United States        Washington DC 20460    OPA113/0
            Environmental Protection               June 1980
            Agency
vyEPA      Concept Paper:
            Emission
            Reduction
            Banking and
            Trading Systems

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Contents
Exhibits
Key Concepts of Emission Reduction Banking
and Trading Systems

Analogies and Precedents for Pollution Rights
Banking and Trading

Defining the Commodity. Emission Reductions
and Emission Reduction Credits

The Banking and Trading of Emission Reduction
Credits

Use of the Term "Banking"

Banking and Trading System Components

Component 1 • Creating Emission Reductions

Component 2: Confirmation of Emission
Reductions

Component 3: Certifying Emission Reduction
Credits (ERCs)

Component 4- The Banking and Trading of
ERCs

Component 5 Permit Modification to Use the
ERC

Alternative Banking and Trading Systems

What Are the Relative Merits of Public and
 Private Systems?

 What Are the Characteristics in General of the
 Public Auction System?

 What Are the Characteristics of the Public
 Monopoly/Monopsony System?

 What Are the Characteristics of the Private
 Trading System?

 Combinations
Exhibit 1: Overview of Components of Banking
         and Trading Systems

Exhibit 2: Creation and Use of Emission
         Reduction Credits

Exhibit 3: Potential Adjustments to Emission
         Reductions and Emission Reduction
         Credits

Exhibit 4: Three Alternative Banking and
         Trading Systems and Representative
         Issues

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	  2^975
Concept Paper:
Emission Reduction
Banking  and Trading
Systems
Preface
This concept paper was
prepared for the U S Environ-
mental Protection Agency by
ICF Incorporated under
contract 68-01-5908 The
purpose of this paper is to
explore the concept of
emission reduction banking
and trading, especially issues
relating to operational.
administrative, and policy
options  In addition, under this
same contract. ICF In-
corporated is preparing four
manuals describing how to set
up alternative banking and
trading programs This paper
and the four subsequent
manuals were prepared by a
project team including Paul
Bailey (Project Manager). David
Bruce, and Steve Seidel

The views expressed in this
paper do not necessarily
represent the official policy of
the United States Environ-
mental Protection Agency
 Prepared for the
 United States Environmental
 Protection Agency
 by
 ICF, Incorporated
 1850 K Street, NW
 Washington. D C 20006
 In conjunction with
 EPA's Emission Offsets,
 Banking and Trading Team
 January, 1980

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Key Concepts
of Emission
Reduction
Banking  and
Trading
Systems
                              Analogies and
                              Precedents for
                              Pollution Rights
                              Banking and Trading
The first section of this paper
highlights key concepts and
terms critical to an
understanding of our approach
to the design of banking and
trading systems  Also included
in this section is an overview
of the five components which
comprise a banking and
trading system. Specific topics
examined in this section
include:

• A discussion of analogies
and precedents for banking
and trading systems

• A definition of the
commodity—emission reduc-
tion credits—what is actually
banked and traded, and how it
relates to the initial reduction
of emissions by a source.

• An overview of the five
components in a banking and
trading system

• A comparison of the
different uses of the term
"banking"
Although it is acceptable to
speak colloquially of the
banking and trading of
"Emission Reductions", it is
important to recognize that
what is of marketable value
are the rights connected with
or resulting from an emission
reduction A buyer would want
those rights to use  as new
source offsets or for a  more
cost-efficient satisfaction of
emission limitations (i e ,
application  of the "bubble")
How do we categorize  these
rights? Broadly, they are a
right to credit emission
reductions against an emission
limit requirement More
specifically and operationally,
they are the right to have
one's permit adjusted (or
established, in the case of a
new source)  The nature and
characteristics of the
commodity or right created by
banking and trading systems
will determine the success of
those systems If the right is
not marketable, the systems
will fail.
  While this may sound like
terminological hair-splitting, it
is not  Before "investing in"
(e.g., creating) emission
reductions  for banking and
trading purposes, potential
sellers will want to know (1)
the expected economic value
they could  get for their
investment and (2) possible
legal problems affecting
marketability (and hence, the
return on investment)
Potential buyers will likewise
need engineering and financial
analysis to determine the
value to them, as well as legal
counsel regarding possible
pitfalls The air pollution
control agency will want to
know what effect these
systems will have on their
administrative workload and
their budget, and how these
systems will affect the
achievement of ambient air
quality standards In addition.
speculators, conservationists.
and others may want to
participate in the market All of
these actors will want and
need to know

• What is the nature of the
commodity being traded'
• How does it affect their
rights and obligations'
• What incentives/disin-
centives will result'

  Economic literature
describing the concept of a
market for pollution rights
generally discusses the
theoretical merits of such
markets in terms of economic
efficiency (cost-effectiveness
and resource allocation)
However, little attention is
given to more practical issues
In some cases,1 analogies to
the markets for taxi
medallions, offshore oil drilling
rights on federal land, and
liquor licenses are made
Other possible analogies could
include  state turnpike
restaurant concessions.
mineral  land leases, water
rights in Western states.
transportation route certi-
ficates (CAB, ICC), hospital
certificates of necessity, and
broadcasting licenses  In all of
these "public franchise"
situations, there are
government regulations
concerning transferabihty of
rights to other parties and
related issues
  These precedents and
analogies  can be misleading
In particular, it should be
stressed that the proposed
emission reduction banking
and trading systems differ
from existing precedents and
economic  models of
marketable pollution permits m
one very important feature  it
is not the  administrative
permits themselves that are to
be banked and traded Rather.
the commodity consists of the
"right" to  have one's permit
adjusted (or issued, in the case
of new sources) based on a
prior or contemporaneous
emission reduction certified by
the air pollution control
agency
  The marketable pollution
permit systems described in
the economic literature
concern (i) the initial

'See. eg.de Lucia. An Evaluation
of Marketable Efficient Permit
Systems (Meta Systems. Inc,
 1974)

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                              Defining the
                              Commodity:
                              Emission Reductions
                              and Emission
                              Reduction Credits
allocation, and (n) rules for
subsequent trading of pollution
permits. Likewise, the official
rules (if any) regulating the
transfer of oil drilling rights,
taxi medallions, liquor
licenses, turnpike concessions,
transportation route certifi-
cates, hospital certificates, and
broadcasting licenses all
concern the transfer of the
entire package of rights
included in the "franchise "
On the other hand, the notion
of marginal cost-effectiveness
underlies the concept of
emission reduction banking
and trading Except where
emission reductions are
created by the complete shut-
down of a source (i e ,
emission elimination),  the
seller is transferring—//?
effect—only a part of his
permit to the buyer. Moreover.
the rules of banking and
trading will operate to reduce
somewhat the pollution rights
transferred For example, even
the shutdown of a source
emitting 100 tons of a pollutnt
will not enable the buyer to
increase his emissions by that
full amount Finally, in no
meaningful sense can we
claim that the permit itself is
being traded; emissions
permits are source specific and
non-transferable
   In conclusion, it is essential
that a clear idea of the
commodity created for
emission reduction banking
and trading systems be
communicated in the
information manuals and other
marketing and technical
assistance efforts.  In the next
section, we describe that
commodity as "emission
reduction credits" and explain
its relationship to pollutant
emission reductions and the
permit process
Exhibit I presents an overview
of the process by which
emission reductions become
amenable to banking and
trading. The process has five
components. (1) creation of an
emissions reduction, (2)
confirmation of the reduction
and permit modification; (3)
certification and registration of
emission reduction credits, (4)
"banking", storage, and
trading; and (5) subsequent
modification of permits. The
five components represented
in the flow chart will be
described in more detail m
Part II of this concept paper.
Here, we want to draw an
important distinction between
two major concepts (1)
emission reductions and (2)
emission reduction credits.
  In thinking through how a
banking and trading system
would function operationally,
we found it necessary to
distinguish between the
physical reduction of
emissions by a source and the
commodity that is to be banked
and/or traded  The two are not
identical  As we discuss below
in Part II, the use of "taxes" to
either finance the system or
create a public reserve,
"discounts" to reflect changes
in SIP's, or other
"adjustments", as well as the
offset ratio which may be
required to satisfy the
"demonstration of attainment"
requirement, means that while
actual source emissions-may
be reduced, for example. 100
tons of a pollutant, only 80
of these tons may be available
for banking and trading In
order to avoid confusion
between the physical pollution
units and the intangible
pollution "rights" which are
banked and traded, we call the
latter "emission reduction
credits "
  The permit system is the
administrative mechanism
through which emission
reduction credits can be
created and used This is
shown in Exhibit 2  Emission
reduction credits may  be
created by a source through
the use of the permit system
A source may apply to change
its permits  in the direction of
lower emission limits  by
installing controls, altering
operating parameters  and
inputs, suspending operations,
etc., so as to reduce emissions
below the existing baseline
level of emissions  Reductions
of emissions below the
baseline amount are eligible
for conversion into emission
reduction credits. Once
emission reductions below the
baseline are documented, the
Exhibit 1
Overview of Components of Banking and Trading Systems
Emission
Reduction
Creation

	 7
Confirmation
of
ERs
\
)
Certification
and Registration
of Emission
Reduction Credits
N

Banking
Storage and
Trading
Systems
	 .)

Use
in
Permits

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                                                                                            The Banking and
                                                                                            Trading of Emission
                                                                                            Reduction Credits
source is bound to the new.
lower baseline, but is free to
"bank", use. or trade the
emission reduction credits in a
manner consistent with
applicable rules. Emission
reduction credits may be used
by being converted back into
physical pollution units
through the permit system in a
manner consistent  with other
requirements (e g ,  new
sources, bubble) Conversion of
the ERC's into an emissions
allowance in a permit
extinguishes the emission
reduction credits Thus, while
there is a close relationship
between emission reductions
and emission reduction credits,
the two are different in
function and amount
Conversion must take place by
using the permit and
certification system
 Exhibit 2
 (I) How Emission Reductions (ERs) Can Be Converted into Emission Reduction Credits (ERCs)



Emission
Reduction

Baseline





\
/


AIR POLLUTION
CONTROL AGENCY

Confirm Ers


Change Permit
Certify ERC
Register ERC

)
/



\.
X
Emission
Reduction
Credits

-1-

New Lower
Emissions
V
^
<
/




                                                                          BANK .
                                                                          USE  .
                                                                          TRADE.
 (II) How Emission Reduction Credits Can Be Converted Back into Allowable Emissions

Emission
Reduction
Credits

X
/
AIR POLLUTION
(TNTROL AGENCY
• Confirm ERCs
• Change SIPs
• Change or
Issue Permit
• Extinguish ERC
• Debit ERC
Register
•s
/

Emissions
Allowance
From Use
of ERCs

It is helpful to distinguish the
five components of this
process displayed in the
Exhibit 1 flowchart The first
component represents the
physical reduction of pollutant
emissions from a source The
source always has the option
of using controls and other
means of voluntarily emitting
lower levels of pollution than
currently allowed under its
permit This preserves the
right of that source to return,
at any time, to the higher
actual levels of emissions
authorized by its permit This
can be done without the
approval or even knowledge of
pollution control authorities
  However, the transfer or
reallocation of pollution rights
between and among sources
(i e , banking and trading)
requires

• the confirmation of the
emission reductions by the air
pollution control agency and
the modification of source
permits,

• the certification and
registration of emission
reduction credits;

• "banking" and  trading
according to the rules of the
system established, and

• modification of the permits
of transferee and transferor
and the extinguishment of the
credit

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                               Use of the Term
                               "Banking"
These requirements are
described in detail in the
following parts of this paper
  In conclusion, the
commodity which can be sold
or transferred by a source is
an "emission reduction credit"
which entitles the owner to
the modification of emission
permits The permit documents
themselves are not the
commodity '
  The term "emission reduction
credit" is useful and
descriptive Moreover, the term
signals the fact that the
commodity traded—a "credit"
—is embedded in the context
of the permit process of a SIP
The term also suggests that
the "credit"  necessarily is
based on a definable emission
reduction and it sounds more
positive than "pollution rights"
(a very misleading expression).

'This distinguishes the proposed
system from other "marketable
pollution permit" ideas, eg.de
Lucia. An Evaluation of Marketable
Effluent Permit Systems. (Meta
Systems, Inc, 1974)
Throughout the development
of this paper, we have been
concerned with the "correct"
use of the term "banking". In
general, we use the phrase
"banking and trading system"
to describe the mechanism by
which aspects of the offset
and bubble policies can be
effectuated. However, we
recognize that these terms are
not always used consistently
in the literature and that
confusion—both conceptual
and terminological—cannot'be
eliminated by fiat. Neverthe-
less, it is important that we
distinguish and be aware of
several possible uses of the
term
  Four broad usages of the
term can be  distinguished:

• the activity of "banking" an
emission reduction,

• the status of emission
reductions as "banked",

• the collection of emission
reductions in a "bank
repository", and

• the agency and body
involved, the "bank".

  These uses are relatively
easy to describe in the
abstract
The activity of "banking"
emission reductions: In our
formulation, this is equivalent
to the activity of applying for a
permit change and an
emissions reduction credit The
use of the term "credit"
suggests the commonly
understood notion of having
deposits in a commercial
financial  bank Synonyms
could include "storing" and
"depositing"

The status of emission
reductions as "banked":
Again, this suggests the
common  idea of demand
deposits in commercial
financial  institutions. While
the depositor retains
ownership of the banked
emission reductions, custody
and control are out of his
hands

The collection of certificated
emission reductions: In this
usage, the bank comprises the
store or pool or stock of
emission reductions that have
been certificated and
registered. The registry serves
as an index of what is in the
bank  The certificate is the
evidence of deposit ownership
and may  be traded or
transferred as allowed
The agency or body that
issues emission reduction
credits: In this usage, the term
bank refers to an institution
and the procedures used for
making  sure the system works
We have avoided this use by
employing such terms as
"public  authority", "public
body", and the like

  Complications enter during
the banking and trading phase
Because the systems (e g ,
public auction, monopoly/
monopsony, private trade) have
different critical features,  the
four common usages of the
"banking" concept undergo
changes in the context of each
system
  Consider, for example, the
public auction option As the
agency  or body  conducting the
auction, the "bank" can either
buy emission reduction credits
outright or accept them for
auction  on consignment In the
former instance, it owns the
credits,  in the latter instances,
it acts as a selling agent for
the actual owners of the
credits  In both  instances, the
emission reductions seem to
be "banked". However, the
producer cannot "withdraw"
any emission reduction credits
that the b3nk has purchased
outright. The emission
reduction credits consigned to
the public body are analagous
to bank deposits, but the ones
sold directly to the public body
have  a different status.

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                              Banking  and
                              Trading
                              System
                              Components
                                                                                        Component 1: Creating
                                                                                        Emission Reductions
  Similarly, calling the public
body a "bank" does not
distinguish its possible
different roles as (1) repository,
(2) consignee for sales, (3)
purchaser for later disposition,
(4) sole sales outlet under the
monopoly/monopsony option,
and (5) clearinghouse or
broker We have tried to use
these more explicit terms in
the body of this paper.
  One final point should be
raised The focus of this paper
is on banking and trading
systems It is the trading
aspect that will be particularly
difficult to implement What
we mean by "trading" is the
transfer of emission reduction
credits from  one legal person
to  another We have not
explicitly addressed the case
where one person wishes to
create and transfer emission
reduction credits among its
sources; in this instance, there
is  no trading per se, but there
is  banking for future use and
the modification of source
permits. For example, in the
Louisville  emission reduction
bank to date, withdrawals have
been limited to firms drawing
against their own deposits If
this is expected to be the more
common pattern, it may be
preferable to develop one
manual concerning banking
and three separate manuals
concerning banking and
trading.
In this section, we describe
five components of an
emissions reduction banking
and trading system and the
issues raised in each
component.

Creating Emission Reduc-
tions (ERs)
• What are the different ways
of producing an ER?
• What restrictions should be
placed on producer eligibility?

Confirmation and Permitting
of Emission Reductions
• How can ERs be confirmed?
• How can the permanency of
ERs be assured?
• How should administrative
costs be financed?

Certifying Emission Reduc-
tion  Credits (ERCs)
• How should producers of
ERCs be classified?
• How should sources be
classified?
• By what process are ERs
converted into ERCs?
• How are ERCs to be
accounted for?
The Holding, Sale, or Transfer
of ERCs
•  How should buyers be
classified?
•  What requirements should
guide the actual transfer
process?

Permit Modification After
Sale
•  How should ownership of
ERCs be confirmed?
•  In what regulatory contexts
may ERCs be applied?
•  Are the ERCs of the
appropriate characteristics for
the source seeking to use
them?
•  What permit modifications
are necessary?

  These issues are discussed
in  the following sections In
Part III of this paper, we focus
on the components and
structures of alternate models
of  banking and trading
exclusively.
The initial component of a
banking and trading system
involves the creation of
emission reductions (ERs) It is
the first step in the production
of the commodity—emission
reduction credits (ERCs)—
which ultimately will be
banked and traded
  The principal goal in setting
up rules for this component of
the process is to maximize
production of emission
reductions At the same time,
other factors including equity,
administrative necessity, and
economic efficiency must also
be considered to ensure the
viability of a banking and
trading system and the
achievement of its desired
goals  Specific issues which
arise in the context of this
initial component include1

• What are the different ways
of producing  an ER?

• What restrictions should be
placed on producer eligibility?

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What Are the Different Ways
of Producing an ER?

A source creates an ER by
lowering its emissions below a
definite baseline (e g , the
amount actually emitted) This
reduction can be accomplished
in a number of ways A plant
could shutdown existing
facilities, cutback its
operations, alter its production
processes, or add abatement
equipment For  each source
seeking to create an emission
reduction, there must be a
definite baseline against which
to measure the  reduction
Absent such a baseline,
enforcement problems arise
because there is no way to tell
whether the current "reduced"
emission level is sufficiently
below the previous unspecified
higher level to accurately
account for the  ER allegedly
created In some situations, a
source may not be subject to a
permit (e.g, a minor source or
a source in a state without a
permitting system) or the
terms of the permit may not
specify a definite level of
emissions (e g.,  the permit
specifies operating procedures,
work practices, operation of
equipment, etc ) or the permit
may not reflect existing
emissions at the time the SIP
design value was calculated
To determine the baseline in
these situations, some form of
engineering analysis,
monitoring, or other form of
audit is required Because
emission reductions must be
real, permanent,  and
enforceable, the establishment
of before and after baselines is
an important function
  In terms of improved air
quality, the origin of the ER is
of little concern. Although a
banking and trading system
will lead to emission  reductions
that improve air quality,  at
least temporarily, it may also
take mto account effects on
employment and economic
development in the area For
this reason, it  may be
desirable to differentiate
among the various ways in
which an ER is produced
Operationally,  differing
incentives to reduce emissions
could be incorporated into the
system by varying the
percentage of ERCs awarded
for the production of ERs on
the basis of the method  in
which they were created For
example.

• Awarding ERCs for a plant
or source shutdown would
create an incentive (i e ,  profit
from the sale of the ERC) for
this action, the award of ERCs
for reductions produced in this
manner could be restricted Of
course, prohibiting such
reductions could create
perverse incentives to continue
use of polluting facilities rather
than shutting them down

• It may be desirable to create
an incentive for the use of
innovative technologies as the
means of producing an ER
Bonus ERCs could be issued to
encourage this method of
reducing pollution

The use of ERC certification as
an incentive device to affect
the manner  in which actual
emissions are reduced will be
discussed in greater detail in
Component 3, "Certifying
Emission Reduction Credits".
From the standpoint of
a state or local air pollution
control agency, it may be
desirable to first adopt a
straightforward banking and
trading system with relatively
few complicated rules or
exceptions Refinements such
as those discussed throughout
this paper may be added later
at the discretion of the
controlling agency
  An additional method of
discouraging the creation  of
certain types of ERs would be
to limit the context (e g , new
vs expanding source) in which
they can be used on the basis
of the manner in which the ER
was created  For example, ERs
created by a plant or source
shutdown would be limited to
use by the same firm in
opening a new facility  Limits
on  user (buyer) eligibility will
be discussed in "The Holding.
Sale, or Transfer of ERCs "
  One final point related to the
creation of ERs is that many
sources may now have actual
emission levels which are
below that specified in their
permits, if any  This situation
may exist because pollution
control equipment operates in
a step-wise (and not
incremental) manner to control
emissions or because of the
costs of inputs (e g ,  in  the
West, low sulfur coal is
relatively inexpensive)  In
effect, these sources may have
"paper" ERs, the question is
can they have them certified m
order to bank and trade them?
If this is allowed, and their ERs
are ultimately bought and
used, air quality could actually
deteriorate To guard against
this occurrence, states  must
be sure that credits are given
only for sources that make real
reductions that have not
already  been accounted for in
a demonstration of attainment
If the SIPs were developed in
such a way that allowing pre-
existing ERs to be credited
would interfere with
"reasonable further progress"
or attainment, it will be
necessary to limit a source's
ability to cash-in on "pre-
existing" ERs This could be
accomplished by limiting the
award of ERCs only to
reductions in "actual" and not
"allowable" emissions.

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                                Component 2:
                                Confirmation  of
                                Emission Reductions
 What Restrictions Should Be
 Placed On Producer
 Eligibility?

 Any source can create an
 emission reduction. As
 suggested earlier, there may
 be legitimate reasons for
 restricting which sources can
 participate in a banking and
 trading system. This would be
 accomplished by not certifying
 a source's ER or by only
 certifying a percentage of them
 as  ERCs. Situations in which
 restrictions may be placed on
 producer eligibility include:

 • where a source is
 purchased for the purpose of
 obtaining ERs by closing the
 facility;

 • where a source is marginal
 or where it is obsolete and
 likely to be shutdown for
 economic reasons in the near
 future; and

 • where the source seeking to
 create ERs owns other
 facilities which are not in
 compliance

  The actual restrictions
 placed on sources would occur
 at the time a source goes
 before the governing body to
 have the ERs certified as
 ERCs.  This process will be
 discussed in detail in
 "Certifying Emission Reduction
 Credits". At this juncture.
it is important that all sources
are aware that restrictions
may be placed on having their
ERs certified as ERCs. This could
 be accomplished by making
available to all sources explicit
guidelines describing the
conditions and restrictions on
certification of emission
reductions.
 After an ER is created, but
 before it can be banked or
 traded, it must be entered in
 the records of the air pollution
 control agency (APCA). The
 creation and magnitude of the
 ER must be confirmed, and the
 source's permit and the SIP
 must be altered to reflect this
 change.
  To the extent practicable,
 these administrative steps
 should be incorporated into
 on-going agency activities
 Some states have developed
 inventories of existing sources
 and currently have under
 permit most, if  not all, major
 stationary sources. States have
 also developed  approved SIPs
 which include emissions
 limitations for each major
 stationary source, and most
 importantly, have programs to
 enforce these requirements
 The effectiveness of state and
 local APCAs in  implementing
 these existing programs (e g .
 the reliability of data in
 inventories and permits, the
 certainty of enforcement, etc.)
 vanes considerably across
 states. These administrative
 systems may have to be
 strengthened in order to insure
 the integrity of  the banking
 and trading system. Where
 sources are not under permits,
the APCA will have greater
 difficulty in determining the
 appropriate baseline against
which emission reductions can
 be evaluated.
  The primary function of the
confirmation and permitting
component of a banking and
trading system  is to officially
 incorporate newly created ERs
 into the SIP through the
permitting system The change
 in a permit would also provide
an administrative record which
 would clearly identify the
 ownership, quantity, and
 characteristics of emission
 reductions The principal issue
 which must be addressed in
 designing this component
 include

 • How can ERs be confirmed?

 • How can the permanency of
 ERs be assured?

 • How should administrative
 costs be financed?

 How Can ERs
 be Confirmed?

 As part of the process to
 develop and implement their
 SIPs, most states  have
 compiled an inventory of the
 major sources of emissions
 located within their
 jurisdiction These inventories
 typically list the facility, point
 sources within the facility,
 applicable emission standards
 for each point source, and the
 pounds of pollutant each
 emits
  Most sources in an inventory
 are also included within the
 state's permitting  system.
 Pollution control permits have,
 within the past decade, been
 issued by some states for all
 new major sources of
 pollution Existing sources
 have also been brought within
 the permitting system at the
 time they installed pollution
 control equipment or when
 complaints or inspections
 brought them to the attention
 of the APCA
  Permits typically include
 more detailed information
 about a source than that found
on an inventory (e g.,
compliance method and
timetable ar d ooerat-ng
characteristics) They also tend
 to be more up to date than the
 inventory, but may not be as
 comprehensive in the number
 of sources recorded
  The existing inventory and
 permitting systems provide an
 excellent starting point for
 determining the types of ERs
 which should be certified
 Emissions found on the
 inventory and specified in a
 permit go into developing the
 SIP and therefore are included
 as part of the state's strategy
 to comply with ambient air
 quality standards Any real
 reduction below the existing
 emissions would represent an
 improvement in air quality and
 thus qualify as an ER
 However,  reductions that
 affect permitted or allowable
 levels but not actual emissions
 would not be an improvement
 in air quality  Consequently,
 their acceptance as ERCs and
 use in permit applications
 would be in conflict with
 maintaining the SIPs
 approvability  Consequently,
 while a useful starting point,
 relying on state inventory and
 permitting systems as the
 basis for certifying ERs has its
 limits There are several
 potentially significant
 problems.

 Nonconventional Sources: A
 large quantity of certain
 pollutants (e g , participates.
 hydrocarbons) are the  result of
 nonpomt sources including
 roadways, construction sites,
 etc. These pollutants are
difficult to control, but more
 importantly from the
standpoint of  an agency
confirming a reduction in
emissions, they '-.re difficult to
 measure  Frarii  .nai forms of
 measurement •;• rli as

-------
 engineering analysis and stack
tests are inapplicable. Without
 the ability to clearly measure
 current emissions and the
 level of proposed abatement,
 any award of ERCs to the
 source would be arbitrary Yet
 reductions from these sources
 clearly do result in improved
 air quality, may be relatively
 cost effective to achieve, and
 may be essential to achieving
 ambient air quality standards
   Because it may  be desirable
 to incorporate this form of
 abatement into the banking
 and trading system some
 technique to confirm the
 creation and amount of  a
 reduction should be developed.
 Possible methods to treat
 nonconventional sources
 include1  only ERs which result
 from permanent changes
 would be permitted, the
 quantity of ERs would be
 determined by engineering
 analysis or ambient air
 monitoring at the property line
 before and after improvements
 ere made, or to offset the
 uncertainty inherent in the
 creation of this type of ER,
 only a percentage of the ERs
 claimed  would be  certified as
 ERCs or the use of this form of
 ER could be limited to similar
 circumstances at the facility of
 Jhe buyer.
   In treating  non-conventional
 sources  and minor sources
 it may be useful to apply an
 incremental approach to these
 sources' incorporation into the
 banking  and trading system
 For example, as the banking
 and trading system is being
 established, it may be more
 practical and realistic to focus
 on major, conventional
 sources. Once the program
has been successfully
implemented for major,
conventional sources, the
banking and trading system
can be expanded to include the
more difficult problems posed
by non-conventional and minor
sources

Minor Sources: Minor sources
are those stationary sources
which emit less than 100 tons
per year of pollution 2 This
category includes small
industrial sources, commercial
sources, and household
boilers. They are excluded
from the new source
permitting primarily because of
administrative necessity. This
is not to suggest, however,
that they may not be
significant and  potentially
attractive sources of ERs As
was discussed  previously in
reference to nonconventional
sources, it may also be more
cost effective to reduce
pollution from these sources
than to attempt to obtain
additional abatement from
large stationary sources

Inaccuracy of Data: Since
reductions must take place in
actual emissions, air pollution
control agencies may have to
establish definite procedures
for estimating historical  or
existing emissions baselines.
To do this, air pollution control
agencies must develop
reasonable, consistent, and
reliable procedures for
determining baselines which
preclude opportunistic
behavior on the part of
sources. Significant problems
exist even for those major
sources on the  inventory or

^Alabama Power  Company vs
Costle(DC Cir 1979) (No  78-
10006), Initial ruling reported in
13ERC 1225
under permit for which data on
current emissions exist The
accuracy of emissions data
derived from both monitoring
and engineering analysis, the
most commonly used methods
of estimating emissions, has
been found to be of
questionable reliability. (In
some situations, however,
engineering estimates may be
the most effective tool
available.) This problem is
heightened over time, in part
because a source alters its
operating characteristics and
employs uncertain  operation
and maintenance practices A
potentially attractive al-
ternative would be to monitor
key operating parameters.

How Can Permanent
Enforceability of ERs
Be Assured?

In addition to the requirements
that an ER be confirmed and
the level of abatement be
accurately assessed, an
additional requirement is that
the source producing the
reduction must permanently
maintain that reduced level of
emissions While this
requirement will be written
into a revised permit, current
practices suggest this action
by no means ensures the
continued compliance of that
source with the terms of the
permit. One alternative is to
limit the certification of ERs to
those which are clearly
permanent, e g.. the closing of
a facility, the shutting down of
a boiler unit, a change  in
process equipment. But this
restriction would unnecessarily
limit the production of ERs
Instead, the potential benefit
from the sale of an ERC could
be used as leverage to
implement potentially useful
measures to ensure continued
compliance Another al-
ternative would be to require
sources seeking to have an ER
certified to include monitoring
measures such as installing
stack monitoring equipment,
installing parameter moni-
toring devices, or periodically
sampling ambient air quality at
the property line  Alternatively,
instead of requiring some form
of continuous monitoring,
sources which fail to provide
such  measures could have
only a percentage of their ERs
confirmed for sale as ERCs
  Assuring the permanency of
ERs through continuous
compliance is as critical to the
integrity of any banking and
trading system as it is to
attainment Providing
incentives for the adoption of
monitoring measures would be
a significant boon to state and
local APCA efforts to improve
the effectiveness  of their air
quality programs  A banking
and trading system does not
present any enforcement
problems different from those
currently encountered by state
and local agencies. It does,
however, provide  a mechanism
which could be used to create
an incentive which would
facilitate future, enforcement
activities

How  Should Administrative
Costs Be Financed?

The administration of the
certification process will
necessarily place  an added
burden on state and local
APCAs. To the extent possible,
this burden can be minimized
and the possibility of delay
reduced by utilizing existing
administrative systems. As

-------
                                                             Component 3:
                                                             Certifying Emission
                                                             Reduction Credits
                                                             (ERC)
discussed earlier, the
documentation of ERs can
readily be incorporated into
existing permitting and SIP
systems, although exact
estimation of actual emission
reductions will be difficult.

  Possible additional ad-
ministrative costs associated
with the confirmation and
permitting of ERs may include1

•  Engineering analysis of
proposed plans performed by
the APCA staff to determine
the magnitude of the ER
created,

•  Site visits by APCA staff to
examine the nature of the
change, e.g., installation of the
control equipment, change in
process equipment, shutdown
of facility, and

•  Monitoring of emissions
before and after the proposed
change to determine the
magnitude of the ER created
The costs of these
requirements should probably
be born by the source
producing the emission
reduction and applying for an
ERC. The APCA could perform
most of the tests and be
reimbursed for costs by the
source, or the burden  could be
placed directly on the  source
to provide specified
documentation of the  results
of required emissions tests
which would then be reviewed
by the ACPA's staff
  A possible financing
alternative would be to assess
a charge on the source in the
form of a specified number or
percent of ERCs created  In
this way, a "public bank"
would be created for
discretionary allocation, sale,
or to offset a future revision in
the SIP. in addition to paying
for the administrative
expenses incurred in the
creation of an ER However,  a
direct fee charge  for permit
change application, processing,
and compliance monitoring of
ER's has the important
advantage of administrative
simplicity—and would not
operate to complicate the rules
of banking  and trading
systems.
As emphasized in earlier
sections, an ERC is not the
same thing as an ER The ERC
is an outgrowth of the ER; this
section describes the issues
surrounding the ERC's
emergence from an ER  This
discussion concerns four
issues.

• How should producers of
ERCs be classified?

• How should sources be
classified?

• By what process are ERs
and ERCs adjusted?

• How are ERCs to be
accounted for?

  There is a strong supporting
rationale for introducing
classification schemes
Although allowing economic
growth is one goal  of a
banking and trading system.
growth is only to be allowed if
air quality can be
simultaneously maintained
Thus, reducing the emissions
of current sources is used to
create "room" (in terms of air
quality)  for economic growth
However, as discussed above,
the science of measuring and
monitoring emission per-
formance is, at best, an
inexact  one In this climate of
technical uncertainty and
administrative constraints, the
responsible public authority
must move cautiously both in
allowing participation in the
banking and trading system
and in the degree to which
emission reductions can be
converted into allowances for
economic growth A carelessly
structured and administered
banking and trading system
will encourage economic
growth at the expense of air
quality, the Congress has
made the policy decision that
this is not an  acceptable
tradeoff.
  Thus far, we have discussed
the banking and trading
system to the point where ERs
have been confirmed  It now
remains for ERCs to be
fashioned  from the ERs The
ERC emerges only after the
producer of the ER has met
the eligibility requirements for
converting its ERs into ERCs.
the source from which the ER
comes is taken into
consideration as are the
characteristics of the ER, and
any "adjustment" measures
are taken  Thereafter, the
administrative steps of
certifying the ERC are taken

How Should  Producers of
ERCs Be Classified?

  The banking authority should
find it useful  and necessary to
regulate who can produce and
trade ERCs However, the
eligibility criteria for producing
ERs should-not create
unnecessary disincentives to
their production There are two
reasons for this

• It is in the  interest of air
quality to encourage the
production of as many ERCs as
possible—it obviously leads to
cleaner air, at least
temporarily The appropriate
regulatory body should
welcome the decrease in
emissions, whether or not it is
produced  by a source that in
the past has been cooperative
with clean air goals (Note that
a source cannot produce ERCs
until it has reduced emissions
10

-------
below the relevant baseline
thus, by the time of ERC
production, the emissions
requirements at that source
will, by definition, be
satisfied.)

•  Buyers warrant closer
scrutiny because they seek
ERCs for the purpose of
increasing pollutant emissions
—thus degrading  air quality in
an absolute sense In this
situation,  more so than with
producers, there should be
concern about past behavior
This is consistent with Clean
Air Act provisions which
require that all of a source's
facilities in a state be  in
compliance before it can use
an offset

  The producer of ERCs and
the seller of ERCs, while
frequently the same, are not
always synonymous In a
system which  has some kind
of middleman, producer or
seller may be different and
eligibility criteria will have to
be met by both entities.  Two
eligibility criteria seem most
relevant

•  The current status of the
producer and its past activities
in relation to clean air goals—
even though the producer's
record is not as crucial as that
of the buyer, it still  is  relevant
Past activity is more important
jf the seller is  different (i e., a
middleman) from the producer
Unscrupulous  dealings in  the
past should put a regulatory
body on notice that a particular
seller may bring more trouble
than efficiency to the  banking
system. In addition, when
considering whether a
producer source can/will
maintain an emission
reduction, past performance is
relevant  However, use of past
performance as a qualifier can
not be left entirely to the
discretion of the public body.
Rather, explicit criteria must
be set and measures taken to
assure that producers have
prior knowledge of these
cntera

• The method by which the
ER is obtained—This is a
relevant consideration in
deciding whether a producer
may participate in the banking
system. For example, certain
reduction activities may be
encouraged (e g , installation  -
of innovative control
technology) while others are
discouraged (e g., buying a
plant for the purpose of closing
it—while this produces the
emission reduction, it also
costs local jobs and may,
therefore, be considered an
undesirable method of
production)  In such a
situation, an ER created in an
unfavored manner might not
qualify for conversion to an
ERC.  or might qualify for an
unfavorable conversion ratio. It
is obvious that in very few
instances will  an ER  be
produced if the producer is
aware that it cannot  be
converted into an ERC (except
where ERs are created
"inadvertently").
How Should Sources Be
Classified?

It will be useful to classify
sources creating ERs so that
the participation of their
owners in converting ERs to
ERCs can be regulated
effectively. Several criteria
characteristics could be used
to classify sources for
differential treatment. Five are
mentioned below.

•  The type and characteristic
of pollutant. This basis for
classification is probably the
most obvious. Different
pollutants have different
properties, they affect health
and welfare differently, they
are not equally susceptible to
measurement or controli/and
so on  It seems clear that
sources, if classified on the
basis of nothing else, must be
classified on the basis of,the
kind (type, size, and source) of
pollutant emitted.

• The size of the source- It
may be helpful to classify
sources according to whether
or not a source is major or
minor Minor sources should
not be excluded from
producing emission reductions,
since air quality is
substantially affected by
unregulated  minor sources, it
is worthwhile to seek minor
source participation, especially
since many major sources are
already well controlled
However, minor source
participation raises difficult
questions about permanence
and will have to pass rigorous
tests to assure permanence
This is particularly true since
ERCs used as offsets allow
major new sources to
permanently increase
emissions, while minor
sources are not subject to new
source review at all  Since
major sources provide a single
location with greater potential
for ERC production, and since
these sources  are currently the
subject of new source
regulation, it might be easier
to treat them separately from
minor sources

• Current Compliance Status
Sources have one of three
compliance statuses. (1) in
compliance, (2) not in
compliance, but on an
approved compliance schedule,
and (3) not in compliance and
not on an approved compliance
schedule  This is strictly a
factual determination and does
not address motive or intent  A
                                                                                                                        11

-------
source which is in compliance
with the appropriate emission
limits should qualify for
participation without any
restraint based on compliance
status. A source not in
compliance but on an approved
schedule could simultaneously
come into compliance and
obtain credit for any reductions
beyond that required for its
compliance, and it might be
permitted to purchase credits
for expansion purposes A
source in the third category
could not produce credits, and
serious questions should be
raised about its participation in
any phase of the banking and
trading system           f

• Presence on Inventory A
state or locale's inventory is a
touchstone for determining (at
least m a first cut) what is a
legitimate source Appearance
on the inventory suggests a
relatively established source
for which  emissions may have
been catalogued previously, so
that a reasonably accurate
measure of reductions can be
made  The past performance of
a source not on the inventory
is difficult to track Sources not
on the inventory probably tend
to be minor or nonconven-
ttonal sources. As such, it is
not as easy to keep track of or
to verify their continued
compliance It is also  important
to note that emission reduction
credits cannot be given for
sources not included in the
inventory  until the SIP is
revised to include them.
• Impending Change in
Standards: There may be
various industrial processes
that, from time to time, are the
subject of new or revised
regulations—presumably a
further "tightening" of
permissible emissions In such
a situation, it may be desirable
for the public body to place a
temporary prohibition on the
granting of ERCs for these
process changes so that  the
new, lower limits cannot be
avoided by a last-minute
"voluntary" reduction thai
would  soon thereafter be
required anyhow. Such a
prohibition would necessarily
be publicized in advance

By What Process Are
Emission Reductions and
Emission Reduction Credits
"Adjusted"?

During the trading and banking
process, there are three  points
at which either ERs or ERCs
may be adjusted downward for
valid policy reasons The
discussion of the adjustment
process is in three parts

• To put the adjustment
points  in perspective, a brief
outline of the banking and
trading system is provided and
the points at which adjustment
may occur are identified;

• The rationales for
adjustment are discussed in
detail;  and

• Three varieties of
adjustment are described.
Identification of the Points At
Which Adjustment May
Occur
Within the five basic
components of a banking and
trading system, there are five
points at which adjustment
may occur This is shown in
Exhibit 3, and is discussed
below.

Component 1. The ER is
created;

Component 2. The ER is
confirmed;

• Adjustment point 1 After
the ER is confirmed (i.e., the
producing source's permit is
changed to reflect a lower
level of permissible emissions),
the ERs may be adjusted
downward for two reasons. (1)
uncertainty concerning the
creation, magnitude, and
permanency of an ER, and (2)
producer or source classifica-
tion Thus, the producer may
be required to maintain
emission levels that are lower
than the reduction level on
which its ERCs are based

Component 3. The remaining
ERs become ERCs and are
entered and stored in a  central
registry;

• Adjustment point 2. The
ERCs just created from
adjusted ERs may themselves
be adjusted for two possible
reasons (1) to help finance the
administration of the banking
and trading system, (2) to     '
create a public reserve or help
drive  attainment.
Component 4. The ERC is
banked and/or traded, and

• Adjustment Point 3 While
the ERC is banked, and prior to
its use, ERCs may be adjusted
to reflect a change in the SIP
or national ambient air quality
standards.

• Adjustment point 4 At the
time of sale, the buyer should
be aware of what the precise
"loss" is that it will suffer
from this adjustment The
adjustment may  be made for
two possible reasons- (1) to
help finance the banking and
trading system, and (2) to
create a public reserve or to
help drive attainment

Component 5. The ERCs are
used up in permits The
buyer's permit is issued or
revised to reflect compliance
through the use  of the ERCs

• Adjustment point 5 When
the ERCs are used  to satisfy a
new or changed  permit, it may
be necessary to adjust the
ERCs to satisfy the
"demonstration of attainment"
test An ERC is a type of
contingent "procedural"
property right which entitles
users to have permits adjusted
'or issued according to the
requirements of  the Clean Air
Act and incorporating an
emissions allowance based on
a confirmed and permanently
enforceable preceding
emissions reduction. Thus, the
ERC is clearly not an absolute
license to pollute.
12

-------
Exhibits
Potential Adjustments to Emission Reductions and Emission Reduction Credits
  Components
  of
  System
  Points at Which
  Adjustments May
  Be Necessary
Creation of
Emission
Reduction
Confirmation of
Emission
Reduction
Certification of
ERCs
                       1 When the permit
                       is changed to
                       confirm the
                       emission
                       reduction
  Potential Reasons
  for Adjustments
Banking of ERCs
Trading of ERCs
                       2 When the
                       emission reduction
                       credit is certified &
                       registered
                       A Because of
                       uncertainty (i e.
                       magnitude/
                       permanency)
                       of emission
                       reduction

                       B Because of
                       producer or source
                       classes
                       3 Prior to use of
                       the credits
                       A In order to
                       finance the
                       administrative
                       costs
                                                                      B To create a
                                                                      public reserve


                                                                      C To help drive
                                                                      attainment
Use of ERCs in
Permit
Modification
                   4. When the credit
                   is transferred
                       A In order to
                       comply with e
                       change in the SIP
                       or ambient air
                       quality standards
                      5 When the ERCs
                      are used to satisfy
                      e new or changed
                      permit
                   A To finance
                   administrative
                   costs
                                                                 B To create a
                                                                 public reserve
                                                                                         C To help drive
                                                                                         attainment
                      A. To satisfy
                      demonstration of
                      attainment test
                                                                                                                                                     13

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The Reasons
for Adjustment

Six reasons for adjusting ERs
and ERCs were noted above
They are discussed below in
terms of legal, political.
administrative, and incentive
issues

Reason 1. ERs may be
adjusted to compensate for
uncertainty in the technology
used to create and measure
the ER. The underlying
purpose is to assure that
credit granted corresponds to
emission reductions which
were actually created

• Legal Issues There  should
be no legal problems related  to
this reason Uncertainty should
be relatively constant for types
of industries  and pollutants,
and the adjustment should be
relatively uniform (thereby
avoiding any equal protection
problems)

• Political Issues This reason
for adjustment should  not
cause significant political
difficulties  Given the state-of-
the-art in emission control and
measurement technology, the
need for a  downward revision
to compensate for uncertainty
is readily apparent Uniform
handling of this downward
revision (e  g , a flat percentage
adjustment for a  particular
pollutant emission) enhances
its acceptability
• Administrative Issues  There
are significant administrative
problems raised by this reason.
Initially, there will be technical
debate to determine what
levels of imprecision exist and
what the proper response to
such imprecision should be
Subsequently, as the state of
the art improves, the means of
compensating for uncertainty
will have to be altered  The
administrative burden of
resolving technical debate and
keeping abreast  of technical
developments could be
substantial.

• Incentive Issues This
reason for adjustment should
not create any perverse
incentives if the  reduction in
ER is reasonable in light of the
level of uncertainty It may,
however, have the negative
impact of encouraging the use
of existing technology

Reason 2.  ERs may be
adjusted because the producer
or the source falls within a
particular classification This is
an attempt to assure that, if
the source  or producer  fall
within  a defined class,  the ERs
are revised downward for valid
policy reasons.(see the
preceding discussion on
producer and source
classification)

• Legal Issues  Equal
protection issues probably
would arise due  to the
differential credit allowed
based on source classification
However, as long as the
classification is reasonable and
shown to be related to  the
regulatory purpose, the equal
protection claim  would not
stand

• Political  Issues.  The  political
repercussions from this
method are sure to be strong
Source classification will
cause significant discrimi-
nation in credit allowed
Although no source should be
classified without sub-
stantiating  evidence, documen-
tation, and explanation, it still
may be difficult for a source
owner in a valley to
understand why the reduction
credit allowed is only 60%,
whereas the same kind of
source on a plain is allowed
80% credit Some effort will be
required to make difficult
technical issues compre-
hensible to the public

• Administrative Issues The
adjustment imposes great
difficulties on an adminis-
trative system For example,
different sources could be
subject to different downward
adjustments depending on age,
past performance, and a host
of other variables To keep
track of these variables would
be a difficult and time-
consuming task (assuming that
a banking region has enough
sources to constitute a viable
market)

• Incentive Issues Treating
producers and sources
differently may have the effect
of encouraging more ER
production and more economic
growth in those industries for
which the adjustment is less
severe. A significant incentive
problem would also be posed
by the consideration of past
performance. This is sure to
provide a disincentive to the
"bad actor" unless it is
carefully fashioned  While past
behavior seems relevant, it
should not obscure the
purpose of a banking and
trading system—to produce as
much ERs (and ERCs) as
possible

Reason 3. ERCs may be
adjusted to help finance the
banking and trading system
The public authority could take
some of the ERCs from both
the producer and the buyer for
it to sell on its own account
Proceeds from the sale of
these ERCs would help the
public authority to finance the
banking and trading system's
costs  An alternative, of
course, is to charge the
producer or buyer a flat fee in
the nature of a brokerage fee
or user charge (i e., for using
the banking and trading
system) This latter alternative
is preferable because it avoids
undue complication of the
system

• Legal Issues. Adjusting to
finance the banking and
trading system should qualify
as a valid exercise of the
police power  To be a valid
exercise of the police power,
courts generally require that
the amount of the fee (here,  it
would be some amount of
ERCs) bear some relationship
to the costs of regulation,
inspection, or monitoring
necessitated  If the fee greatly
exceeds these costs, it  is
generally held to be either a
tax or an illegal exercise of the
police power  Many states
recognize an exception to this
rule where the fees are also
based on the indirect (e g ,
social) costs to the public
suffered as a consequence of
the activities listed In addition,
another exception appears to
be recognized by most courts
and allows police power fees
to be set high enough to effect
a reasonable restriction or
restraint of business activities
deemed harmful to public
morals, productive of disorder,
or injurious to the public

• Political Issues  Initial
opposition would come from
the producers and buyers of
the credits  They probably
would argue that the costs of
14

-------
 running the banking and
 trading system were too high.
 If economic gains are
 sacrificed because of this
 adjustment, subsequent
 opposition might arise from
 community leaders and from
 the workforce. When the
 economic tradeoffs become
 apparent, many individuals and
 politicians may be willing to
 compromise environmental
 values.	         	

 • Administrative Issues:
 Adjusting to finance, at least
 in part, the operating expenses
 of the banking and trading
 system does add a significant
 administrative burden. More is
 required than just a few
 additional lines in a ledger.
 The ERCs used for financing
 purposes must be managed or
 disposed of—this is not a self-
 executing task.

 • Incentive Issues: This
 adjustment will affect the
 incentive to produce ERCs  If
 the "payment" to the public
 authority is too high, it will
 cost the producer more  to
 produce its "net" ERCs  than
 some buyers may decide to
 pay. The practical result will be
 that ERC production will cease,
 defeating both purposes of  the
 banking and trading system
 (enhancing economic growth
 and improving air quality).

 Reason 4. ERCs may be
 adjusted to help create a
 public reserve. The ERCs taken
 from producers and/or buyers
 could be set aside for public
 use—whether to maintain
 clean air or to promote certain
 types of economic growth.

 • Legal Issues: The public
.reserve purpose for adjusting
 seems, like the financing
purpose, to fall within the valid
exercise of the police power.

• Political Issues: Opponents
to this aspect of adjusting
(initially producers and buyers
would object, but others would
join if the economic       <
consequences become more
widespread) probably will
argue that the public reserve is
too large. The  adjustment  level
must be set prudently,  so that
its use is not unreasonably
burdensome.

• Administrative Issues: The
public reserve will create
management requirements
and undoubtedly will induce
controversy over its use—
should it be set aside (like a
national park) to be used only
for clean air purposes,  or can
the public authority use it  to
encourage or direct economic
growth in the locale  or state.
Other possible  uses will be
suggested, and strong opinions
are sure to arise in favor of the
several possible uses.

• Incentive Issues: This
adjustment can either reduce
the supply of ERCs (if the
public reserve  is" used solely
for clean air maintenance) or
increase the public authority's
stance as a competitor  with
producers of ERCs (if the
public reserve  is used to
encourage economic growth).
In the former instance, the
price  for ERCs should respond
to the supply (i.e., if ERCs  are
"retired" in the public reserve,
ERCs will be more scarce and
consequently should bring a
higher price per unit), but  it is
not clear how elastic the
demand is. Response to the
expected higher price might
offset the producer's reduced
supply. In the latter  instance.
however, the public reserve
competes with the private
supply, and care must be taken
that such competition does not
result in a significant lowering
of ERC production or price.

Reason 5. ERCs may be
adjusted when an SIP is
altered to further restrict
allowable emissions. In  such a
situation, the ERCs might be
subjected to a pro rata
reduction or to some other
form of downward adjustment.
This adjustment is removed in
time from the other
adjustments. It affects all ERCs
that have been certified, but
not used. This adjustment
would diminish outstanding
ERCs to the point that if they
were used immediately, the
new SIP standard would not
be violated. This can occur
only after the ERC has been
certified and before it is used
by either the producer or a
later purchaser. Thus, if a
buyer purchases the ERC and
holds it without using it (i e.,
without having its permit
altered), the ERCs so held
would be subject to downward
'revision to accommodate a
SIP change

• Legal Issues: There should
be no legal difficulty with this
use of adjustment. However, it
would be prudent to advise the
holder of the ERC at the time
the ERC is obtained (either
through creation or purchase)
that until it is used, the  value
of the ERC is subject to  certain
contingencies, including a
reduction in its quantitative
worth.

• Political Issues: If
adjustment is done on a pro
rata basis, there seems  to be
little difficulty from the political
standpoint. However, if some
differential reduction is
applied, substantial political
problems may appear.

• Administrative Issues:
Applying this adjustment
should be relatively easy from
an administrative standpoint.
In terms of an SIP change, the
discount can be made on the
credit ledger and the holder
can be notified (this assumes
that there is some central
registry).

• Incentive Issues- If
uncertainty exists about the
actual ERC quantity a source
has (after  having either
created or purchased it), there
may be some reluctance to
participate in the process.
What actually may occur  is
that the ERCs will be
purchased only as the need
arises, instead of for future
expansion plans  This should
not have too adverse an effect
on the production of ERs
(assuming the price adjusts
with any changes in supply).
Speculation, if permitted, may
occur. In fact, the prospect of
diminishing supply at a higher
price may be incentive to
purchase early against future
shortages, thus assuring that
some ERCs will be available if
needed In the final analysis,
ER production will continue as
long as if pays the producer to
do so—i e., as long as the
marginal cost of production is
less than the marginal price
the producer can obtain, the
production will continue. This
assumes, of course, that the
particular  market is operating
efficiently, especially in terms
of information flow.
                                                                                                                       15

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   Note that Reason 5 risks
 both in delaying ER production
 and in proceeding with ER
 production.  Delay may result in
 a lost opportunity to create
 ERs (i.e., if the SIP is altered to
 further restrict allowable
 emissions, a producer probably
 will have less room for
 improvement after meeting the
 amended SIP) Alternatively.
 proceeding with ER production
 at an early date does expose
 the ERC to possible
 discounting. However,
 something is better than
 nothing, especially since those
 somethings—bankable emis-
 sion  reduction credits—will be
 significantly more valuable
 after a major SIP revision.

   Reason 6. ERCs may be
 implicitly adjusted during a
 permit application to satisfy
 the requirement in non-
 attainment areas that any use
 of an ERC as an emission
 offset must satisfy the
 "demonstration of attainment"
 test  The relative location and
 pollutant characteristics of the
'buyer and producer of the ERC
 will determine the ERCs
 required for a transaction
 between two particular parties.

 • Legal Issues- There seems
 to be no legal difficulty with
 this use of adjustment  It  is
 merely an application of
 existing policy interpreting the
 Clean Air Act's requirement
 that m non-attainment areas
 "reasonable further progress"
 be made in achieving ambient
 air quality standards

 • Political Issues There may
 be some political difficulty in
 adjusting for this reason—
 offsets should not necessarily
 be used to "drive" attainment
 If the adjustment is  more than
 necessary to sustain
 reasonable further progress
 (RFP). it could run into
 significant resistance Explicit
 criteria should exist for
 determining the offsets
 required to satisfy the
 demonstration of attainment
 test

 • Administrative Issues: The
 major difficulty will be
 determining the ratio of ERCs
 to new emissions required for
 an offset If general guidelines
 showing the affect  of location,
 plume rise, etc., cannot be
 devised, some degree of
 emission dispersion modeling
 may be necessary to determine
 that the reasonable further
 progress requirement is being
 satisfied

 • Incentive Issues: Incentives
 should not be adversely
 affected if requirements are
 not excessive. It is a policy
 currently in effect and requires
 only a small "discount" as
 currently interpreted

 Three Concepts of
 Adjustment
 There are three concepts
 around which downward
 revision of  ERs and ERCs may
 be organized.

 • Tax: The means of adjusting
 ERs and ERCs could be called
 a tax. If "tax" is used,
 however, special legal and
 political problems are created
 that otherwise could be
 avoided. "Tax" is a term which
 flags everyone's attention  and
 evokes strong reactions It may
 be prudent to apply some other
term to the adjusting process.
especially for those  kinds of
adjustment which m no way
are taxes.
• Adjustment The term
"adjustment", used above as a
generic term, is accurate for
reductions not intended to
raise "emission reduction
revenue" for use by the state.
"Adjustment" aptly describes
the fine-tuning necessary to
bring the idea of ERCs into
harmony with reality.

• Discount. Discounting
accurately describes the
process of reducing the
quantitative value of ERs and
ERCs when the total set of
emissions allowed must be
reduced to bring an area into
attainment. Again, this term is
not as evocative a term as
"tax"

Any of these three (or other)
terms could be used to
describe the downward
revision of ERs and ERCs.
However, though substantively
they accomplish the same
result, careful consideration
should be given before a short-
hand term is selected for the
different contexts in which
adjustment may occur.
How Are ERCs
To Be Accounted For?

To maintain order in the
creation and transfer of ERCs,
some accounting process must
be used  This will impede
fraudulent use of ERCs,
carelessness in transferring
ERCs. and generally will
enable the public authority
operating/overseeing the
banking and trading system to
keep a tighter rein on banking
and trading activities The ERC
accounting  system should
coincide with the permitting
and SIP systems in order to
achieve maximum efficiency
and accuracy Administratively,
it should be relatively easy to
establish one set of books
which would include
information on permit
limitations,  including their
quantity, their characteristics.
and any downward revisions
which have been assessed
against ERs  These records
should also include the
conversion ratio applied to
create ERCs, the number of
ERCs (their characteristics
should be the same as those
of the ERs from which they are
derived), and any assessments
against ERCs. The registry
would denote creator, chain of
ownership,  etc —in sum. a
running tally of the ERC's
history until it is extinguished
by use (i e., the buyer has its
permit changed)  The registry
should contain all information
necessary for a potential buyer
to make an  initial
16

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                               Component 4:
                               The Banking and
                               Trading of ERCs
determination of the potential
utility of the ER for the buyer's
particular use. Available ERs
should be indexed by pollutant
type and location and. if
feasible, be recorded on  a
computerized system. General
guidelines concerning
geographical limitations  on the
use of ERCs should also be
readily accessible*
Because the banking and
trading system is very
sensitive to misuse, this
careful "tracking" is
necessary. The final registry
might be analogous to the
system of recording
requirements for real estate'
and its transfer. A registration
system for ERCs should  be
centrally compiled so errors
can be minimized and more
easily located and resolved.
For information purposes.
duplicate sets could be placed
in key locations throughout the
banking region. Presence on
the registry should be an
invariable requirement for the
transfer and use of an ERC.
 Once the ERC is created, it is
 transferable according to the
 rules of the particular banking
 and trading system. These
 rules will deal with two
 primary issues:

 • What buyer eligibility
 criteria should be established
 for participation in the banking
 and trading system?

 • What requirements does the
 banking and trading system
 place on the actual mechanics
 of the transfer process?

 The first issue is discussed
 here in some detail, and the
 second issue is overviewed. A
 full treatment of the second
 issue is presented in Part III
 which discusses in detail three
 alternative banking and trading
 systems.

 How Should Buyers
 Be Classified?
 This is a crucial issue because
 buyers are a key point of
 control and enforcement. The
 banking and trading system
 cannot succeed if ERCs are
 misused. It is reasonable.
 therefore, to impose some
, restrictions or requirements on
 those who wish to purchase
 ERCs. Several criteria seem
 especially relevant.

 • Current Status—The
 question posed is whether the
 buyer owns or controls other
 sources which are not in
 compliance with relevant
 ambient air quality standards?
 The public authority could
 require a buyer to be in
 compliance with emissions
 limitations at all sources it
 owns or controls.
• Benefits of Trade—The
public body may want to limit
participation of buyers who
will obtain the most economic
"mileage" from the ERCs. This
could be in terms of jobs.
gross products, etc.

• Reason for Purchase—this
issue goes to the  nature of the
buyer: Is speculation
permitted? Can environ-
mentalists participate and buy
credits that will be withdrawn
and not used for economic
growth? And so on. The
underlying question is whether
the buyer will use the credit to
fuel additional economic
growth  This can be a difficult
question to answer since there
is no objective test to
determine whether a purchase
is to be made for  purposes of
economic growth. In addition,
there would be strong
sentiment both to permit
purchase for non-economic
reasons and to forbid such
purchases. Whether or not
other users (i.e.. environ-
mentalists, speculators, etc.)
are permitted is a policy
decision to be made by the
appropriate public authority.
However, the legal and
administrative realities may
limit actual policy choices.
                           *
• Government Subdivision as
Purchaser—\l is possible to
permit intervention by the
public body in the purchase of
ERCs (e.g., by tightening
standards on existing sources
to obtain ERCs). This
intervention could supplement
an economic development role,
and also could be used to
effect other desirable goals
(e.g., countering market
dominance).
• Past Performance—While
not central to producer
eligibility, past performance is
crucial to buyer eligibility. The
question is whether the buyer,
if not cooperative in the past,
should be permitted to benefit
under this system which
facilitates economic growth It
is reasonable to suggest that
such buyers be required, as a
"gesture of good will, to meet
some higher standard for
participation (e.g , they may be
required to contribute more to
a public reserve of ERCs).
However, it should  be
remembered that the central
purpose of the  banking system
is to permit economic growth
and not to punish past
misdeeds.

• Market Dominance—This
issue has two facets. The first
regards a potential  buyer that
has a market dominant
position in the  banking region.
The public body may want to
limit such a buyer's
opportunity to solidify its
dominant position by obtaining
ERCs necessary to economic
growth. The other facet goes
to intent and is very difficult to
determine—is the buyer trying
to attain or maintain a market
dominant position by
'purchasing ERCs so that
competitors will be  excluded
from expanding or locating in
the banking and trading
region. The public authority
will have to determine, first, is
 it possible to deal with this
 issue and, second,  if it wants
to deal with this issue. (Note
that anti-trust law could inhibit
the market dominance strategy
described above. However,
there would be a lag time
 before anti-trust enforcement
 action "caught up" with such
 a ploy) There are means of
                                                                                                                      17

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                              Component 5:
                              Permit Modification to
                              Use the ERC
dealing with the market
dominance issue. For example,
there could be limits on how
much of the bank any person
or firm could control. Another
possibility is to limit
participation to persons or
firms who have less than a
specified percentage of the
market.

What Requirements Guide
the Actual Transfer Process?

The final part of this paper
discusses at length three
alternative banking and trading
systems. The three are
summarized below with
special emphasis on the sales
process.

• The public auction system:
The public authority collects.
either by purchasing outright
or by taking consignments,
ERCs for sale at a public
auction. The form of the
auction may vary (see the
discussion below on the
differences of the "Dutch".
"English", and 'Traditional"
options), but the public
authority controls who may
bid, whether or not minimum
bids are  required,
frequency of auctions, and the
block size of ERCs offered. *

9 The public monopoly/
monopsony system: The 'public
body could act as the sole
purchaser from producers/
sellers and the sole supplier to
buyers. ERCs are  collected
only through purchases from
the producers of ERCs. The
public body determines to
whom it will sell, what the
conditions of the sale are. and
what price will be charged.
However, there probably will
be some room for limited
negotiation between the public
body (monopolist) and the
buyers. It is not necessary that
the monopoly or monopsony
organization be publicly
owned. For example, the public
body could grant the monopoly
to some private organization—
perhaps along the lines of a
turnpike concessionaire who
bids for the right to operate
the monopoly. In addition, the
public body could retain
control of this system, but
rather than sell the ERCs, it
would give them away to new
sources as a means of
promoting economic growth.
Where the market does not
generate enough capital to
support one of the other
banking and trading options,
the monopoly/monopsony
option can generate the
desired level of activity.
Instead of funding the
purchase of ERCs through the
proceeds of sales, the public
body could assess a tax
against all existing sources
and provide ERCs to new
sources free of charge.

• The private trading system:
There are many variations of
this system, but all must
involve some degree of public
intervention. At a minimum,
the public authority will have
to direct the process of
certifying/registering ERs and
ERCs, and monitoring/
enforcing  their proper use.
Additional public involvement
ranges from no control over
ERC price and market
participation to stringent
guidelines regarding prices
and market entry. However,
negotiation and sale
consummation will be
accomplished through the
private parties involved in each
transaction.
Once a transaction has
occurred, the emission
reduction credit can be applied
toward compliance with the
emission standard faced by its
new owner. This last step in
the trading and banking
system incorporates the    _
transfer of an ERC into the	
permitting system at which
time the ERC is extinguished.
It attempts to ensure that
ERCs are properly used and
recorded. Issues arising in the
design of this component
include:

•  How should ownership of
ERCs be confirmed?

•  In what regulatory contexts
may ERCs be applied?

•  Are the ERCs of the
appropriate characteristics for
the source seeking to use
them?

•  What permit changes are
necessary?

How Should
Ownership of ERCs
Be Confirmed?

Before approving a new source
permit or altering an existing '
permit which includes the
application of an ERC, the
state or local APCA would first
want to confirm that the
prescribed ERC is genuine, and
that the source is the
legitimate owner. Because
notification of the registry
would be a requirement of any
transaction, this information
should be readily available
from a central registry
(discussed earlier). Thus, the
registry serves the dual
function of providing
information concerning the
9V.J!3t:.*i.'v of ERCs and
documentation relating to
ownership. In the context of »
the latter function, the registry
should reduce the likelihood of
an ERC being sold twice or
being fraudulently created, and
therefore should provide the
level of certainty critical to
creating an effective market
for this commodity.

In What Regulatory
Contexts May ERCs Be
Applied?

There are several possible
regulatory requirements to
which ERCs may be applicable.
The use of internal and
external offset arrangements
has been proposed and
adopted in  a number of
contexts and has resulted in
considerable litigation.
  At this time, ERCs could be
applied to:

• a new source wanting to
locate in a non attainment
area;

• an existing source wanting
to expand in a non attainment
"area;

• a new source wanting to
locate in a PSD area but with
emissions which would bump
the allowable increment; and

• internally within an existing
source seeking a less costly
mens of satisfying an SIP   w
requirement (i.e., the bubble).

-------
                                                                                          Alternative
                                                                                          Banking
                                                                                          and  Trading
                                                                                          Systems
  The APCA creating the
banking system may decide to
limit the use of ERCs to one or
more of these contexts.
Alternatively, it could decide to
provide different requirements
for each. This decision would
be determined by air quality
characteristics (What class:
PSD? Non attainment?) and by
the exact nature' of the
incentive sought by the APCA.
It should be noted,  however,
that broader application of the
banking and trading system
would increase the number of
potential buyers and sellers
and therefore would be
somewhat more advantageous.

Are the Emission Reduction
Credits "Appropriate" for the
Proposed Use?

Before a permit can be
changed to reflect the
application of an ERG, the
APCA will first have to make a
final determination  that the
magnitude of the ERC offered
and its pollutant character-
istics (e.g.. pollutant type, size
of particles, source) are
appropriate for the proposed
use.
  Presumably, the source
 seeking to apply the ERC to its
 permit had performed the
 required analysis and had
 discussed the matter with the
 APCA authority at a pre-
 application conference. At the
 time the owner came into
 possession of the ERC (either
 having created the ER itself or
 purchased the credit), it should
 be clear what is permissible
 and what requirements will be
 imposed on the use of the
 ERC. Unless a potential owner
 of an ERC can be reasonably
 certain of these factors before
 actually taking ownership of
 the ERC, the uncertainty
 surrounding future use would
 severely impede the efficient
 functioning of a market. If
 these precautions are taken,
 final approval of the particular
 use of an ERC and
 documentation of this use
 through its recordation in a
 permit should be little more
 than a perfunctory adminis-
 trative step.

What Permit Changes
Are Necessary?

If deemed suitable to be used
to satisfy the required
emission standard, the ERC
would be "extinguished" as a
credit in the registry. At the
same time,  use of the credit
would be entered as part of
the  permit for the source to be
applied against the source's
actual emissions. The registry
would document the creation
and eventual use of the ERCs.
 • It should be noted that the
magnitude of the emissions
offset by the ERC will not
necessarily be equivalent to
the certified amount of the
credit. The APCA may require
a more than one-for-one offset
to ensure the achievement of
reasonable further progress, or
it may assess a charge in
order to pay administrative
costs, or to establish a public
bank. This is discussed at
length in a previous section on
adjustments.
  At the time the source's
permit is changed or issued
(for a new source), it is also
necessary  to change the SIP to
reflect the rearrangement of
emissions. In addition, in those
situations where a greater
than one-for-one offset was
required, the total amount of
emissions  would be reduced
and should be reflected in  the
SIP. Because of trading and
banking, changes in the SIP
may become more frequent
and it may be desirable to
reduce some of the
administrative steps currently
required. It may be possible to
exempt SIP changes related to
banking  from some of these
requirements or to develop a
more effective means of
satisfying the goals of these
procedures. One possibility
might be to include ERCs in a
state protected "growth"
margin.
Three alternative banking and
trading systems (two "public"
systems and one "private"
system—see Exhibit 2) will be
the subject of three "manuals"
to be prepared by the ICF
project team. In this section of
the initial concept paper, the
following issues are discussed:

•  What are the relative merits
of public and private systems?

•  What are the characteristics
of a public auction system?

•  What are the characteristics
of a public monopoly/
monopsony system? and

•  What are the characteristics
of a private trading system?

  Each system will be
described, including its
advantages and disadvantages.
In  addition to these three
systems, hybrid alternatives
are possible and are briefly
discussed to show the
flexibility available to states
and locales in developing a
system suited to their unique
requirements.

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Exhibit 4
Three Alternative Banking and Iradlng Systems and Representative bsues
Public Auction System
Producer/
Seller of
ERC

Consigns
or
Qalle
ERC \

Publicly
Assessibte
Entity


Auctions
ERC
\
	 7

Buyer/
User
of
ERC
• Does the public body buy the ERC. or take it on
consignment?
• What units of ERCs are offered for sate?
• By what process do buyers establish their
qualification to bid for the ERCs being offered?
Public Monopoly/Monopsony
Producer/
Seller of
ERC

Sells
ERC
>
/
Publicly
Assessible
Entity

Sells
N
/
Buyer/
User
of
ERC
• How are prices determined?
-WOI differential pricing be used?
— Win^rice negotiation occur?
• How many ERCs with what characteristics should
the public body buy?
Private Trading System
Producer/
Seller of
ERC

consigns
or
SeDs
ERC \
s
Private
Middle-
man
broker

Sells
ERC
V


Buyer/
User
of

• Is the brokerage function regulated'
• Us speculation permitted?
• How can the achievement of public goals be
ensured?
• How will trade restraint practices be policed'
                                                • In general what are the relative merits of e public and a private system?
                                                • Who qualifies to produce/sell/buy ERCs d.e. how is market entry regulated)?
                                                • How will the system be financed?
                                                • What incentives ere Greeted for each participant?
 20

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 What are the Relative
 Merits of Public and
 Private Systems?
 Selecting between some kind
 of public or private system
 "requires consideration of the
 relative advantages and
 disadvantages of each.
 Although there is not always a
 one-for-one comparison
 between an advantage in the
 public system and a
 disadvantage in the private
 system (and vice versa), this
 frequently is the case. Some of
 the most important advantages
 and disadvantages are
 discussed topically, below.

 • Market Certainty—Initial
 success of a banking system
 may hinge to a large degree on
Jiow certain the emission
Teduction credit (ERC) market
 is. The public alternatives
 provide more assurance for
 potential buyers and sellers
 (because of government
 control of prices, supply,
 market entry, etc.) than do
 private alternatives.

 • Socially Desirable Goals—A
 banking system can take
 account of a broad range  of
 goals in addition to economic
 efficiency. For example,
 considerations of equity may
 lead to exclusion from or
 limiting of participation in the
 banking system by a particular
 source owner. A private
 System,  concerned primarily
 with economic efficiency,
 might not respond to this kind
 of concern. It is possible.
 Viowever, to design a private
 system so that social goals are
~ adequately considered. Yet in
 the prototypical private model
 {i.c . one with very Itmitad
 government intervention),
 those goals may not be
achieved. The public
alternative would be able to
control this situation It would
also be more effective in
preventing the creation of
private monopolies achieved  *
through purchase of available
ERCs. In addition, it could
encourage entry of new
sources by adjusting the price
of ERCs.

•  Transaction Costs—Both
public and private systems
create transaction costs that
are avoided by the other
system. The public systems
introduce more "red tape"
than the private system simply
because a public body is
involved as the middleman.
Although there may be less
red tape in a private system,
more time will be required to
locate buyers and sellers, to
negotiate sale prices, and
other elements of the ERC
transfer transaction It also will
be necessary to closely
coordinate the activities of the
private system with the local
APCA.

• Market Stability—This  refers
not to the initial certainty
discussed above, but to the
market's long-term stability.
The public system should be
able to avoid much of the
fluctuation which a private
system may exhibit—especially
in terms of ERC price. This
greater stability of price may
reduce the potential for
opportunistic prices which
could result where buyers are
not fully aware of prices.
However, certainty may be
achieved at the expense of
econom'c efficiency.
• Incentives to Produce
ERCs—The private system may
provide greater opportunity for
the profit incentive to operate
in encouraging the production
of ERCs. When prices are
manipulated/set by the public
body, they may be lower than
a market-determined price. In
such a situation, fewer ERCs
will be produced than if there
were no publicly-set price.
(Note that "publicly-set" prices
can also refer to prices
determined publicly, not just
prices set by a public body.
Thus, an open auction could
result in "publicly-set prices")
Such "public" prices would
provide a tremendous
incentive for the production of
ERCs, acting as market signals
to potential producers.
"Private" negotiations would
often deprive the market  of
this important information.
Alternatively, it may be
possible for an artificially high
price to be set by a  public body
purchasing the ERCs from the
producer. There is precedent
for this kind of government-
induced production  incentive.

• Duplication of Effort—To
keep the prices for ERCs  at a
level which will encourage
activity, the public body would
have to keep abreast of
developments in the business
and technological community.
This attempt to keep current in
the demand and supply levels
for credits is extremely difficult
to do and may duplicate
existing private efforts to
maintain awareness of these
same developments.
  The "public" advantages are
that the regulatory body is able
to control the system enough
to ensure that all public policy
goals are taken into
consideration and to avoid the
ill effects perceived to occur
when only economic efficiency
and market allocation  goals
"drive" the system. Thus, in a
"public"  system, economic
growth can be encouraged in
situations or locales where it
would  be discouraged by a
"private" system; private
monopoly situations can be
avoided;  recalcitrant sources
can be prevented from
profiting through their past
uncooperative behavior; and so
on. While a purely private
market system does not
provide these advantages, it
does provide a simple and
efficient  mechanism for
achieving the primary goal of a
banking system—permitting
economic growth while
safeguarding air quality. What
is required in this situation is a
policy decision about what is
expected from a banking
system—is it to be a system
which  promotes economic
growth and safeguards air
quality without  regard to
collateral issues and concerns,
or is it to be a system which
sacrifices some efficiency in
promoting environmentally
safe economic growth in order
to protect other societal
values.
                                                                                                                        21

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What are the
Characteristics  in
General of the Public
Auction System?
This system is operated
entirely by some banking and
trading authority—already
existing or created
specifically—to administer the
banking and trading system.
The banking and trading
authority does not have to be a
public (i.e., government) body,
but'the auction must be
publicly conducted. (Note that
"public" in this sense differs
from "public" in the monopoly
and monopsony option.) The
gist of an auction system is
that a responsible  banking and
trading authority governs the
transfer of ERCs by conducting
auction sales of credits to
qualified bidders. The banking
and trading authority acts as a
middleman or sales agent in
bringing the buyer and seller
together. However, it should
be emphasized that a public
body (e.g., the Air Pollution
Control Agency) may be
involved to the extent that it
regulates who may create, sell,
and purchase reduction credits
as well as other related issues.
  Description. The auction
alternative encompasses a
number of options, including
three discussed below:

•  The "Dutch" auction;

•  The "English" auction; and

•  The 'Traditional" auction.

In each of these three, the
actual auction is conducted
differently, but some common
issues exist. These issues
relate primarily to adminis-
tration of the auction system
and to other support activities.
These issues are discussed
briefly, and then the three
auctions are described in
detail.
  Issues. The administrative
and other support functions
are framed in terms of
options—i.e., there  are several
means to achieve a particular
end, and a decision must be
made about which of those
means to use.

• Publicity: The auction must
be publicized, and there are
several means of doing this—
advertisement in local
newspapers, mailouts to
sources on the inventory,
personal contacts, and
publication in trade/industry
journals are possible ways to
accomplish this. In addition to
the medium of publicity, a
decision must be made about
the content of publicity—it can
be very brief with a contact-
person listed for further
information, or it can be quite
comprehensive in listing
number and characteristics of
the ERCs that will be offered
for sale.

• Transfer to the Trading and
Banking Authority. The trading
and banking authority can
obtain the ERCs for the
auction in two basic fashions:
it can purchase them outright
or it can accept the ERCs on
consignment. The purchase
option contains inherent risks
and benefits—the trading and
banking authority may not be
able to sell ERCs at the price it
paid (to avoid this it might set
minimum bids) or it may be
able to turn a "profit" (thereby
financing at least a  portion of
the system). On the other
hand, the consignment option
is safer, and the banking and
trading authority does not run
the risk of losing money in the
transaction (or being left with
a supofv of unsold ERCs) nor
wouio it have the opportunity
of turning a "profit". (However,
the consignment option may
provide less incentive to the
public body to "move" the
ERCs.) In subsequent
discussion, the banking and
trading authority will be
described as "collecting" the
ERCs for sale—this term
includes both the purchase
and consignment options.

• Reserves: When an
auctioneer has items on
consignment, the consignor
may establish a price below
which it does not want to sell.
This is referred to as a
"reserve". In the ERC auction,
the banking and trading
authority may or may not want
to permit this practice.
However, the use of it does
give the producer/seller some
certainty, and this certainty
will strengthen the incentive to
produce ERCs. The banking
and trading authority also may
use a version of the reserve by
setting minimum bids.

• Pre-auction Conference. It
may be advisable to hold a
pre-auction conference to
explain to bidders the rules to
be used in the conduct of the
auction (The same conference
might include producers/
sellers, but logistically it seems
that they will have to have
been familiarized with the
system before they
sell/consign ERCs to the
banking and trading authority.)
Instead of a conference, it may
be possible to prepare an
information packet which will
detail the information for
bidders.

• Credentials for Use of
ERCs: There may have to be
some process whereby bidders
establish their qualification to
use the ERCs being offered
(especially if participation in
the banking and trading
system is limited to those who
are using ERCs for economic
growth). This can be done on a
personal one-on-one basis—
representatives of the banking
and trading authority and the
public body will meet with a
representative of the potential
bidder to evaluate the potential
bidder's qualifications.
Alternatively, the potential
bidder can submit documenta-
tion for review and verification.
There also could be a
combination of these two
alternatives For example,
private firms could be licensed
to perform this analysis and
certify appropriate trades

•  "No Sells": It is possible, in
some of the auction options, to
have items offered for sale
which are not purchased. (In
the "Dutch" system, this is not
a problem as will become
evident in the description of
that system ) A decision  must
be made whether to hold on to
the no sells (until the next
auction) or whether to try to
dispose of them by a direct
sale. Of course, if the public
body takes the ERCs on
consignment, this is not  a
problem—the "no sells"  are
merely returned to the
producer (or retained for the
next sale). However, if this
occurs too often, it will be a
disincentive for the creation of
ERCs; in such a situation, the
public authority may want to
consider  "buying in" the
unsold lots, with the price
established by some formula
based on the successful  bids
on the ERCs which were sold
at the auction.

-------
• Unit of Sale: There are a
rjumber of options for the unit
of sale. Once the method of
quantifying the ERCs (an issue
discussed elsewhere in this
concept paper) is determined,
there will presumably be a
single unit which can be
identified (for example, one
ton/year). Three options'are
possible for the number to be
offered for sale:

• they can be sold singly (i.e..
one unit);

• they can be sold in uniform
blocks (e g , 10 ERCs/block);
and

• they can be sold as they are
created by the producer/seller
(i.e.. if a producer/seller
created 9 ERCs,  they would be
sold as a block—there would
not be uniformity amongst the
blocks offered for sale).

There are advantages and dis-
advantages to each of these
options. The single unit sale
enables each source to buy
only the amount it needs—
thereby facilitating maximum
economic growth. However.
units would not  be created on
a single unit  basis, and
permitting single unit purchase
would involve additional
Administrative effort  to keep
track of how  much of a
particular "lot" had been sold
and for how much. The
uniform block approach
imposes a rigid framework
which may require buyers to
over-buy in substantial
amounts. Not only does this
r?H.jce economic growth
potential, but it drives up the
s^rtive price for a buyer to
expand to the degree planned.
For example, if a buyer needs
only 10 ERCs. but only 15
unit-blocks are available, the
cost of expansion will be 15
ERC units and not 10 ERC
units The adverse effect
created by this situation may
be modified if the excess 5
ERCs are viewed as an
investment; but m terms of
Immediate cash outlay, the
cost remains at 15 ERC units.
This may not be a significant
deterrent to large firms, but it
may prevent smaller firms
from entering the ERC
market—thus contributing to
market dominance. The sell-
as-created option imposes little
administrative burden and
facilitates accounting require-
ments. However, it also suffers
the drawbacks of non-flexibility
exhibited by uniform blocks.
• Classification of Bidders:
This is a difficult issue. For
example, a particular ERC in
particulate emissions may be
worth more to a facility near
the producer of the ERC than
to a similar plant further away
The reason related to the
diffusion of emissions and
their effect on ambient air
quality. An ERC represents an
improvement in air quality that
is being used to offset a
degradation in air quality.1 An
ERC will represent a greater
improvement in nearby air
quality than in the air quality

 'EPA's Emission Offset
 Interpretative Order states that to
 achieve reasonable further
 progress (a requirement for each
 offset trade), a higher ratio of
 offsets (ERCs) will be required the
 further away a facility is from
 where the offset was created.
 Each trade must satisfy the
 "demonstration of attainment"
 rule
 at a dista'nt site. Consequently.
 the ERC may be worth more
 (i.e., will permit more pollution
 to be offset) to a source near
 the producer than to a source
. further removed. An example
 illustrates the point. Source A
 installs technology which leads
 to the creation of 10 ERCs.
 Source B is one mile from A,
 and Source C is 100 miles
 from A. The reduced emissions
 have a greater impact on
 ambient air quality closer to A
 than further from A (at least in
 the simplistic world of this
 example). Because B and C are
 differently situated, their
 respective uses of A's ERCs
 would probably differ. It  may
 be useful, in dealing with  such
 situations, to develop a matrix
 indicating what differently
 situated sources can do with
 the same ERC. The matrix
 should be geared to a
 demonstratipn of attainment
 by the purchasing source. In
 this example, such a
 matrix probably would require
 that C buy more of A's ERCs
 than B in order for C to
 increase its emissions by  an
 amount equal to B's increase.
 It will be necessary to clearly
 inform buyers of how many
 ERCs are needed to satisfy the
 "demonstration of attainment"
 rule.

   The discussion of these
 issues indicates that many
 options exist concerning the
 structure of the administration
 and support of a particular
 auction system The three
 alternative auction systems2
 are next described  and

 H'he discussion of the "Dutch"
 and "English" systems is based on
 de Lucia, An Evaluation of
 Marketable Effluent Permit
 Systems, pp 17-20(1974)
critiqued in terms of their
advantages and disadvantages.

The "Dutch" Auction System

The "Dutch" auction system is
a method for determining the
market clearing price of the
ERCs. The public body
conducting the auction collects
enough ERCs from interested
producers to justify holding an
auction. The public body
publicizes the auction and
what is being offered as well
as the conditions of sale. It
then announces an initial
(relatively high) price per unit
for the ERCs, and invites
orders at that price. If a full
subscription is not obtained, all
the orders are returned,  a new
lower price is announced, and
the process of receiving  bids is
begun anew. The process is
repeated  until a full
subscription is obtained. It is
possible to avoid multiple steps
by using a schedule-of-
payment order—the bidders
indicate how many ERCs they
want at each of several
alternative prices, and the first
price for which  all  ERCs are
ordered is the overall unit
sales price.
 The "English"
 Auction System

 This alternative is similar to
 that used for the sale of U.S.
 Treasury bills. Blocks of ERCs
 would be auctioned serially
 until all were gone, The blocks
, would be uniform (e.g., 10
 ERCs per block), but the price
 would not. The first block  sold
 would probably bring a higher
 price (from a bidder who needs
 them more than bidders at
 lower prices) th^n the last
 block sold. One difficulty-
 involved is the meaning of a
                                                                                                                        23

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"uniform block". As noted
above, because the ratio of
offsets required to ensure
reasonable further progress
may vary, B's purchase of 10
ERCs created by A may not
enable B to increase its
emissions as much as if C had
purchased, the same 10 ERCs.
Therefore, uniform block can
have two meanings:

•  Uniformity, as determined at
the producing source (i.e . if
the block is to be 10 ERCs.
then regardless of bidders'
characteristics, they will have
to buy 10 ERCs as measured
at the producing source); and

•  Uniformity, as determined at
the buying source (i.e., if the
block is to be 10 ERCs. then
buyers must buy in blocks of
ERCs that are commensurate
to an increase of 10 emission
units at the buying source—
this may require the purchase
of fewer than 10, more than
10, or 10 ERCs as measured at
the producing source).

The latter option presents
some substantial adminis-
trative hurdles which,
practically, require that only
the same class of bidders be
permitted to participate in any
one auction.

The "Traditional" Auction
System

This system responds more to
the specific character of an
ERC as a commodity, i.e., each
block of emission reductions
has relatively unique
characteristics  (e.g., pollutant
size and location) and because
of dispersion factors, will
affect potential buyers
differently. What is offered for
sale is the ERC as created by
any one producer. The
"blocks" in the traditional
auction are individual "lots" of
ERCs either consigned or
bought outright, and therefore
would not be uniform. This
system would  be similar to
that used in auctioning oil
leases. Oil lease tracts are not
uniform in size, and may vary
in value from bidder-to-bidder
based on considerations such
as proximity to other otl  lease
tracts held by the particular
bidder. In an ERC auction, a
particular block might be worth
more to a buyer source close
to a producer source than to a
buyer located further away.
Thus, ERCs would be offered
"as is", and the bidder would
have to buy enough blocks to
cover its needs. (This suggests
that a bidder will sometimes
have to buy more ERCs than it
actually needs simply because
no one block had the exact
amount of ERCs needed by  the
buyer source.) In this system,
two considerations will
dominate bid decision:

• how close is a particular
ERC block to the number
required by the bidJer? (The
possibility exists that the bid
for  a block which is relatively
close to the number required
will represent a high per unit
price than a bid for a block
which has many more ERCs
than required. For example, if
a bidder  needs 19, it might
offer  more per unit for a bloc
of 20 than for a block of 25.);
and

• how much value the ERC
has for the bidder (i.e.. Is it  a
block which can be usert
almost one-for-one to allow
increased emissions? As
discussed above, the closer the
producer/seller source is to
the buyer source, the more
likely is the one-for-one
correspondence).

  Advantages. There are a
number of advantages in using
some form of the auction. They
are detailed below:

• Administrative Efficiency:
The auction is a convenient
method of handling the sale of
ERCs. Instead of proceeding in
a piecemeal, transaction-by-
transaction fashion, the sale
effort can be focused on
relatively few points in time.
The administrative burden  is
thereby reduced.

• Transaction Costs: The
parties involved (producer/
seller, public authority, and
buyer) will have minimal
transaction costs. There is
little, if any, negotiation
required Information is easy to
obtain, and the actual sale
normally will  not be a
protracted event. (However, in
the "Dutch" system, if a
schedule-of-payment variation
is not used, the actual sale
could be a very time-
consuming transaction.
Avoiding such delay is a strong
advantage of  the schedule-of-
payment variation.)

• Market-Clearing Price. This
price is easy to determine  in
the auction program, whether
available ERCs are sold
simultaneously (as in the
"Dutch" system) or whether
ERCs are sold serially (as in
the other two variations). The
market is defined as that group
of potential bidders who are
actually qualified/certified to
participate in the auction
(rather than defining it as the
group of bidders who would
participate if there were no
barriers to entry). The auction
system also focuses the
bidders' attention on the
demand for ERCs. This helps
bidders to assess not just what
they want to pay for the ERCs,
but what they will have to pay
in order to win the bidding
competition for these scarce
ERCs.

• Promoting Clean Air. It is
possible that an auction
system may inadvertently
result in additional
improvement in clean air. If a
buyer must bid on blocks of
ERCs. it may end up buying
more than it wants—this
means some ERCs will exist.
at least for a while, which may
not be used. This maintains
cleaner air than would be
required. Of course, the source
which bought too many would
try to sell the excess through
the auction system, but that
source would then have to
meet the seller qualifications
set  by the public authority.
Even if the buyer of too many
ERCs would resell them
through the  auction system,
there would be that temporary
cushion of excess ERCs—and
this "temporary" cushion
might remain fairly constant
from auction-to-auction with
the only change being the
identity of the source providing
the cushion.

  Disadvantages. There are
also disadvantages in selecting
one of the variations of the
auction system. These are
noted below along with some
possible remedial'measures.

-------
                                                             What are the
                                                             Characteristics of the
                                                             Public Monopoly
                                                             Monopsony System?
•  Time Inflexibility. To be
efficient (one of its major
advantages), an auction of
ERCs probably will not be held
with great frequency.  It is not
impossible for an auction
system to operate with
frequency (for example, the
auction of Treasury bills is
held weekly), but the demand
and supply must be sufficiently
high to justify frequency. This
may not be true of the market
for ERCs. This time inflexibility
inhibits immediate purchase to
satisfy ERC needs as they
arise However, this
disadvantage probably is not
great since the technical
preparation and planning for
the purchase and use of an
ERC ordinarily will require
lengthy periods of time during
which it is likely that an
auction will occur. The
frequency of auctions will in
part be determined by the
thinness of the market for
ERCs

• Block Inflexibility. If a buyer
source must buy blocks of
ERCs, it will often be  forced to
buy more ERCs than it needs.
While beneficial from a clean
air standpoint, this will inhibit
economic growth (by
unnecessarily limiting the
supply of ERCs) This  can be
avoided in both the "Dutch"
and "English" systems (but not
in the "Traditional" system) by
defining "block"  to be one unit
of ERC.
 •
• Classes of Buyers  When
there are different classes of
 buyers, it is more difficult to
 establish their credentials than
 wlien there is only one class
 It should be noted, however.
 that multiple classes  of buyers
 detract from the administrative
 efficiency advantages noted
above  In a banking and
trading system, however, this
disadvantage seems unavoid-
able—and it is a disadvantage
for all three banking and
trading alternatives being
considered.

• Sell-out Requirements. If
the ERCs on auction are
required to be sold out,
significant delays in the sale of
ERCs occur  The "Dutch"
system is the only auction
variation which has this
requirement, and it is a
significant deterrent for
selecting that variation. Not
only are time delays
encountered, but such a policy
could lead to a short-term
price that did not reflect the
value of the credit over the
long-term It is possible to
modify the "Dutch" system to
include a  minimum bid which,
if reached without attaining
full subscription, would be the
final price acceptable—those
orders at that price would be
filled and the unsold portion
would be kept until the next
auction.

  Summary. The systems
described offer flexible
opportunities to provide the
means of using the auction
concept to allocate ERCs. The
three variations presented
above are not rigid, and it
would be possible for an
entirely new variation to be
created by combining different
aspects of the three. In
addition to the specific
advantages and disadvantages
of the auction, per se, the
variations also exhibit the
advantages and disadvantages
of the public option,  discussed
generally at the beginning of
this part of the paper.
This second public option gives
the banking and trading
authority (as noted above, this
is not necessarily a public
body) extensive control over
the sale and purchase of
emission reduction credits. In
essence, the banking and
trading authority exercised
great influence over the entire
process of banking and trading
emission reductions—from
production  to final sale.
Production  is influenced by the
price at which the public
authority purchases the ERCs,
and the sale (and subsequent
economic growth) also is
influenced  by the price which
the banking and trading
authority charges the buying
sources  This is not to say,
however, that the banking and
trading authority is the sole
motivating  force to production
and sale of ERCs Control
technologies are not so precise
that a source will invariably
comply precisely with its
permit requirements As a
result of its compliance efforts.
a source might "inadvertently"
create ERCs which it then
would try to sell to the banking
and trading authority.
Similarly, a buyer's need for
ERCs might be of such a
nature that the price is not
much of an object In both
these situations, the activities
of the banking and trading
authority in setting sale and
purchase prices would not
affect the sources' incentive to
create or purchase ERCs. As in
the public  auction system, the
public body will have a role
that extends, at least, to
regulating  who may produce.
sell, and purchase ERCs as
well as other  related issues.
   Description. A banking and
trading authority would serve
as the sole purchaser of ERCs
from producers and the sole
supplier of ERCs to buyers.
Both the banking and trading
authority and the public body
(if different) would engage (to
varying degrees) in several
administrative duties. Included
in these duties are the
following:

• Publicity—the banking and
trading authority and the
public body would disseminate
information about the ERC
trading system. Possible
mediums of communication
include special information
packets, advertising in
newspapers, advertising in
trade/industry journals,
conducting seminars, and so
on.

• Explaining the mechanics of
the trading system—this could
be covered in  the publicity, but
it seems more effective to
direct these explanatory efforts
to sources which express an
interest in participating in this
trading system. The
explanation could be on a
large scale (e.g., by using a
packet of information and
conducting outreach seminars
and meetings on the topic) or
on a one-on-one basis (i.e.. in
dealing with producer/sellers
and buyers, one of the first
things done would be some
kind of conference during
which the rules and
regulations of the trading
system were explained). These
efforts could be coordinated
with the APCA. Chamber of
Commerce, economic develop-
 ment agency, or could be
 undertaken independently by
the  banking and trading entity.
                                                                                                                        25

-------
• Determining the eligibility of
producer/sellers and buyers—
this is another administrative
task which must be taken care
of early in the trading
transaction. As noted in the
discussion of auctions,
establishing the eligibility of
participants can be quite
complicated. It can be
executed  in at least two
different ways—the potential
participant can submit
documentation prior to
beginning the trading process,
and eligibility and demon-
stration of attainment require-
ments can be determined
before the process continues;
or an eligibility and
demonstration of attainment
determination can be made on
a one-on-one basis during the
initial stages of the trading
process. This  latter alternative
involves personal communica-
tion, technical evaluations,
documentation, and the like.
Of course, a combination of
the two alternatives is
possible.
  The banking and trading
authority determines at what
price it will buy ERCs and at
what price it will sell ERCs. In
this sense, then,  the authority
is the sole buyer  (monopsonist)
and the s&le seller
(monopolist). Although the
authority's position suggests
that it can dictate these two
prices (purchase  and sale), its
actual power to do so is
constrained. The  authority
cannot dictate the behavior of
the market. Quite simply, if it
is paying too little for ERCs,
sources will  not go to the
expense of creating  them, or if
a source does reduce
emissions, it will not go
through the process of
converting those  reductions
into ERCs. Presumably, a
producing source can back out
of the process anytime before
its permit is changed to reflect
the emission reductions on
which its ERCs are based. In
such an  instance, the source
could maintain the documen-
tation of its reduction and wait
to convert into ERCs until the
ERC market appears more
favorable, or until the
producing source decides it
must usejor dispose of the
Emission reductions. Alterna-
tively, if the selling price is too
high, sources wishing to
expand or build simply will
decide to cancel  or postpone
their plans, or to seek a
different location. Thus, the
banking  and trading authority's
power is constrained by
market considerations.
   The banking and trading
 authority also needs some
 mechanism for determining
 what is to be chargedjn each
1 sale and what  is to be paid for
 each purchase. A major issue
 is whether or not these prices
 should be uniform It is
 possible to use differential
 pricing as a means to regulate
 entry and participation in the
 system. For example, the
 authority might pay reduced
 prices for ERCs which result
 from plant shutdowns or from
 plants just now coming into
 compliance.  Differential
 pricing, however, could
 present serious legal
 difficulties,1  and it would
 certainly place a substantial
 administrative strain  on the
 authority's controlling the
 banking and trading system. In
 determining the price charged
 or asked, there may be room
 for negotiation between the
 authority and the buyers and
 sellers. The extent of this
 negotiation is set at the
 discretion of the banking and
 trading authority  Negotiation
 is  attractive  in that it may
 permit some transactions to
 occur which would not have
 been consumated otherwise.
 However, it also .can  introduce
 delay, added administrative
 cost, and  unbridled
 administrative discretion to
 this banking and trading
 system.

 'Differential pricing raises the
 issue of equal protection Unless
 there is a rational relationship
 between the action taken and the
 regulatory purpose, the action cah_
 be successfully attacked. If it is
 shown that a differential price is
 used as a punitive measure for
 past behavior, it also is subject to
 attack.  No attempt is made in this
 paper to explore or resolve these
 potential legal issues
  Advantages. There are
several attractive advantages
to this public option, which are
discussed as follows.

• Time flexibility. The
monopoly/monopsony (M/M)
alternative provides a
continuous opportunity for
buyer sources to obtain ERCs.
Instead of waiting for a
periodic opportunity to
purchase ERCs, the buyer
source can obtain them as
necessary. This also benefits
the banking and trading
authority which does not have
to concern itself with selling
out an entire subscription or
with what to do with ERCs  in
the interim between sales.

• Achievement of social goals.
Although this is an  advantage
of all public banking and
trading options, the M/M
system is particularly
adaptable m order to achieve
these goals. By manipulating
prices paid and asked, the
banking and trading authority
administering the system has
a quick and efficient tool for
achieving societal policies—
i e., rather than issuing flat
prohibitions to sources which
have not cooperated in the
past, the authority can merely
place an appropriate premium
on  that source's participation.
This does not preclude the
current participation/coopera-
tion of the source, but does
force it (as the price of
participation) to demonstrate
good faith in light of its past
misdeeds.
26

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 • Efficiency in the transaction.
 .This advantage encompasses
 reduced transaction costs, but
 goes beyond that. Buyers and
 sellers save time and effort in
 selling and seeking ERCs
 because there is only one
 purchaser and one supplier—
 the banking and trading
 authority. In addition to this,
 the banking and trading
 authority system avoids the
 need for oversight and
 regulation of many private
 brokers  Although such
 regulation is not a sine qua
 non of the private system, it is
 a probably outgrowth of such a
 system. Since in the M/M
 system, there is only one
 broker, this oversight/
 regulatory duty is diminished
 substantially and public
 resources are conserved

 • Market certainty. The
 certainty imparted to the
 market by the M/M system
 goes beyond mere stability
 The M/M does provide
 stability, but it also assures the
 producer/seller that there will
 be a buyer. Since the ERC
 created by the producer is sold
 to the banking and trading
 authority, the producer does
 not have to be concerned with
 the possibility of a no-sale.

*» Block flexibility It is possible
 in the M/M system to sell to
 the buying source that exact
^amount  of ERCs  it needs. The
 banking and trading authority
 can tailor the blocks available
 to a buying source to reflect
 any discounts to be imposed
 on the buyer
• Allocation of attainment
burden: The M/M system can
be used to alfocate the cost of
achieving attainment. Instead
of placing the full burden on
new sources, the M/M system
could arrange to give ERCs to
new sources. ERCs could be
financed through a tax levied
proportionately on all major
sources of pollution or they
could be acquired by imposing
further reductions on existing
sources.

  Disadvantages. Some of the
disadvantages of selecting an
M/M banking  and trading
system are described as follows.

• The nature of monopoly and
monopsony to producing and
buying sources. In the M/M
system, the various sources
must deal with the banking
and trading authority, or else
abstain from participation in
the banking and trading
system. If the authority
appears intransigent to a
producer/seller or buyer, there
is no other purchaser or
supplier with whom to deal.
This dominant position of the
authority can lead to a certain
insensitivity about the
concerns of producer/sellers
and buyers. Although this is
not inevitable, it is a possible
development to guard against.
As noted in the description,
though, the authority's power
is not unconstrained, and the
purpose of a trading and
banking system (to permit
economic growth while
improving air quality) should
mitigate against the tendency
of the authority to become
isolated from the needs of the
        it serves.
• Non-market price. It will be
difficult for the banking and
trading authority to determine
the market clearing price.
There is no easy mechanism
for determining the price as
there was in the auction
alternative. The authority can
proceed in an iterative fashion
to adjust the price charged
until it is able to sell all ERCs,
but this is an inexact and time-
consuming process. On the
other hand, the authority may
not be overly concerned with
finding and charging the
market price, and may
concentrate instead on other
goals. The issue is whether
the authority can determine
the price of ERCs so that both
economic efficiency and
related goals of trading and
banking are promoted.

• Administrative burdens. The
use of discriminatory pricing
(and payment), aside from
difficult legal issues, would
create tremendous administra-
tive problems.  When a
transaction deviates from the
payment/charge usually made,
special attention will have to
be given to the transaction—to
determine if such a deviation
is justified, to decide what the
difference in payment/charge
should be, and to document
the decision. If such instances
are relatively rare, the M/M
system will be able to absorb
the disruption  caused much
more readily than if they occur
as a matter of course.
• Classes of buyers.
Classifying buyers according to
the effect a particular ERC has
on the air quality in the
buyer's area  is another
substantial administrative
burden. However, in order for
the trading and banking
system to operate in ajrashion
that ensures The achievement
'of reasonable further progress,
this is an essential
requirement to comply with
the Clean Air Act, and one
which, in one way or another,
must be performed in all three
of the alternative systems.

• Administrative inefficiency.
Since the sales process is
continuous, it is necessay to
maintain constantly the
administrative apparatus to
conduct the sales transactions.
This could be avoided in the
auction system since sales
occurred only at specified
intervals. This disadvantage
does not apply to the purchase
of ERCs since all three
systems contemplate con-
tinuous or open-ended
purchasing (or consignment) of
ERCs

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                               What are the
                               Characteristics of the
                               Private Trading
                               System?
• Unbridled discretion. The
M/M system raises the
possibility that the banking and
trading authority will be given
too much power. Failure to
hold it accountable for its
activities fosters a climate
conducive to favoritism, or
even corruption.

  Summary. The M/M system
provides greater flexibility than
the auction system, but
introduces some elements
which create greater
administrative burdens.
Although greater flexibility
exists for the banking and
trading authority producer/
seller and buyer sources may
face greater constraints in
disposing of and purchasing
ERCs.
The alternative to a "public"
system is a "private" system—
one in which government
participation is kept to a
minimum. In an area such as
emissions control, it is
impossible and undesirable to
bar all government
involvement, but a private
trading system would limit the
govenment to its current
responsibilities (e.g., setting
emission standards in the
SIPs, monitoring and enforce-
ment activities). In addition,
the APCA would be required to
certify the creation and use of
emission reductions and
ensure that all transactions
satisfied the demonstration of
attainment rule.

  Description. The private
trading system encompasses a
variety of options which all
share the characteristics of
being dominated by private
parties and concerns rather
than government regulatory
bodies. Two major design
options dominate this system:

•  The direction transaction in
which the buyer and seller
deal face-to-face; and

•  The middleman transaction
m which the transfer of ERCs
is accomplished through the
office of some private
middleman or brokering
organization.
  The most likely scenario
would involve a source that
wished to expand or locate in
an area. That source, needing
ERCs to accomplish its
planned expansion, would turn
to some middleman which  had
ERCs to sell. If there were not
enough ERCs on hand, the
middleman would try to
negotiate a price for ERCs
which would induce their
production by some existing
source. Assuming that the
market was big enough, a
middleman would probably
find it worthwhile to develop a
stock of ERCs—whether
through purchase or
"consignment"—so that a
buyer could be readily
accommodated This develop-
ment would, of necessity,
involve speculation. As the
incentive for middleman
participation, there must be
the expectation of a
reasonable profit.
  The concept  of a middleman,
however, suggests that a
market is fairly well developed
In the initial stages of a
banking and trading system,
this would not necessarily be
the case. As a  result, there
may be more direct
transactions in the early
stages of the banking and
trading system. In fact, under
the existing emissions offset
policy, the overwhelming
number of completed offset
arrangements were produced
internally at facilities owned by
the same source seeking to
expand.
  The size of the market does
not necessarily dictate
whether or not a middleman
can operate m it. There may
develop several regional or
national middlemen firms who
maintain local market
information and therefore can
efficiently service a small
market that could not provide
enough activity to support a
permanent  local middleman
organization.
  A private trading system can
involve varying degrees of
government involvement.
Access to the ERC market
could be unregulated, except
insofar as existing laws (e.g.,
antitrust laws) restricted the
sources which would
participate.  On the other hand,
eligibility requirements could
be set which limited the
sources which could
participate in the creation,
sale, and purchase of ERCs. In
a very real sense, this power
to control market entry is
inherent in  the public
authority's power over
verification  of emission
reductions and changes in
source permits and the SIP.
Similarly, the public body could
exercise varying degrees of
control over any middleman
organization. Such control
could range from a laissez
faire attitude, to simple
registration requirements, to
strict licensing, reporting, and
oversight activities. Insofar as
discounts, adjustments, and
taxes have  to be assessed,
government involvement is
unavoidable.
 28

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  There is one area which
 probably will be  left entirely to
 the private parties—price. The
 prices for ERCs will be
 determined by the parties
 involved, with no minimum
 and no maximum  Yet. it is an
 option for the public body to
 set price guidelines which
 would establish  ceilings and
 floors for prices  However, if
 government involvement
 became so detailed that it
 determined the price,
 controlled access to the
 market, and exercised strict
 oversight of each transaction,
 much, if not all,  of the
 rationale for a private system
 would have been preempted
 In such a situation, it  is better
 to conclude the de facto nature
 of the system, and call it a
 "public" rather than "private"
 system
  Advantages. The private
 system's advantages are
• Limited government
resources required Limited
activity on the part of the
public authority will conserve
public resources relative to the
resources which must be
expended in the two "public"
alternatives, the private
system, to a great extent, runs
«pn its own fuel
• Limited administrative
burdens  Since government
regulation is kept to a
minimum, resource-consuming
efforts to satisfy the
administrative burden usually
generated by such regulation
would be avoided The effect of
this advantage may not be
great, because there will be
strict  government control over
the documentation, verifica-
tion, and maintenance of
recorded emission reductions
The administrative burdens
imposed by this control cannot
be avoided

• Market price  If government
intervention in price setting is
avoided, the price charged for
ERCs  should reflect a relatively
accurate market price

• Incentive to produce and
trade  ERCs The pnvate'system
allows the appropriate
economic signals to be sent m
encouraging or discouraging
the production and trading of
ERCs  If the demand is low.
the price will drop as will
production The system will
not produce {at least ideally it
will not) ERCs that cannot  be
justified from an economic
standpoint
•  Timing of Availability  ERCs
will be available without any
time restriction That is, the
on-hand supply may not
always satisfy the current
demand, but there is no
waiting period once the ERCs
are created Of course, there
will be the delays experienced
in every system—having
changes made in the SIP and
source permits

•  Block flexibility The buying
source will be able to
negotiate for  precisely the
amount of ERCs it needs. This
permits efficient use and
allocation of ERCs so that the
maximum allowable economic
growth can occur

  The extent  of these
advantages is heavily
dependent on the degree of
government involvement in the
private system  Many of the
advantages mentioned are
predicated on relatively little
involvement by the public
authority (i e  , the public body
would perform only those
activities which must be
performed by the government)
As the degree of government
involvement rises, these
advantages diminish
  Disadvantages. The private
system has several drawbacks
which are discussed, below

• High transaction costs The
private transaction, whether
through a middleman or direct,
may require fairly substantial
transaction costs as compared
with the "public" alternatives
The purchaser/supplier of
ERCs must be sought, and
negotiated with instead of
being readily apparent and
available. This search requires
the participating firm to
expend its own resources in a
direct transaction, and to pay a
middleman in the non-direct
transactions

• Abuse potential When
there are primarily private
actors participating in the
transaction process, the
potential for abuse rises
When the government holds
the reins of the actual
transaction process, it is  much
easier to guard against abuse
than when it exercises an
oversight function of many
different private sectors
                                                                                                                        29

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                                                                                             Combinations
• Duplication of effort If the
private system requires
substantial government
involvement, it might be  more
efficient to allow the public
authority to operate the
banking and trading system
There either will be overlap in
function, or the public body
will be performing most of the
essential tasks  In either case,
it probably should be asked
whether a  "public" system
would be a  more efficient use
of resources

• Uncertainty There is an
element of uncertainty in the
private system that is not
present in the public systems
Especially during the  initial
stage of a market's operation,
the private system will have to
"feel" its way to stability
Because the public systems
have governmental under-
pinning, much of this
instability is avoided Of
course,  in a private market,
there are more risks involved
than m  a publicly controlled
market (as evidenced by  the
presence of speculators in  the
private market), but that  is
merely a characteristic of the
private market place
• Market Imperfections The
private system will exhibit
some market imperfections
which realistically affect any
private market and keep it
from responding precisely in
accord with economic theory
A good example of this is
imperfect information In a
public system, all the
information about prices is
readily available from the
public authority (actually, the
issue is somewhat meaning-
less in those situations where
the public body sets the
price)—the buyer source
knows what is available and
what  its own needs are and
can make an informal decision
on what to pay However, in
the private system, there is no
guarantee that the buyer
source will bo aware of the full
supply picture, and an
improper decision about what
price to pay for ERCs might
ensue
  Summary. The private
system provides greater
freedom and flexibility in
satisfying a source's needs for
ERCs However, it offers less
certainty to the participant,
posing risks avoided by the
public systems
It is possible for states or
locales to decide that there are
characteristics of each of these
options that are desirable, and
that a combination of these
three options is preferrable to
selecting only one of the three
For example,  it is possible to
use the private trading system.
but limit to some degree who
may  participate Or, use the
monopsony portion of the
public option  for collecting
ERCs for sale, but use the
auction system to dispose of
the ERCs The intent of com-
binations is to fashion an
alternative that is suited to the
needs of a particular banking
and trading locale—since local
and state conditions vary
considerably,  it is reasonable
to assume that the
combinations selected would
also exhibit variation

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