?
When'a firm makes capital outlays for property with an
extended useful life, it cannot claim a current tax deduction
for its costs. Instead, the firm must estimate the useful
life of the asset and its salvage value and charge off the
cost of the asset over the period it is used in the business.
To stimulate capital formation, Congress has provided for the
use of several accelerated depreciation methods for business
j equipment that have the effect of permitting disproportionate
|. .., .. depreciation deductions .in the first, years the equipment i.s ...
| used in the business. An additional incentive, the investment
! . tax credit, is available in the year the equipment is placed
i. -'.:... in service. Finally, special rules providing significant tax
benefits through rapid amortization deductions have been
enacted by Congress to stimulate the acquisition of pollution
control equipment. A firm may elect to amortize a portion of
the cost of newly-acquired equipment over a 60-month period to
begin in the month, following completion or acquisition of the
facility or with the first month of the following taxable
year. But, only equipment that is certified as a "pollution
control facility" by state and federal authorities and does
not reduce the firm's total operating costs qualifies.
Firms are limited in selecting among the available tax
benefits. Elective rapid amortization can only be used in
lieu of depreciation deductions otherwise allowable. If
acquisition of the equipment is financed by tax-exempt
industrial development bonds, election of rapid amortization
over a 60-month period potentially results in a reduction of
the investment tax credit available to the company. Firms
must carefully evaluate.which of these tax provisions are
applicable to their investment in creating ERCs and which will
provide the most tax benefits.
The creation of an ERC should not affect the firm's right
to an investment tax credit or accelerated depreciation for
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-18- .
the pollution control equipment. However, the IRS could argue
that 60-month rapid amortization is not available for the
equipment because the profit realized on the sale of a ERG may
have the effect of reducing total operating costs.
Nevertheless, the chances are good that the IRS will not adopt
this position. .
j - -..'
i What will be the tax basis of newly-acquired control
I equipment? .
j The tax basis assigned to pollution control equipment
j purchased to reduce emissions will be the costs incurred by
i the firm in acquiring, constructing, or installing it. . The
! tax basis of the equipment should not be affected even though
an ERG is created. This is true even in cases where equipment
is installed for the specific purpose of creating an ERG.
Where the equipment in part satisfies a control requirement
and in part creates an ERG, no portion of the cost of the
- equipment should be subtracted from its basis and allocated to
the ERG.
-.-.- ''--. -.- - The -tax basis- of-the- equipment -is important in -;; ','-".- ... , :
determining the tax benefits to be derived from the .
acquisition. Basis .will determine the amount of the firm's:
o investment tax credit;
o depreciation deduction?
o elective rapid amortization deduction, if the
equipment qualifies as a pollution control facility;
and
o taxable gain or loss on the subsequent sale or
abandonment of the equipment.
Will the creation of an ERG through source shut-down,
curtailment in operations, or replacement of out-moded
equipment affect otherwise available loss deductions?
A company generally is entitled to a deduction for a loss
incurred on the shut-down, abandonment, or sale for scrap
value of its plant or equipment. The loss deduction is
measured by the company's basis remaining in the plant or
equipment less any salvage value or compensation for the loss
received by the company.'.
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A firm should be allowed a loss deduction even if the
shut-down, abandonment, or sale results in the creation of a
valuable ERG. It is unlikely that an ERG created in this
manner will be treated for tax purposes as compensation for
the firm's loss.
2. Financing Issues
Emission reductions can be achieved through funding from
several outside financing so.urces: .
|f|.p- use of tax-exempt industrial development bonds;
o payment by unrelated new sources seeking offsets;
. o payment by unrelated sources within a bubble;
o loans or private bond issues; or
o equipment leasing.
'Public financing through industrial development bonds
frequently is the most attractive alternative. Industrial
development bond, financing is only.available in a limited ..
number of situations', however. Where available, use of this
financing tool also has drawbacks that must be evaluated. A
firm will give up the full benefit of elective 60-month rapid
amortization, if industrial development bonds are used. The
most important issue with respect to industrial development
bonds is whether the creation of a valuable ERG precludes
their use as a method of financing emission reductions.
Another alternative is funding through term loans,
project loans, or a .private bond issue. The firm's deduction
.for interest payments on the loan or bond and its tax basis in
the equipment used to purchase the equipment are the primary
tax considerations in a borrowing arrangement.
Can tax-exempt industrial development bonds be used to
finance the installation of pollution control facilities to
create an ERG?
The three most common methods of qualifying the
acquisition of pollution control equipment for tax-exempt
industrial development bond financing are:
(1) a small issue of $1 million or less;
(2) acquisition of facilities costing $10 million or
less; or .
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-20-
(3) issues of unlimited amount for the acquisition of a
qualified "air pollution control facility.."
For larger bond issues, at least 90 percent of the bond
proceeds must be used to acquire a qualified "air pollution
control facility" to make tax-exempt industrial development
bond financing feasible. An "air pollution control facility"
is depreciable business property used to abate or control air
pollution or contamination by removing, altering, disposing,
or storing pollutants, contaminates, wastes, or heat. It can.
be designed to exceed applicable federal, state, and local
requirements for the control of atmospheric pollutants or
contaminants (e.g., it can create an ERG), but equipment built
in anticipation of capacity expansion may not qualify because
it does not currently control pollution. ;
Restrictions in regulations proposed by the Treasury
Department may effectively preclude this type of industrial
development bond financing for:
aprocess .changes . that_.c0atrol. or_prevent pollution;
6 ' equipment '.that 'prevents" the 'creation .of pollutants,
rather than equipment that: operates at the
. : ' ; end-of-the-pipe (e.g./ coal washing facilities); :
o equipment that treats materials or heat that are no
longer pollutants;
o equipment that disperses pollutants, rather than
abates them; . .
o equipment that prevents the release of pollutants but
which causes an imminent risk of damage or injury to
property, employees or other persons;
o equipment that prevents the release of pollutants in a
major accident;
o equipment used to control pollution but which would
be considered a public nuisance; and
o equipment that has been used as a customary practice
in' the industry, and is not required for reasons of
compliance with pollution control requirements.
Even if none of these restrictions apply, the IRS could
adopt the position that tax-exempt industrial development bond
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i
I
i financing for control equipment is not available to the extent
the firm is able to recover all or part of its investment
through the sale of an ERG. Existing, regulations provide that
the full cost of the facility only can be financed with
tax-exempt bonds if the expenditures for the property would
not be made "but for" the purpose of controlling pollution,
and if the equipment acquired has no "function" other than
controlling pollution. If the facility is constructed for a
dual purpose, only, the "incremental cost" of fulfilling the
pollution control purpose qualifies, i.e., the excess of the
total cost of the facility over the cost expended for a
purpose other than the control of pollution.
At this time it is unclear whether the IRS will deny
tax-exempt industrial development bond treatment because a
valuable ERG is created. But, there are strong arguments to
support the position that an ERG is not the type of economic
benefit that should preclude industrial development bond
financing. The cost savings contemplated by the proposed
regulations are the type that are directly derived from the
operation or "function" of the facility. In contrast, the
economic advantages that can be derived from an ERG stem from
the rules implementing the Glean Air Act, not from the
operation of the control equipment.
:'-:.-. If qualification of equipment as an "air pollution
control facility" is in doubt, financing through tax-exempt
small issues may be a viable alternative. If the aggregate
face amount of the bond issue is $1 million or less,
tax-exempt industrial development bonds may be used for the
: acquisition, construction, reconstruction, or improvement of
land or depreciable business property, including pollution
control equipment without the restrictions imposed, upon larger
issues.
A second funding alternative is available if
substantially all of the proceeds of a $10 million small issue
are used for the acquisition, construction, or improvement of
land or depreciable business property. This funding
alternative is not available, however, if the facility and
other capital expenditures made by the firm in the same
locality cost more than $10 million, even if the aggregate
face amount of the issue is less than $10 million. In
determining whether the.$10 million limitation had been
exceeded, costs chargeable to the company's capital account
incurred during the-six-year period beginning three years
before the date of the issue and ending three years after the
issue are taken into account. A significant limitation on the
use of a $10 million.small issue is that the firm's total
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-22-
capital expenditures made during the six-year period in the
same municipality or county cannot exceed $10 million.
What are the tax consequences where pollution control
equipment is acquired using borrowed funds or funds secured
through a private bond issue?
An important financing alternative for the creation of an
ERG is to take out a loan or issue bonds, and use the proceeds
to purchase the pollution control equipment. In a loan
transaction, the firm is entitled to a deduction for interest
payments. However, no deduction is available for principal
payments made in repayment of the loan or payments made in
redemption of bonds.
A significant tax benefit from a loan transaction is that
it creates "leverage" for the borrower. This means that a
firm is able to use the borrowed funds to acquire a large tax
basis in the purchased equipment. Thus, for a relatively
small initial capital investment, the firm can obtain
disproportionate tax benefits through the investment tax
credit, accelerated depreciation, or elective 60-month rapid
amortization measured by the full cost of the equipment.
3. Administrative Costs Relating to the Creation and
Banking of an ERG
In section 1 tax considerations relating to the costs of
acquiring and installing pollution control equipment were
discussed. Generally, tax benefits for acquisition and
construction costs is obtained through the investment tax
credit and deductions for depreciation or amortization over
the life of the equipment.
This section deals with administrative costs incurred by
a firm in qualifying, quantifying and certifying an ERG.
Before deciding to initiate an emission-reduction, a firm may
incur costs in consulting with appropriate agencies and
estimating the credit potentially available. Engineers may be
needed for testing and measuring emission reductions,
preparing applications, or rewriting permits. Attorneys may
be hired to represent a firm during the certification process.
If the firm is not operating under an effective permit, costs
may be incurred in establishing and documenting a baseline of
current emissions for measuring any potential reduction. The
responsible agency^also may decide to pass on to the firm as a
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permit fee the agency's costs incurred in quantifying an
emission reduction or revising the source's permit.
The primary issues relating to administrative costs
incurred during the certification process will include:
o whether the expenses may be currently deducted or must
be captalized; and
o what will be the tax basis of the ERG?
Can the administrative costs incurred in qualifying and
certifying an ERC be deducted?
An expenditure made to acquire property with a useful life
of over one year is not deductible for tax purposes.
Consequently/ a firm is not entitled to a deduction for the
administrative costs incurred during the certification and
banking process because the ERC created has an extended life.
The administrative expenses must be capitalized which means
that the costs are added to the tax basis of the ERC and
accorded tax recognition either through allowable amortization
deductions or through a reduction'in the taxable gain realized
when .the ERC is sold.
. What is the tax basis of an ERC owned by the firm
creating it? .
The basis of an ERC owned by the firm that created it
will be the administrative costs incurred during the
certification and banking process. The basis in the ERC
probably will not include any costs relating to the
acquisition and installation of the pollution control
equipment responsible for the' emission reduction. The
equipment will have its own distinct basis.
The tax basis .of an ERC is important in determining the
creating firm's: '
o amortization deduction, and
o taxable gain on the sale of the ERC.
4. Banking of an. ERC
Once an emission reduction is qualified, quantified,
certified, the ERC may be used, sold, or banked. This
section considers the tax issues that relate to the ERC
and
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-24-
after banking has occurred. A company that decides to
participate in the banking program may have no intention of
immediately using the ERG. The company may consider it
advantageous to retain the banked ERG:
o to satisfy more stringent emission requirements that
may be anticipated in the future;
o for later sale or lease to another firm when market
conditions are more favorable;
o for future use as an offset or within a bubble
application.
The primary issue relating to a banked ERG that has not
been sold or used to meet a permit requirement is whether the
ERC's cost basis may be amortized or depreciated.
Is an amortization deduction available for the cost of a
banked ERG that has not been used?
Whether: an amortization deduction .will be allowable for ^
the cost of a banked ERG: may' dependr"upbri applicable state
banking rules. An amortization deduction is available only
where a useful life of the ERG can be established. ;
Consequently, where banking rules do not provide an expiration
date for an unused ERG, an amortization deduction probably
will not be allowable during the banking period.
Even if state banking rules established an ERG forfeiture
i
' date, the IRS could take the position that the ERG is a
nonincome-producing investment asset not subject to
amortization. The IRS has lost in court cases, however, where
it has made this argument with respect to other investment
assets held by individuals.
If amortization of a banked ERG is allowable, the
deduction would be taken on a straight-line basis.'
Accelerated or 60-month rapid amortization probably would not
be available.
5. Sales of ERCs
- -^
The most common method of disposing of an ERG will be by
a sale transaction. Typically, the company needing an ERG
to expand its operations, in a nonattainment area or to reduce
its control costs through use of a bubble will acquire it from
the source creating itr a governmental agency, or a dealer.
An ERG may be acquired for cash or deferred obligations.
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Alternatively, a source needing an ERC could purchase another
company's entire business and in that manner acquire the ERCs
owned by the company.
The primary tax considerations that arise for the firm
acquiring an ERC are:
o Are the acquisition expenditures currently deductible
or must they be capitalized; and if capitalized, what
is the tax basis in the ERC? (These issues are
important for purposes of determining the amount of
amortization deductions, gains or losses on subsequent
resales, and losses upon abandonment or in the event
of confiscation through SIP revisions.)
o Can tax-exempt, industrial development bonds be used
for financing the acquisition of an ERC?
o Can the benefit of the investment tax credit be
obtained for the purchase of an ERC?
The most important tax issues relating to the seller of
an ERC are:
.-.. o- How is the-taxable* gain or'loss on the sale measured?
*,
o What will be the character .of the gain or loss, i'.e
long or short-terra capital gain or loss, or ordinary
income?
What are the tax consequences to the purchaser of an ERC?
The purchaser of an ERC cannot currently deduct the
purchase price because the ERC is a valuable commodity having
an extended useful life. Acquisition costs must be
capitalized and become part of the basis of the ERC.
After the acquisition, the purchaser can amortize its
cost for the ERC in the same manner as if it had been the
i source creating it, but only if amortization is otherwise
j available for .an unused ERC. (See the discussion of
j amortization of banked ERCs in section 4.) The benefits of
1 60-month rapid amortization, accelerated depreciation, and the
; investment tax credit are not available because an ERC is an
! intangible asset. Theoretically, it may be possible to use
j tax-exempt industrial development bond financing to purchase
j an ERC, but such financing ordinarily is not used for the
: purchase of intangible assets, such as ERCs. A specific
; ruling on this.matter is advisable before proceeding.
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What are the tax consequences to the seller of an EEC?
A seller of an ERG will realize taxable gain or loss
measured by the difference between the amount realized in the
sale transaction and the seller's basis in the ERG, as
adjusted for prior amortization deductions. The creator- of an
ERG or an investor will derive tax-favored long-term capital
gain treatment only if the ERG has been held for over one
year. For dealers regularly buying and selling ERCs, the
transaction will result in "ordinary" gain or loss.
6. Use of an ERG 'in an Operating Permit
The final component of .the banking system is the use of
an ERG through its incorporation in an operating permit.
Typical permit uses may include:
o use within a bubble to reduce costs of meeting current
emission limitations;
o use as an offset in a nonattainment area for a planned
new or expanded facility; and
j ' '' o use in an attainment area to meet or avoid prevention
.I. . .... of .significant ^deterioration., requirements. . ....... ... ,
i , Tax issues relevant to the .use of an ERG include:
i . -"..' ' ' ...' . . p
i '''"'.
j o whether an amortization deduction is.available; and
I . .
o if an amortization deduction is allowable, what method
may be used and over what period is the amortization
taken?
Is amortization available when an ERG is used in an
. operating permit?
An amortization deduction for the cost of an ERG that has
been used is allowable if the firm can establish a useful life
for the benefits derived from the cost. In analogous cases
dealing with intangible rights acquired through government
programs, courts have allowed amortization over the life of
the tangible asset to which the right relates. Consequently,
amortization of ERG costs should be allowed over the life of
the operating facility with respect to which the ERG is used.
If amortization is. allowable, it would, be on a
straight-line basis. As. an intangible right, the benefit from
using an ERG would not qualify for accelerated depreciation or
60-month rapid amortization.
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7. .Government Subsidies and Grants of ERCs
One potential method of securing ERCs in a nonattainment
area is from grants from the state or local air pollution
control agency or economic development agency. The air
pollution control agency could mandate emission reductions
from each business in the area or from particular industries
in order to secure a government-owned reserve of ERCs (i.e. a
growth margin or a community held pool of ERCs) which may be
made available to new or existing sources. The public body
may then contribute an ERC to a firm as an inducement for the
construction or expansion of a plant in a particular location
or to prevent loss of jobs through the shut-down of an
existing source. One notable example of an offset grant is
the creation and acquisition of ERCs by the state of
Pennsylvania followed by a contribution of the ERCs to
Volkswagen to secure the location of a new manufacturing plant
in Pennsylvania.
Government subsidies also can be an important source of
public financing of emission reductions. A government agency
could seek to reduce emissions in its area by subsidizing a.
private" 'fir"mTar~cbst of reducing emissions.
The principal issue with respect to government subsidies
and grants of ERCs is whether the subsidy payments or grants
represent gross income to the recipient for tax purposes.
Will a firm be taxed on subsidy payments or grants of
ERCs received from government agencies?
A source should not be taxed on government grants made to
induce the construction and installation of abatement
equipment if .the grant constitutes a "contribution to
capital." Under rules established by the Supreme Court,
tax-free contribution to capital treatment may be available
where:
(1) the recipient is a corporation;
(2) the recipient acquires ownership of the control
equipment; and
(3) the grant proceeds are used exclusively to purchase
the equipment.
In contrast, government grants subsidizing the cost of
operating and maintaining the pollution control equipment
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-28-
probably will be taxable. Although government grants will not
be taxed, the tax basis in the equipment acquired will be
reduced by the amount of the grant. Thus, the firm will
receive a reduced benefit for its depreciation or rapid
amortization deductions. A government grant of an ERG to a
corporate-recipient also can qualify as a tax-free
contribution to capital, but only if the ERG actually is used
by the recipient. A grant of an ERG or subsidy payments made
to an individual businessman or partnership probably will be
taxable. The amount included in taxable income would be the
fair market value of the benefit received, whether it is the
ERG or subsidy payments.
8. Leasing Transactions
Where permitted by banking rules, ERG leasing may play an
important part in the controlled trading program. For
example, ERG leasing could be used in a situation where an
emission reduction is needed to meet control requirements at a
facility with a limited remaining useful life. In this case
leasing an ERG for five years may be more economical than
retrofitting the facility.
In addition to leasing ERCs, a firm could also lease
control equipment 'to create the underlying- surplus- emission
reduction. ....
The primary tax benefit to the firm .leasing the ERG or
control equipment is the deductibility of rental payments.
For tax planning purposes, the primary tax consideration is to
ensure that the IRS will not recharacterize the transaction as
a sale transaction. In any leasing transaction care should be
taken in structuring the arrangement so that tax benefits and
burdens are distributed as intended by the parties.
When will the IRS treat a lease transaction as a sale?
The IRS has stated that it may recharacterize a lease as
a sale transaction where one or more of the following
conditions are present: . ,
o portions of the periodic payments are applied for the
acquisition of the property by the lessee?
o the lessee will acquire title upon'the payment of a
stated amount of "rentals" which under the contract it
. is required to make;
152
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-29-
o the total amount which the lessee is required to pay
for a relatively short period of use constitutes an
inordinately large proportion of the total sum
required to be paid to secure the transfer of the
title;
o the agreed "rental" payments materially exceed the
| current fair rental value;
j o the property may be acquired under a purchase option
| at a price which is nominal in relation to the value
i of the property at the time when the option may be
j exercised, as determined at the time o.f entering into
I the original agreement, or which is a«|relatively small
j amount when compared with the total payments which are
required to be made; or
o some portion of the periodic payments is .specifically
designated as interest or is otherwise readily
recognizable as the equivalent of interest.
The consequences of IRS treatment of the lease
transaction as a sale would be that "rental" payments would be
.-considered payments made for the purchase of-the pollution
control equipment or ERG and would not be deductible by the
source-using the .asset. Thus, in an equipment leasing
transaction, the "lessor" would not.be treated as the owner of
the equipment, for investment tax credit, depreciation and .
60-month rapid amortization purposes. These tax benefits
. would be reallocated to the firm using the equipment.
In summary, any financing alternative that contemplates a
continuing leasing arrangement between the parties must be
carefully structured to ensure that the company that is
intended to benefit from the depreciation or amortization
deduction and investment tax credit will be recognized by the
IRS as the owner of the property.
VII. Conclusion
This paper has examined a number of critical tax issues
that arise.in the context of ERG transactions. Consideration
of these tax issues will be an important factor in the
financial desirability of participating in controlled trading
activities. Brokers can provide an important service to their
clients by maximizing their tax benefits in structuring the
153
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-30-
financing and sales agreements, both at the time an ERG is
created and at the time it is sold or used.
Few of the -issues discussed in this paper have been
clearly resolved by IRS rulings. In several instances,
existing IRS rulings involving other government programs are
sufficiently analogous to provide some guidance in ERG
transactions. Final resolution of other major issues (e.g.,
j industrial development bond financing) will have to await
j examination by the IRS.
154
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SUPPLEMENTAL INFORMATION
-------
BUBBLE POLICY FACT SHEET
Bubble Applications:
Total Expected Savings:
Average Savings:
First Bubble Approved:
(1-12-81)
60 (as of 1/15/31)
$200 million by
end of 1981
$1 - ?2 million
Narragansett
Example of Cost Savings:
Narragansett Electric Co.
(Providence, R.I. j
E.I. DuPont
- (New Jersey)
Potomac Electric Co.
(Washington, D.C.)
Minnesota Mining $ Mfg. Co.
(Bristol Pennyslvania)
U.S. Steel Co.
(Fairless Pa.)
- 3M
Armco
(Middietown, Oh)
$3m/yr.
$12m in initial
capital
$4ra/yr.
$3m in initial
capital
$lm - $2m/ yr.
$15 in initial
capital
> $10m in initial
capital
155
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EXAMPLES OF EXPENDITURES TO CREATE
AND PURCHASE EMISSION REDUCTION CREDITS FOR USE AS OFFSETS
Firm
f of Tons Received/yr
$/Ton
Volkswagen received
donated ERCs from
BP Oil, Season All
and Moly Climax.
location: PENNSYLVANIA
444 Tons of HC
$250,000
$563
Marblehead Lime Co..
paid the cost.of ...
paving a road within
the confines of a
National Steel Co.
plant.
50-100 Tons of TSP . _S10,OOQ___.
._S500-rlQOO .
Location: MICHIGAN
City of Columbus Ohio
compensated Aggnegated
Rock Corp, Columbus
Bituminous and an
undisclosed company for
the costs they incurred
in adding pollution
control equipment and
raising stack heights
at their facilities.
9000 Tons of TSP
$410,000
$45
Location: OHIO
156
-------
- 2 -
General MDtors received 1230 Tons of HC $200,000 $163
donated ERCs fran the
Sun, Chanplin, Continential
and AFC Oil Companies.
Cbst data was only
available for the ERCs
donated by Chanplin.
Location: OKLAHOMA
General Portland Inc. 1013 Tans of TSP $375,000-$520,000 $370-$513
paid for the cost of
designing and installing
control'(equipment at ' .-,,«.. , :.
Parkers Brothers, a . . .
nearby limestone .
operation.
Location: TEXAS
Wickland Oil Corp 73 Tons of HC $25,000 $342
paid the City of
Paris Dry Cleaners
to renovate its
facility.
Location: CALZPOKOA
157
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APPROVED AND/OR PENDING BUBBLE, OFFSET AND
BANKING TRANSACTIONS
OFFSETS BUBBLES
I 1 X*
US 620+
Region I 8
II 4
III 9
IV 16
V 60
VI -8
.: VII 4
VIII
IX 503+
5
32 64
0 3
-
0 6
-
5 12
2 10
11 24
-. -5- "->:'./;; -.-..- ''- .6-' -<; w~v ...
'.-*: ..'"-' ': -:1' V/K;
'': ' 'r. ';';"'':" '
7 1
1 1
BANKING
100+
1 -
30
20
.17
,- 2 -..'.;
+
92
* I/X= I denotes those transactions that involve only reductions
generated within the corporate holdings of a firm; X
indicates that the transaction occurred between two
distinct firms.
Sources; Data set compiled by Was Vivian at the Institute of
Public Policy Studies, University of Michigan, Ann Arbor;
and EPA Regions*
1S8
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A COLLEGE
U.S. ENVIRONMENTAL PROTECTION AGENCY
MAJOR INSTALLATIONS
ALASKA
BOSTON
\ *
\ NARRAGANSETT
R.I.
NEW YORK
EDISON
'**»
SEATTLE / I*10*"-
Q PORTLAND
CORVALLIS
/ (ROCHESTERi
ANN
ARBOR. JGROSSE
ISLE
ILL. V i .
CHICAGO^ >OH1°
SAN FRANCISCO
A*DENVER| KANSAS CITY^
KAMI.
D-C* ANNAPOLIS
sc
"ATHENS
v ^ATLANTA
\ s.
MONTGOMERY
GULF
O RESEARCH TRIANGLE
PARK
EPA-HQ
* REGIONAL OFFICE
©MULTI-LABORATORY COMPLEX
LABORATORY
A FIELD INSTALLATION
-------
REGIONAL OFFICES AND REGIONAL ADMINISTRATORS
REGION I
William R. Adams. Jr.
John F. Kennedy Federal Building
Room 2203
Boston. Massachusetts 02203
Phone: FTS - 223-7210
CML - 617-223-7210
Hours: 8:00-5:00
REGION VI
Adlene Harrison
First International Building
1201 Elm Street
Dallas, Texas 75270
Phone: FTS - 729-2600
CML - 214-767-2600
Hours: 8:00-4:30
REGION II y.
Charles Warren
26 Federal Plaza
Room 900
New York, New York 10007
Phone: FTS - 264-2525
CML - 212-264-2525
Hours: 8:00-5:00
REGION III
Jack Schramm
Curtis Building .
6th & Walnut Streets
Philadelphia, Pennsylvania 19106
Phone: FTS - 597-9814
CML - 215-597-9814
Hours: 8:00-4:30
REGION IV
Rebecca W. Hanmer
345 Courtland Street. N.E.
Atlanta, Georgia 30308
Phone: FTS - 257-4727
CML - 404-881-4727
Hours: 8:15-4:45
REGION V
John C. McGuire
230 South Dearborn Street
Chicago, Illinois 60604 ..
Phone: FTS - 353-2000
CML - 312-353-2000
Hours: 8:15-4:45
REGION VII
Kathleen Q. Camin
324 East 11th Street
Kansas City, Missouri 64106
Phone: FTS - 758-5493
CML - 816-374-5493
Hours: 7:00-4:30
REGION VIII
.Roger L Williams
1860. Lincoln Street ......
Denver, Colorado 80295
Phone: FTS - 327-3895
CML - 303-837-3895
Hours: 7:00-5:30
REGION IX
Paul DeFalco, Jr.
215 Fremont Street
San Francisco, California 94105
Phone: FTS - 556-2320
CML - 415-556-2320
Hours: 8:00-4:30
REGION X
Donald P. Dubois
1200 6th Avenue
Seattle, Washington 98101
Phone: FTS - 399-1220
CML - 206-442-1220
Hours: 8:00-4:30
XVI
1GO
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Ulas Jung ton Post
Selling the Right to Pollute
MARYLAND'S Economic Development and Coin-
munity Administration has asked the General -
Assembly to consider a proposal that would allow .
businesses in the state to buy, sell and trade the right ,
to pollute the air. If the plan is eventually adopted, it: ;
would likely make Maryland the first state to try out'';
:what amounts to a revolutionary idea in pollution
control. . :
-' The plan has been largely developed by the federal;.
.Environmental Protection Agency in its search for
ways to bring down the.cost of pollution control
which will otherwise inevitably rise as the economy V
Crows. In industrialized, polluted areas, such as parts '-
of Maryland, a way also had to be found to avoid an '
imminent choice between economic stagnation and'.
unsafe .air. Allowing industries to earn pollution.;
credits should, EPA reasoned, help solve this problem.'.
in two crucial ways.
The ability to build up pollution credits would, for
the first time, give industry an incentive to remove;
.more pollution than the regulatory minimum. This-.
-would create a pool of clean air that could be used by
. a new plant or expansion of an existing business. It
would mean that if one business could remove sulfur,
for example, at a cost of a few cents per pound, it.
could sell the pollution it didn't release to another .
business whose sulfur removal might cost a dollar
per pound. Under the proposed rules, which would
require that every trade result in cleaner air, the
first business could suddenly find itself trans-
formed from an environmental polluter to a pollu-
tion controller, making a healthy profit in the proc-
ess. . ,:-. ;;.,;?.! '.;:ii".-iitiT:.--;:
TUo new plan would also cive industry a powerful"
profit motive to develop new pollution control tech-
nologies that could drastically reduce costs. There is
an urgent need for such innovation, for although
most of today's technologies are relatively primitive
and expensive to run, little researchexcept that
paid for by the federal governmentis goins on. The
reason is simple: research costs a lot of money, and
federal standards that tell a business exactly how
much pollution 11 may miiil,-:and how it should-be--
controlled, remove most of the.'incentive to remove
more or" to do it mm e cheaply. ' .' ' '
.In considering the new proposal, the General As-.
sembly will find itself wrestling with a lot of ques-
tions for which there are no tried and tested answers
Should the state be able to acquire and dispose o.'.
pollution rights? How should sales of pollution
credits be taxed? How can the program be monitored
to ensure that the air does in fact get cleaner? How,
under this plan, would Maryland interact with, its
neighbors? And these are just a few.
But these, admittedly formidable problems should
not dissuade the legislators from giving the proposal
a thorough hearingall truly new ideas, even the
best, can look impossibly difficult at the beginning.
Government regulations, are generalizationsde-
signed to manage broad problems, not to fit specific
situations. In theory at least, a free market in pollu-
tion rights offers a more flexible and economically
sensible alternative yielding more pollution con-
trol at less cost. If Maryland can solve the many ad-
ministrative problems, it seems a worthwhile experi-
'-v? : ' f. -.:r-*- - ' < :'
1G1
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WALL STREET JOURNAL 12/19/80
Pennsylvania
Industrial
EMISSION
CREDITS
FOR SALE
750 tons of hydrocarbon emissions
per year which can be used as offset
credits for a new or modified source
within 40-mile radius of COMSHO-
HOCKEN,: PEMHSVlAJANlAv.ih
southeast Pa. Air Basin. Write
or'call:''. "'. ''"' '>V;'.*.'" '..'-
GOODYEAR
REAL ESTATE DEPARTMENT
1144 E. Market Street,
Akron, Ohio 44316
Tele: 216-796-2238
J. A. Armstrong
1G2
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For more information on controlled trading, please contact:
Michael Levin
Chief, Regulatory Reform Staff
U.S. Environmental Protection Agency (PM-223)
401 M Street S.W.
Washington D.C. 20460
(202) 287-0750 -
For more information on brokering, please contact:
Denise Thai
Regulatory Reform Staff
U.S. Environmental Protection Agency (PM-220)
401 M Street S.W. ,
Washington, D.C. 20460
(202) 287-0711
1G3
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