United States
Environmental Protection
Agency
Tools of the Trade
A Guide to Designing and
Operating a Cap and Trade
Program for Pollution Control
-------
Tools of the Trade
A Guide To Designing and
Operating a Cap and Trade
Program For Pollution Control
United States Environmental Protection Agency
Office of Air and Radiation
EPA430-B-03-002
www.epa.gov/airmarkets
June 2003
-------
Table of Contents
Acknowleg merits.
Chapter 1: Introduction 1-1
Introduction 1-1
Purpose 1-1
Structure 1-1
Cap and Trade 1-2
Chapter 2: Is Cap and Trade the Right Tool? 2-1
Introduction 2-1
General Assessment Issues 2-1
Comparison of Cap and Trade and Other Policy Options 2-5
Chapter 3: Developing a Cap and Trade Program 3-1
Introduction 3-1
Guiding Principles 3-1
Establishing Legal Authority 3-2
Creating an Emission Inventory 3-3
Program Design Elements 3-4
Other Design Considerations 3-25
Chapter 4: How to Implement and Operate a Cap and Trade Program 4-1
Introduction 4-1
Integrated Information Systems 4-1
Auditing and Verification 4-4
Technical Support for Regulated Sources 4-5
Administrative Costs Associated with Cap and Trade 4-6
Chapter 5: Assessment and Communications 5-1
Introduction 5-1
Communicating Status and Results 5-1
Communication Issues Unique to Emission Trading Programs 5-2
Modes of Communication 5-5
Continued Assessment 5-5
Glossary of Terms Glossary-1
Acronyms Acronyms-1
References References-1
Appendix A:The Optimal Level of Pollution A-1
The Economics of Emission Trading A-2
Appendix B: Example Assessment of the Potential For Cap and Trade B-1
Table of Contents
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Acknowledgments
The U.S. Environmental Protection Agency (EPA) would like to acknowledge the many individual contribu-
tors to this document, without whose efforts this guidebook would not be complete. Although the com-
plete list of experts who have provided technical and editorial support is too long to list here, we would like
to thank some key contributors and reviewers who have played a significant role in developing this guidebook.
In particular, we wish to acknowledge the efforts of the staff of the Clean Air Markets Division (CAMD) of
the U.S. EPA - the division responsible for operating the U.S. SOz Allowance and Ozone Transport Commission
(OTC) NOx Budget Trading Programs. Many staff contributed to this guidebook, including Rona Birnbaum,
Kevin Culligan, Katia Karousakis, Stephanie Grumet, Richard Haeuber, Melanie LaCount, Sasha Mackler,
Brian McLean, Beth Murray, Sam Napolitano, and Sharon Saile. Special mention is due to Jennifer Macedonia
and Mary Shellabarger who did much of the planning and development of this guidebook. Joe Kruger and
Jeremy Schreifels compiled and edited the completed document.
This guidebook benefited immensely from the comments and suggestions of a panel of external reviewers,
including Dallas Burtraw, Resources for the Future; Andrzej Blachowicz, Center for Clean Air Policy; Tomas
Chmelik, Czech Ministry of Environment; A. Denny Ellerman, Massachusetts Institute of Technology; Erik
Haites, Margaree Consultants; Bias Perez Henriquez, University of California-Berkeley; Stan Kolar, Center for Clean
Air Policy; Nancy Seidman, Massachusetts Department of Environmental Protection; Jintian Yang, Chinese
Research Academy of Environmental Sciences; and Peter Zapfel, European Commission. We would like to
thank each of them for their insightful comments and suggestions.
We would also like to thank the staff at ERG for graphics and production support.
Acknowledgements
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Introduction
Introduction
To ensure a cleaner, healthier environment, gov-
ernments are increasingly using market-based
pollution control approaches, such as emission
trading, to reduce harmful emissions. The theory of
emission trading and the potential benefits of market-
based incentives relative to more traditional environ-
mental policy approaches are well established in
economic and policy literature. Until recently, however,
practical applications of emission trading programs
have been relatively limited. In 1990, the United States
enacted legislation to implement a comprehensive
national sulfur dioxide (SO^) program using a form of
emissions trading called "cap and trade." The U.S.
SOz cap and trade program has proven to be highly
effective from both an environmental and an economic
standpoint. The success of this program and others
that followed has spurred interest from policymakers,
regulating authorities, and business and environmental
organizations. Today, emission trading mechanisms are
increasingly considered and used worldwide for the
cost-effective management of national, regional, and
global environmental problems, including acid rain,
ground-level ozone, and climate change.
Purpose
This guidebook is intended as a reference for policy-
makers and regulators considering cap and trade as a
policy tool to control pollution. It is intended to be
sufficiently generic to apply to various pollutants and
environmental concerns; however, it emphasizes cap
and trade to control emissions produced from station-
ary source combustion. In the United States, SOz and
NOx are controlled with cap and trade programs.
These programs provide many illustrative examples
that are described within this text.
Structure
This guidebook is organized as follows:
The introduction explains the policy tool known
as cap and trade.
Chapter 2 provides guidance on how to deter-
mine if cap and trade is the right solution for a
particular problem and describes how it varies
from other policy options, including other forms
of emission trading.
1-1
Introduction
-------
Chapter 3 explains the process for developing a
cap and trade program.
Chapter 4 explains how to implement and oper-
ate a cap and trade program.
Chapter 5 discusses how to assess the results of a
cap and trade program and communicate them to
the public.
Glossary of Terms and Acronyms contains defi-
nitions of the terms and abbreviations used
throughout this guidebook.
References contains a list of articles and papers
cited in this guidebook.
The Appendices contain additional technical
and reference information.
Specific examples are provided throughout the text.
These examples draw on the experience from cap and
trade programs, including the U.S. SOz Allowance
Trading Program (also known as the Acid Rain
Program), the Regional Clean Air Incentives Market
(RECLAIM) in Southern California, the Ozone
Transport Commission (OTC) Regional NOx Trading
Program in the Northeastern United States, and the
United Kingdom's emission trading program for car-
bon dioxide (CCh). These examples were selected to
illustrate various aspects of cap and trade and are not
intended to endorse controls on a specific pollutant.
Cap and Trade
Cap and trade is a market-based policy tool for environ-
mental protection. A cap and trade program establishes
an aggregate emission cap that specifies the maximum
quantity of emissions authorized from sources included
in the program. The regulating authority of a cap and
trade program creates individual authorizations
("allowances") to emit a specific quantity (e.g., 1 ton)
of a pollutant. The total number of allowances equals
the level of the cap. To be in compliance, each emis-
sion source must surrender allowances equal to its actu-
al emissions. It may buy or sell (trade) them with other
emissions sources or market participants. Each emission
source can design its own compliance strategy - emis-
sion reductions and allowance purchases or sales - to
minimize its compliance cost. And it can adjust its
compliance strategy in response to changes in technol-
ogy or market conditions without requiring government
review and approval.
How a Gap and Trade Program Works
1. The regulating authority sets a cap on total
mass emissions for a group of sources for a
fixed compliance period (e.g., 1 year).
2. The regulating authority divides the cap into
allowances, each representing an authoriza-
tion to emit a specific quantity of pollutant
(e.g., 1 ton of SO2).
3. The regulating authority distributes
allowances.
4. For the compliance period, each source meas-
ures and reports all of its emissions.
5. At the end of the compliance period, each
source must surrender allowances to cover the
quantity of the pollutant it emitted.
If a source does not hold sufficient allowances to
cover its emissions, the regulating authority imposes
penalties.
Environmental Certainty
Cap and trade programs offer a number of advantages
over more traditional approaches to environmental reg-
ulation. First and foremost, cap and trade programs can
provide a greater level of environmental certainty than
other environmental policy options. The cap, which is
set by policymakers, the regulating authority, or anoth-
er governing body, represents a maximum amount of
allowable emissions that sources can emit. Penalties
that exceed the costs of compliance and consistent,
effective enforcement deter sources from emitting
beyond the cap level. In contrast, traditional policy
approaches such as command-and-control regulation
generally do not establish absolute limits on allowable
emissions but rather rely on emission rates that can
allow emissions to rise as utilization rises.
With cap and trade programs, even new emission
sources may not increase the limits on emissions. The
regulating authority may require new entrants to pur-
chase or receive allocated allowances from the total
allowable emissions set by the cap (see Chapter 3 for a
description of different ways that new entrants may be
treated). Thus, the emissions target is maintained and
the price of an allowance can adjust to reflect the
increased demand for allowances.
A cap and trade program may also encourage
sources to pursue earlier reductions of emissions than
would have otherwise occurred, which can result in
1-2
Introduction
-------
the earlier achievement of environmental and human
health benefits. This is a result of two primary drivers:
first, the cap and associated allowance market creates
a monetary value for allowances, providing sources
with a tangible incentive to decrease emissions.
Second, a cap and trade program can incorporate the
flexibility of banking (see Chapter 4) to provide
sources with an additional incentive to reduce emis-
sions earlier than required. Banking allows sources to
carry over unused allowances for use in a later compli-
ance period when there might be more restrictive
requirements or higher expected costs to reduce emis-
sions. Essentially, banking gives sources some flexibil-
ity in the timing of emission reductions (i.e., temporal
flexibility). This is in addition to flexibility given to
sources in the location at which they make emission
reductions (i.e., spatial flexibility).
Another environmental advantage of cap and trade
is improved accountability. Participating sources must
fully account for every ton of emissions by following
protocols to ensure completeness, accuracy, and con-
sistency of emission measurement. This system con-
trasts with most environmental programs that base
compliance on periodic inspections and assumptions
that equipment is functioning and the source is in
compliance between inspections.
Accurate measurement of emissions and timely
reporting are critical to the success of a cap and trade
program and the integrity of the cap. After emissions
data and allowance transaction information are reported,
Figure 1. Cost Minimization With Trading
Abatement Cost: $1 00/ton
Reduction: 5 tons
Abatement Cost:$80/ton
Reduction: 7 tons
Abatement Cost: $1 20/ton
Reduction^ tons
Potential transfer of 2 allowances for $80-$120 each
the regulating authority can provide detailed or summa-
ry information to the public (e.g., on the Internet). This
transparency, or access to information, can provide con-
fidence in the effectiveness of the program.
Minimizing Control Costs
In addition to the environmental benefits of adopting
a cap and trade program, significant economic benefits
also support the use of such a mechanism. Gap and
trade programs provide sources with flexibility in how
they achieve their emission target, which is uncommon
under traditional environmental policy approaches.
The cap establishes the emission level for emission
sources; the sources, however, are provided with the
flexibility of choosing how they want to abate their
emissions. Each source can choose to invest in abate-
ment equipment or energy efficiency measures, to
switch to fuel sources with no or reduced emissions, or
to shutdown or reduce output from higher emitting
sources. The regulating authority does not need to
approve each source's compliance choices because the
cap, accompanied by emission measurement and
reporting requirements, enable the regulating authori-
ty to focus on assessing compliance results (i.e., ensur-
ing that each source has at least one allowance for each
unit of pollution emitted). Cap and trade programs
also allow sources to trade allowances, providing an
additional option for complying with the emissions tar-
get. Sources that have high marginal abatement costs
(i.e., the cost of reducing the next unit of emissions)
can purchase additional
allowances from sources that
have low marginal abatement
costs. In this way, both buyers
and sellers of allowances can
benefit. Sources with low costs
can reduce their emissions
below their allowance holdings
and earn revenues from selling
their excess allowances - a
reward for better environmental
performance. Sources with high
costs can purchase additional
allowances at a price that is
lower than the cost to reduce a
unit of pollution at their facility
(see Figure 1). This outcome is
consistent with the "polluter
pays" principle.
Initial Emissions
1-3
Introduction
-------
A well designed cap and trade program can also
provide continuous incentives for innovation in emis-
sion abatement. Because of the value attached to
allowances. The value creates an economic incentive
to invest in research and development for emission
abatement options that can further reduce the costs of
attaining compliance.
Finally, the cost-minimizing feature of cap and trade
has long-term environmental benefits. Driving down
the cost of reducing a unit of pollution means that poli-
cymakers and regulating authorities can set targets that
reduce more pollution at the same cost to society. This
system makes it economically and politically feasible to
achieve greater environmental improvement.
1-4 Introduction
-------
Is Cap and Trade
the Right Tool?
Introduction
Cap and trade can be an effective tool to address
air pollution. However, it is not appropriate in all
situations or for all environmental problems.
Policymakers should consider a number of important
issues before deciding whether cap and trade is appro-
priate. Prior to developing a cap and trade program,
policymakers and other experts should determine
whether the nature of the environmental problem, as
well as the institutional capacity and political situation,
is conducive to the successful establishment of such a
program (Benkovic and Kruger, 2001).
This section begins with a brief discussion of some
of the general issues that must be assessed for any
type of emission reduction program. Next, the section
examines whether cap and trade can address a particu-
lar environmental problem. Finally, it compares cap
and trade to other types of policies including different
forms of emission trading.
General Assessment
Issues
Before making a decision about an emission reduction
program, policymakers should assess a number of sci-
ence, technology, and other issues. For example, regard-
less of the type of program chosen, policymakers must
understand the nature of the environmental or health
problem of concern, the pathways of exposure, the loca-
tion and magnitude of the sources that contribute to the
problem, and the emission reductions necessary to
address the problem. Similarly, policymakers should
have answers to technical and economic questions such
as the cost, availability, and performance of control tech-
nologies. Although a full discussion of these questions
is beyond the scope of this manual, Appendix B sum-
marizes how some of these questions were addressed
under the U.S. SO2 Allowance Trading Program.
Once policymakers have a thorough understanding
of these issues and questions, they can determine
whether cap and trade is an appropriate tool to address
the problem. The following sections outline some of
the key considerations used to determine whether cap
and trade will be an effective program for a particular
situation.
2-1
Is Cap and Trade the Right Tool?
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Is Flexibility Appropriate?
Cap and trade is premised on the notion that regula-
tors do not need to direct the type or location of spe-
cific emission reductions within a region. Instead,
these programs set an overall target and let "the mar-
ket" determine where to make the most cost-effective
reductions. In some cases, however, it does matter
where an emission reduction is made. For example,
some toxic emissions may have primarily local health
impacts in the area immediately surrounding a facility.
Allowing such a facility to buy allowances from other
similar facilities in the area may not fully address the
risks caused by its emissions. It may make a situation
worse by causing a "hotspot" if the cap does not
require sufficient reductions to minimize or prevent
local impacts. In such a case, it may be necessary, from
a public health standpoint, to impose source-specific
controls and limit the flexibility inherent in an emis-
sion trading program.
In general, the more a pollutant is uniformly dis-
persed over a larger geographic area, the more appro-
priate it is for the use of cap and trade.
Even when the location of emissions does matter,
cap and trade may be effective if the environmental
goal can be met through emission reductions in a gen-
eral region. For example, a cap and trade program can
reduce total loadings of a pollutant into the atmos-
phere, particularly if these pollutants are emitted by
many sources and transported over a large geographic
region. This was the case in the United States with
the SC-2 Allowance Trading Program, which is intended
to reduce acid deposition in the Eastern United States
and Canada. Similarly, cap and trade programs can
address ambient air quality problems by reducing
background levels of pollution that contribute to
adverse air quality. For example, if there are prevailing
winds, it may be necessary to include emission sources
upwind of the polluted area that could prevent down-
wind areas from meeting their ambient air quality
standards. The NOx cap and trade programs in the
Northeastern United States were designed to reduce
long-range transport of NOx emissions that lead to the
formation of ground-level ozone.
Before designing cap and trade programs to address
emissions that are not uniformly mixed, it is necessary
to conduct an assessment of the possibility of
hotspots. Chapter 3 contains a discussion about ways
to assess the potential for hotspots and how to develop
policies to avoid them if necessary. In such cases regu-
lating authorities may need to limit emissions at spe-
cific sources or limit trading to ensure that the pro-
gram does not create hotspots and that it achieves the
environmental objectives. It should be noted, howev-
er, that if a program requires too many trading restric-
tions to avoid hotspots, a more conventional regulatory
approach to address the problem might be preferable.
Do Sources Have Different
Control Costs?
Cap and trade programs make the most sense when
emission sources have different costs for reducing
emissions (Newell and Stavins, 1997). These cost dif-
ferences may result from the age of the facilities, avail-
ability of technology, location, fuel use, and other
factors. In the U.S. SOz Allowance Trading Program,
there was considerable diversity in emission reduction
costs because of differences in the age of power plants
and the proximity to low sulfur coal supplies (Stavins,
1998). Where costs are different, there is "room for a
deal," because sources with high marginal abatement
costs have an incentive to buy allowances from sources
with low marginal abatement costs. Conversely, if
affected sources tend to be relatively homogenous,
their marginal abatement costs may be approximately
equal and there is little incentive for trading. In this
case, a cap and trade program is not likely to yield a
significantly more cost-effective outcome than more
traditional types of regulation. Table 1 is a compilation
of SO2 marginal control costs for sources in Taiyuan,
China. The data were used to assess the feasibility of
using cap and trade to reduce SCh emissions. This
type of analysis is critical to determining the merits of
using cap and trade as a policy instrument.
Are There Sufficient Sources?
In general, cap and trade programs should include
enough sources to create an active market for
allowances. If there are too few sources, there may be
few opportunities for trading. In addition, even if there
are cost-effective trading opportunities in a program
with few sources, a market with few transactions could
make potential sellers reluctant to part with their
excess allowances. These potential sellers could be
concerned that if business conditions change and they
need more allowances in the future, they will have dif-
ficulty purchasing them. They may instead hoard
excess allowances even though it might not appear to
2-2
Is Cap and Trade the Right Tool?
-------
Table 1: Cost-Effectiveness of SO2 Control Measures in
Taiyuan, China
Control
Treat post-combustion gas
Flue gas desulfurization (FGD)
Lower sulfur coal (~1.3%)
FGD (simplified)
Limestone fuel additive
Source
Taiyuan District Heating
Eastern Mountain Power Plant
Taiyuan #1 and #2 Power Plants,
Taiyuan Iron & Steel
Taiyuan #1 Power Plant
Coal Gasification Plant
Cost/ton
(US$)
$60
$80
$100
*$240
$130
* In addition to unspecified costs paid through a grant from the government of Japan.
Source: RFF, 2001
be in their economic interest to do so. Additionally,
with fewer sources, there may be a concern that larger
sources may exert market power and withhold
allowances from the market to drive up prices of
allowances.
There is a tradeoff, however, in that the more numer-
ous the sources, the more complex and costly the cap
and trade program may be to establish and operate. For
example, a cap and trade program for vehicles could be
administratively costly if there was a need to measure
and report emissions and enforce compliance at the
vehicle level.1 Technological advances, however, are
making it possible to cost-effectively expand participa-
tion in cap and trade programs (e.g., computerized data
tracking systems, improved emission measurement tech-
nology (Kruger, et al, 2000)).
Is there Adequate Authority?
Another important question government officials must
consider is whether the relevant government entity has
sufficient jurisdiction over the geographic area where
they would implement the cap and trade program. In
many countries, regional or local authorities are respon-
sible for implementing environmental programs. Often,
they must follow national poli-
cies but are given considerable
autonomy in implementation.'
To the extent that the region of
a cap and trade program covers
more than one jurisdiction, the
authorities should maintain
some consistency in key design
elements of the program. To
ensure that the allowances are
consistent and fungible across
jurisdictions, cap and trade pro-
grams require common design
elements, including standards
for determining applicability,
emissions measurement and
reporting, re cord keep ing,
enforcement, and penalties for
non-compliance (Kinner, 2002).
Thus, program designers should answer the following
questions:
Will provinces and municipalities be responsive
to directives, such as monitoring requirements,
imposed by the national government or would
they cooperate to form a collective effort to
develop such requirements?
Does the central government, or coalition of
local governments, have the capacity to enforce
compliance provisions and penalties throughout
the entire trading region?
Other design elements, such as allocation methodolo-
gies for assigning the initial distribution for
allowances, might be left to the provinces or munici-
palities since the allocation methods have little envi-
ronmental impact.3
Are there Adequate Political
and Market Institutions?
For the trading component of a cap and trade program
to work, a country must have some of the same institu-
tions and incentives in place as those required for any
type of market to function. These include:
Other environmental policy tools, or alternatively, the compliance obligation and allowance allocation at the vehicle manufacturer, fuel refiner or
distributor level, may be more appropriate in this case.
For example, China's provincial Environmental Protection Boards have the main responsibility for running air quality and other environmental
programs. Similarly, in Slovakia there are 79 local districts that implement environmental and other programs.
Allowing different provinces or municipalities to have different allocation schemes may have distributional economic impacts, such as favoring
firms within an industrial sector in one region of a country over another. This result could have economic efficiency effects if product markets
are not perfectly competitive.
2-3
Is Cap and Trade the Right Tool?
-------
A developed system of private contracts and
property rights (see Chapter 3 for discussion of
property rights issues associated with emission
trading).
A private sector that makes business decisions
based on the desire to lower costs and raise profits.
A government culture that will allow private busi-
nesses to make decisions about "how" to achieve
objectives with a minimum of intervention.
As with all environmental programs, a cap and trade
program requires adequate enforcement to ensure that
emission objectives are met. In addition, for an
allowance market to develop, market participants must
be confident that sources will measure and report
emissions correctly, the regulating authority will verify
compliance, and, if there is non-compliance, the regu-
lating authority will assess sufficient financial penal-
ties. Thus, cap and trade programs will have greatest
success in countries where rule of law is respected and
enforcement is consistent, impartial, transparent, and
independent of political considerations (EDf and
RSHE, 2000). In addition, once regulations are imple-
mented, they should be changed only through trans-
parent and fair procedures. Participants should clearly
understand from the beginning how the program
works and how regulating authorities will measure and
enforce compliance. Interest in a trading program will
diminish significantly if firms believe that rules are
unfair, arbitrary, or unpredictable.
Even if a country does not yet have all of the attrib-
utes described above, it may still be beneficial to
develop the infrastructure necessary for a cap and
trade program in advance of more comprehensive eco-
nomic changes (Ellerman, 2002). As centrally planned
economies make the transition to become more mar-
ket oriented, they may also transform their environ-
mental programs to become more efficient. Even if
conditions are not yet ripe for trading, the structure of
a cap and trade program may improve environmental
performance. In particular, the emphasis on careful
mass-based emission measurement and accounting
may improve environmental accountability of sources.
For example, recent experiments in Slovakia (CCAP,
2001) and Chile (Montero, et al., 2000) have indicated
that the allocation process associated with cap and
trade has served as an incentive for more complete
and accurate emission inventories.
Are Measurement Capabilities
Sufficiently Accurate and
Consistent?
In considering whether cap and trade is an appropriate
tool to address an environmental problem, policymak-
ers should consider whether sources covered by the
program can measure emissions with sufficient accura-
cy and consistency to support the cap and trade policy
tool. (For a discussion of emission measurement priori-
ties and issues for a cap and trade program, see
Chapter 3.)
Unlike many types of environmental regulation
where regulating authorities judge compliance by
adherence to detailed technology or process specifica-
tions, cap and trade programs require a purely perform-
ance-based test for compliance. Ultimately, measured
emissions dictate how many allowances a source must
surrender at the end of the compliance period. Thus,
the measured emissions dictate how many extra
allowances a source may be able to sell or how many
additional allowances a source may need to buy. If one
source uses a less accurate emission measurement
method than another, and consequently underesti-
mates its actual emissions, it could surrender fewer
allowances than necessary to offset its emissions. If
this scenario occurred, the emission goal (or cap)
would not be met. In addition, facilities with opportu-
nities to reduce emissions beyond required levels
would lose some of the economic incentive, because
the underreporting sources need fewer allowances for
compliance and will therefore either increase the sup-
ply or decrease demand for allowances.
2-4
Is Cap and Trade the Right Tool?
-------
Comparison of Cap
and Trade and Other
Policy Options
A number of different policy tools can be used to
address environmental concerns. These include:
Economic-incentive approaches, such as environ-
mental taxes and emission trading.
Command-and-control approaches, such as tech-
nology mandates or emissions rate standards.
Non-regulatory approaches, such as voluntary
agreements and eco-labeling.
Ultimately, the policymaker's objective should be
to achieve the optimal level of pollution control to
adequately protect human health and the environ-
ment at a minimum cost to society.
Market-Based Approaches vs.
Command-and-Control
Regulation
For many air pollution problems, command-and-con-
trol (or direct regulation) may be the best course. For
example, where regulating authorities can identify a
specific facility as the source of a public health prob-
lem, limiting its emissions may be the simplest and
most effective solution. Also, in the transportation sec-
tor where fuel characteristics can have a direct impact
on the effectiveness of engine technology, it may be
best to directly specify fuel parameters, such as sulfur
content, to permit firms to design engines in the most
cost-effective way to reduce harmful emissions of par-
ticulates or other pollutants such as NOx, hydrocar-
bons, and carbon monoxide.
Command-and-control regulations often work best
when:
Emission reduction experience is limited and
expertise is concentrated among regulators.
Solutions are clear or there are few options for
reducing emissions.
Monitoring total mass emissions is not feasible.
Emissions have serious local health impacts, and
trading might make such hotspots worse.
Emissions are toxic, and the desired emissions
level might be zero.
With command-and-control, the regulating authori-
ty typically establishes a requirement to install a spe-
cific type of emission reduction technology. Although
sources may achieve a certain level of emissions per
unit of heat input or product output using the tech-
nology, increased utilization and new emissions
sources can threaten the ability to achieve and main-
tain an emissions target. Older sources that have been
exempted or "grandfathered" from strict emissions
controls might also threaten the ability to achieve and
maintain an emission target. This threat can affect the
ability to achieve an environmental and/or human
health goal.
For some environmental problems, however, specif-
ic requirements may cost more than flexible policy
approaches and inhibit innovation. These types of
environmental problems may work well for a transi-
tional application of incentive-based approaches or
economic instruments, such as taxes or a cap and
trade program. Such programs may be preferred to
encourage more economically efficient solutions. If
properly designed, economic incentives can harness
market forces to work toward environmental improve-
ment. By internalizing pollution control costs they can
make pollution reduction in the economic interest of
the firm and promote innovation.
It is also possible and, in some instances, beneficial
to use a hybrid approach where command-and-control
policies are implemented side-by-side with a cap and
trade program. Command-and-control policies, if not
overly restrictive, can establish a backstop or safety net
to adequately protect human health and the environ-
ment (see Chapter 3).4
Cap and Trade vs.
Environmental Taxes
Environmental taxes are another significant market-
based instrument for reducing pollution. The major
difference between cap and trade and environmental
taxes is that cap and trade imposes an absolute restric-
tion on the quantity of emissions allowed (i.e., the cap)
and allows the price of emissions to adjust to the mar-
ginal abatement cost (i.e., the cost of controlling a unit
of emissions). An environmental tax sets a price for a
ton of emissions and allows the quantity of emissions
For a discussion of integrating cap and trade with other instruments, see Schreifels, 2000 arid Ellerman, 2002.
2-5
Is Cap and Trade the Right Tool?
-------
Figure 2. Economically Efficient Control of Pollution
CAP AND TRADE
TAX
~o P*
Q_
u
0
4-J
'c
01
a
Actual Marginal
Abatement Cost
Expected Marginal
Abatement Cost
Q trade
Quantity of Pollution Reduced
Actual Marginal
Abatement Cost
Marginal
Social Benefit
Expected Marginal
Abatement Cost
Qtax
Quantity of Pollution Reduced
Theoretically, environmental taxes or cap and trade will provide the same level of environmental protection. However, if policymakers have
incomplete or imperfect information about costs and benefits, researchers create new control technologies, or unforeseen developments arise,
cap and trade provides certainty that the level of emissions will not increase beyond the emission cap. However, there are no assurances about
the cost of the program. An environmental tax does not provide certainty about emissions, but it does establish a limit on the cost of the pro-
gram to ensure that the price of emitting a unit of pollution does not exceed the tax level. In the second graph, the actual marginal abatement
cost is higher than expected leading to fewer emission reductions (i.e., higher emissions) for the tax program. If the actual marginal abatement
cost were lower than anticipated, the emission reductions for the environmental tax program would be greater than for the cap and trade pro-
gram (and costs would be higher.)
to adjust to the level at which marginal abatement cost
is equal to the level of the tax (See Figure 2).
Environmental Certainty
There is extensive discussion in economics literature
about the relative merits of cap and trade and environ-
mental taxes.5 In situations where greater environmental
certainty is needed, cap and trade programs are prefer-
able because the cap sets an emission goal that sources
must meet. With taxes, the regulating authority must
establish a tax per unit of emissions. However, due to
imperfect information (e.g., regarding marginal abate-
ment costs and price sensitivities) and technological
changes, setting the tax at the level required to attain the
emission target becomes difficult and uncertain.6
Moreover, under a regime of environmental taxes, new
entrants into the polluting activity will lead to increased
emissions. With cap and trade, regulating authorities can
require new entrants to purchase allowances directly
from the market or the regulating authority can provide
allowances from set-asides that are within the cap. Thus,
the emission goal can be maintained.
Price Certainty
In situations where price certainty is needed, tax pro-
grams are preferable because the tax per unit of emis-
sions limits the cost to firms. For example, where the
costs of achieving a level of emission reductions are
uncertain, policymakers may decide to set an emis-
sions tax rather than taking a chance that an allowance
price will rise to a level that is economically or politi-
cally unsustainable. '
For a discussion of the economic considerations for choosing between taxes versus emissions trading, see Baurnol and Gates, 1988.
A recent study of environmental taxes in Europe showed that these programs have tailed to achieve the expected level of emission reductions
(OECD, 2001).
A third type of economic instrument is essentially a hybrid of a tax and a cap and trade program. Tlu's mechanism, sometimes known as a "safety
valve" or a "price cap" is a cap and trade program with a maximum price per ton. If the market price per ton rises above the maximum price,
regulated sources can buy additional tons at the maximum price. In such a situation, the emission cap is exceeded, but the price per ton does
not rise above the maximum level (Pizer, 1997).
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Is Cap and Trade the Right Tool?
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Administrative Costs
Administrative costs are similar for both environmental
taxes and cap and trade. Each approach requires
sources to keep records of fuel consumption or emis-
sions and to report this information to the regulating
authority. The regulating authority's administrative
costs include processing this information, reviewing it
for completeness and accuracy, and recording it. The
regulating authority could also conduct detailed audits
of selected submissions.
With both instruments the regulating authority
must decide the rigor of emission measurement and
reporting requirements. For example, Sweden's NOx
tax and the U.S. SOz Allowance Trading Program
require the use of continuous emission monitors
(Blackmail and Harrington, 1999). Similarly, the regu-
latory authority's review of data can be more or less
rigorous depending on the level of review necessary.
Under the U.S. SOz Allowance Trading Program, emis-
sion data review is rigorous. Although it is highly auto-
mated, more than 75 percent of staff resources at the
federal and state level are associated with the meas-
urement, processing, and tracking of emissions data
(see Chapter 4 for a more detailed discussion of
administrative costs).
Under a cap and trade program, a small amount of
additional resources are necessary to process
allowance transfers and reconcile emissions and
allowances at the end of a compliance period. A tax
program will require resources to collect and manage
tax receipts. Some fiscal institutions, however, may
already have the resources in place to collect and man-
age receipts from other tax schemes.
Political Considerations
Some regions have a history of implementing environ-
mental tax programs. In these regions environmental
taxes may be easier to implement because they are
already understood and accepted and much of the
infrastructure may already exist. In other regions, there
may be political reasons to opt for a cap and trade pro-
gram. Emission sources may prefer a system in which
allowances are allocated without charge rather than a
system of environmental taxes in which a source has to
pay for emissions. The initial allocation of allowances
reflects a transfer to sources of an asset that is scarce
and therefore has economic value. Recognizing this,
sources are often more supportive of this market-based
incentive program than they are of environmental
taxes. In some circumstances, policymakers might use
both policies, environmental taxes and cap and trade.8
A low tax can generate revenue for the regulating
authority while still offering emission sources the ben-
efits of a cap and trade program. Alternatively, the reg-
ulating authority could generate revenue with a cap
and trade program by distributing some or all
allowances through an auction.
Other Forms of Emission
Trading
This section examines two additional forms of emis-
sion trading - project-based trading and rate-based
trading - and compares them to the cap and trade
approach in terms of potential to limit total emissions,
ability to achieve cost minimization, administrative
overhead, and transaction costs.
Cap and Trade vs. Project-Based Trading
Potential to Limit Total Emissions
Project-based trading, otherwise known as credit trad-
ing or offset trading, is generally not used as a stand-
alone program. It can be used to offer emission sources
the flexibility to seek lower cost emission offsets from
sectors outside a regulatory program. Historically in the
United States, these types of credits or offsets have
been used to meet rate-based emissions limits for con-
ventional pollutants. More recently, there has been con-
siderable international interest in using project-based
trading as a complement to cap and trade to meet vol-
untary or mandatory greenhouse gas emission targets.
Emission offsets, or credits, are typically calculated
by comparing actual emissions against a baseline. The
baseline is an estimate of what emissions would be in
a hypothetical situation (e.g., if the project had not
been created). Determining the baseline is often the
biggest challenge with project-based trading.
Designing effective protocols to verify offsets is diffi-
cult because it requires making a determination about
whether the emission reductions from an offset proj-
ect would have occurred anyway. This type of test is
known as "additionality." If emission reductions from
a project are not "additional," there is a risk that these
reductions could dilute an emissions goal and lead to
For a discussion of integrating cap and trade and environmental taxes, see Elleriuan, 2002.
2-7
Is Cap and Trade the Right Tool?
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increased emissions compared to a case in which no
offsets are allowed.
A similar concern in some situations is "paper cred-
its." These are created when a source uses its legal
allowable level of emissions (e.g., its maximum poten-
tial to emit) as its baseline rather than what emissions
would have been in the absence of the project. These
paper credits are the difference between what a source
is allowed to emit and what a source actually emits.
These credits increase allowable emissions without
generating any real emission reductions.9
Two issues must be addressed for project-based
trading-the effect on total emissions from "non-addi-
tional" offsets and "leakage," which is an increase in
emissions or decrease in sequestration caused by the
project but not accounted for in the emission baseline
for that project activity.10 The underlying concept is
that a particular project can produce offsetting effects
that fully or partially negate the benefits of the proj-
ect. For example, a project that protects a forest tract
slated for deforestation may simply accelerate logging
of the next most suitable location.
Projects that temporarily sequester emissions (e.g.,
forestry projects that sequester carbon dioxide) also
raise issues of "permanence." If the emission reductions
from the project are used to offset other emissions, and
the project subsequently releases the sequestered emis-
sions, not only is the environmental benefit lost, but the
credits may allow emissions to increase.
Cost Minimization
As with cap and trade, project-based trading can
reduce the economic costs of achieving an emission
goal by adding flexibility for sources to develop appro-
priate compliance strategies. For example, a polluting
facility may invest in an offsite emission abatement
project to earn emission reduction credits. If approved,
these credits may be used to offset emissions from the
facility.
Administrative Involvement and Transaction Costs
A key difference between cap and trade and project-
based trading is the way that emission reductions are
verified and the implications for administrative involve-
ment. A cap and trade program requires preliminary
analysis to establish an emission cap for regulated
sources. Depending on the method of allowance distri-
bution (see Chapter 3), additional work may be
required to allocate emission allowances to the regulat-
ed sources. Due to the emission cap and measurement
requirements, there is no need for the regulating
authority to review each emission reduction activity or
to calculate an emission baseline for each activity.
Instead, each regulated source measures and reports its
total emissions, and the regulating authority focuses on
ensuring emissions are measured accurately and an
allowance is turned in for each unit of emissions.
In contrast, project-based trading often requires that
project participants develop a project specific emission
baseline for review by the regulating authority or other
authorized experts.11 Review of such baselines can be
contentious and resource intensive because it is
extremely difficult to define with certainty what
would have happened in the absence of a project.
To reduce administrative and transaction costs and
address additionality concerns, the regulating authori-
ty may establish multi-project baselines. Multi-project
baselines use performance standards or benchmarks
for a type of project. If the project results in emission
rates lower than the standard, the project automatical-
ly receives credit equal to the difference between the
baseline and the actual emissions (Sathaye, et al.,
2001). Standardizing baseline methodologies in
advance can significantly reduce administrative costs
and reduce the subjectivity inherent in the review of a
project baseline. They may not, however, always be a
perfect test for whether emissions are below the levels
that would have occurred otherwise. Also, multi-proj-
ect baselines may be difficult to develop for some
types of projects.
Project-based trading can reduce the costs of
attaining an emission goal, but the administrative and
transaction costs per unit of emission reduction are
often higher than cap and trade programs; there is
greater uncertainty and risk associated with an offset
than an allowance (e.g., due to baseline, permanence,
and leakage issues); and extensive involvement and
oversight by the regulating authority are required to
ensure environmental integrity. These transaction
Paper credits can also affect rate-based trading programs.
Leakage can also occur in cap and trade programs that do not include all sources contributing to the environmental problem. Sources in the pro-
gram may shift production to other sources not participating in the program, thereby negating some of the emission reductions.
Adequate safeguards for using an outside expert for verification include: sufficient direction and oversight from the regulating authority; accredi-
tation of competency; and protection from conflicts of interest.
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Is Cap and Trade the Right Tool?
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complexities vary depending upon project type.
Project-based trading can be an effective way to intro-
duce some sectors to market-based incentive pro-
grams. In addition, it can be effective for sectors in
which it is easier to measure an emission reduction
(e.g., the quantity of gas captured from a landfill
methane recovery project) than total mass emissions.
Cap and Trade vs. Rate-Based Trading
Under a rate-based trading approach, the regulating
authority determines a performance standard (e.g., an
amount of emissions allowed per unit of output) for a
sector (e.g., tons of a pollutant per kWh of electricity
generated). Sources with emission rates below the
performance standard can earn credits12, whereas
sources with emission rates above the standard must
obtain credits for their excess emissions to remain in
compliance.
Sources with low cost opportunities to improve their
emissions rate have an incentive to operate at rates
below the performance standard. They can then sell
the resulting credits to sources that have higher costs
to attain the performance standard. Rate-based trading
programs have been used in the United States to
phase out lead in gasoline and control mobile source
emissions.
One consideration when evaluating rate-based trad-
ing is that if the activity level increases at a rate faster
than the emission rate declines, sources can earn cred-
its while total emissions increase.
Potential to Limit Total Emissions
Perhaps the most important measure of a regulatory
approach is whether it can produce the desired envi-
ronmental improvement. Emission caps set the total
emission level, in effect, constructing a program from
the environmental goal back to the sources. In con-
trast, rate-based trading attempts to establish an emis-
sion rate standard for each source that will, in
aggregate, produce the desired environmental improve-
ment. However, under a rate-based program, emissions
and the pollution load on the environment can
increase if sources increase their utilization or if new
sources are built.
This situation raises a distinction between cap and
trade programs and rate-based programs regarding
industrial growth. Both types of programs accommo-
date growth. The responsibility for addressing growth,
however, falls upon the sources in a cap and trade pro-
gram while it falls on the regulating authority in a
rate-based program. More specifically, under a cap,
sources must determine how to operate new facilities
or increase utilization of existing facilities and still
comply with the emission cap. This approach encour-
ages industry to innovate and find lower-cost
approaches to reducing emissions. In the U.S. SO2
Allowance Trading Program electricity production and
economic growth increased while SO2 emissions
decreased significantly (see Figure 3). In a rate-based
program, as with an environmental tax program, the
regulating authority must periodically impose new rate
standards to achieve and maintain an emission target
and prevent (or correct for) additional emissions that
may result from increased production. This cycle of
revising regulatory programs can create a less certain
regulatory environment for sources to conduct compli-
ance and business planning.
Cost Minimization
As with cap and trade, the fact that sources can trade
their credits under the rate-based approach implies that
the performance standard could be achieved at a lower
economic cost. This is because sources with high mar-
ginal abatement costs will choose to purchase credits
from firms with lower marginal abatement costs.
Administrative Involvement and Transaction Costs
Under a rate-based system, the regulating authority
converts each source's emission rate and activity level
to credits. Because the regulating authority must col-
lect activity level data, the data requirements may be
greater for rate-based trading. Such data may also
include commercially sensitive data that could be diffi-
cult to obtain. This information, however, may be use-
ful for other types of trading programs as well. The
regulating authority can use the information to verify
measured emissions.
Like cap and trade, rate-based approaches do not
necessarily require that the regulating authority
approve each trade (in contrast to the project-based
trading described earlier). Because some additional
steps for government approval may be required, the
level of administrative involvement and costs could be
For electric power sources, the credits earned would be equal to the difference between the performance standard and the source's emission rate
multiplied by the source's current heat input or generation.
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Is Cap and Trade the Right Tool?
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Figure 3. Decoupling Economic Growth and Environmental Protection
60
I 40
20
or
LLJ
Q-
-20
-40
Gross Domestic
Product
U.S. S02 Allowance Trading
Program S02 Emissions
YEAR
the same or slightly greater than those of a cap and
trade program.
Summary of Other Forms of Emission
Trading
Each of the three forms of emission trading is appro-
priate in certain situations. When achieving and main-
taining an absolute emission goal is important, a cap
and trade program can provide more certainty about
total emissions. Administrative and transaction costs
for cap and trade programs are often lower than for
project-based trading, which is burdened by higher
uncertainty and risk and the need for extensive regu-
lating authority involvement.
Project-based trading programs have historically
evolved from the introduction of limited flexibility in
traditional command-and-control programs. Because
project-based programs usually do not require net
emission reductions, they are not effective as stand-
alone programs. However, a well designed project-
based trading program may complement a
command-and-control program that establishes emis-
sion or concentration limits. It may also complement a
cap and trade program in sectors for which accurate
emission measurement of entities or activities may not
be as well developed.
Rate-based trading can be an effective way to pro-
mote efficiency if circumstances do not require an
absolute cap on emissions. The administrative and
transaction costs for rate-based trading programs are
likely to be the same or similar to cap and trade. (See
Table 2 for a summary of the forms of emission trading.)
Table 2: Three Forms
Limit Total
Emissions
Cap and Trade High
Project-based Trading Low to Medium
Rate-based Trading Medium
of Emissions Trading Compared
Cost Administrative &
Minimization Transaction Costs
Yes Low
Yes High
Yes Low to Medium
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Is Cap and Trade the Right Tool?
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Early Emissions Trading in the United States
Cap and trade in the United States evolved to improve upon earlier experiences that were expensive, resource-
intensive and burdened with subjective review procedures, which resulted in limited environmental benefits.The
U.S. EPA and state-level environmental agencies have used several different forms of emission trading with varying
degrees of environmental and economic effectiveness. Although many of the early achievements were modest,
the early efforts in emission trading are important because they provided a foundation and valuable practical
experience for the development of more effective emission trading programs (e.g., the U.S. SO2 Allowance Trading
Program).
Offset Program
EPA first applied the concept of marketable emission permits in the mid-1970s as a means for new sources of
emissions to locate in areas with poor air quality without causing additional air quality problems. New sources and
existing sources that wanted to expand their facilities were required to "offset" their emissions by acquiring emis-
sion reductions from other sources. In this prog ram, off sets are generated when a source reduces actual emissions
below their permitted level and applies to a state agency for certification of the reduction. For a source to receive
an offset, the state must determine that the reduction is:(1) surplus in the sense of not being required by current
regulations; (2) enforceable; (3) permanent; and (4) quantifiable. Offsets are normally denominated by the quantity
of pollutant in tons released over 1 year (tons/year).The most common method of generating offsets is closing the
source or reducing its output. However, sources can also earn offsets by modifying production processes or
installing pollution control equipment.
Bubble Policy
The bubble policy is another approach
that served as a foundation for later
trading policies. Established in 1979,
the bubble policy allowed sources to
meet emission limits by applying a
single aggregate emission limit to
multiple sources within a facility rather
than applying individual control
equipment or emission rate require-
ments at each emission source.The
term "bubble" is used to invoke an
image of a bubble over a facility (such
as a refinery or a steel mill) with sever-
al emission sources. A facility or group
of facilities can aggregate emissions
and use a mix of controls that is differ-
ent from those mandated by regula-
tions, as long as total emissions within
the bubble are equal to or less than
the cumulative limit for all sources
within the bubble (see Figure 4).
By design, bubbles are intended to
be neutral in terms of environmental
Figure 4. Bubble Policy
Emission Limit: 10 tons
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Is Cap and Trade the Right Tool?
-------
impact. However, bubble proposals must undergo individual review and approval, which, over the years, has been
streamlined but is still rather burdensome. Consequently, the bubble provision has been used in less than 100
cases in the United States over the last 20 years.
Evaluation of Early Emissions Trading Activities
Several factors limited the appeal of these early trading approaches.The trading mechanisms were meant to modi-
fy or enhance existing air pollution control programs that did not themselves address total emissions.Therefore,
the trading mechanisms were not effective at controlling overall emission growth.To ensure that air quality did
not deteriorate, expensive air quality modeling was often required before regulators accepted proposed trades.
Deposits to emission banks (credits generated for some later, yet-to-be-determined use) were typically "taxed" by
the air quality management authority to meet state air quality requirements or to generate a surplus that the area
could use, for instance, to attract new firms. Offset ratios (i.e., requiring more than 1 ton of emission reductions to
offset 1 new ton of emissions) used to counter some of the uncertainties from a trade further depressed credit
value. Finally, the administrative oversight to protect against the creation of "paper credits" and "anyway tons"
turned out to be resource-intensive.
In a 2001 study on project-based trading systems, the Environmental Law Institute (ELI) concluded that such
programs in the United States "have generally failed to generate considerable trades and retrospective reviews
have tended to blame their shortcomings on high transaction costs, uncertainty and risk in obtaining needed gov-
ernment approvals, as well as lack of clear legal authority and clearly specified objectives" (ELI, 2001).
2-12 Is Cap and Trade the Right Tool?
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Developing a Cap
and Trade Program
Introduction
Prior to implementing a cap and trade program,
policymakers should examine various design
options, decide which features to employ, and
ensure that there is adequate legal authority. Key deci-
sions include determining which sources to include in
the program (i.e., applicability), the level of the emis-
sion reduction or limitation (i.e., cap), and the timing
when reductions will be required. In addition, policy-
makers should determine requirements for measuring
and reporting emissions, methods of distributing
allowances, rules governing allowance use, compliance
and enforcement provisions, and provisions for inte-
grating cap and trade with existing policies. Before
design work can proceed, it is critical to have informa-
tion on the potentially affected sources, such as their
emissions, utilization, and control options. All of these
issues are discussed in this chapter.
Guiding Principles
Several overarching principles can guide the develop-
ment of a cap and trade program. Adhering to these
principlessimplicity, accountability, transparency,
predictability, and consistencycan promote environ-
mental compliance and efficient markets.
Simplicity
Simplicity is an important goal when designing an
effective cap and trade program. Program operation for
both emission sources and regulating authorities can
be less costly and time-consuming if the rules are not
overly complex or burdensome. Markets function bet-
ter when the rules are simple and easily understood by
all participants. Moreover, the environment is more
likely to be protected when rules are clear and easily
enforced. In contrast, complexity often requires more
decisions, debate, and information collection. This sit-
uation, in turn, can create uncertainty and unnecessary
burden that may lead to delays, opportunities fore-
gone, and ultimately higher costs. In some countries,
complexity may also make it more likely that there will
be litigation over contentious issues.
Another aspect of simplicity that will increase the
economic effectiveness of a cap and trade program is
the fungibility of allowances (i.e., an allowance is a stan-
dardized unit of trade that is interchangeable with other
allowances). Fungibility is highly desirable to minimize
transaction costs in the program and to maximize the
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Developing a Cap and Trade Program
-------
efficiency of the cap and trade program to lower costs.
Simplicity is enhanced by avoiding the creation of dif-
ferent categories of allowances with different attributes,
unless it is absolutely necessary to maintain the envi-
ronmental integrity of the system. For example, dis-
counting the use of certain types of allowances based on
their geographic origin or on their ability to be banked
complicates transactions and reduces the cost effective-
ness of allowance trading and may not have significant
environmental benefits.
More broadly; the principle of simplicity can be
applied to all elements of the program, including:
Applicability thresholds (determining which
facilities are affected)
Allocation formulas
Trading rules and/or restrictions
Measurement options and rules
Reporting requirements
Penalty assessment
Accountability
A cap and trade program must create a framework of
oversight and enforcement that will hold participants
accountable for their emissions and ensure compliance
with the program's requirements. The basis of
accountability is the accurate measurement and verifi-
cation of emissions and the rigorous and consistent
enforcement of penalties for fraud or noncompliance.
The regulating authority can facilitate accountability
through clear and simple rules.
Transparency
Transparency refers to the full and open disclosure of
relevant public and private decisions, such as establish-
ing the rules and regulations for a trading program and
determining if an emission source is in compliance.
Transparency is important to a well-functioning cap
and trade program, both in terms of its design and its
operation. Transparency of the design process can pro-
mote public acceptance and confidence in the cap and
trade program.
Information transparency is also important to the
effective operation of an emission trading program.
Providing public access to source-level emission and
allowance data promotes confidence in the program and
provides an additional level of scrutiny to verify enforce-
ment and encourage compliance. In some jurisdictions
these data are classified as confidential and may require
legal changes to make them publicly available.
Advances in information technology and the
Internet have made it possible to provide interested
parties with timely and useful information about
emissions, allowances, and program results.
Predictability and Consistency
Predictability and consistency in the design and applica-
tion of program rules are important principles for an
effective cap and trade program. They help create the
right circumstances to encourage innovation and lower
costs. With a cap and trade program, emission sources
have an incentive to find better and lower-cost opportu-
nities to reduce emissions. This incentive depends upon
long-term, predictable, and consistent rules that affect
the economic value of emission reductions. This
arrangement does not mean, however, that rules cannot
change in response to new information. Rather, it means
that the framework must include the possibility for
change and a clear explanation of the process for chang-
ing the rules.
Establishing Legal
Authority
As discussed earlier, there must be legal authority to
establish a cap and trade program. Although policy-
makers can include many components in authorizing
legislation, the basic components are listed below.
Several of these components are discussed in more
detail in this chapter and Chapter 4.
Setting the mass-based emission cap: If the cap
is not set directly by policymakers, the regulating
authority must have authority to limit the total
quantity of pollution from the relevant sector(s)
by establishing a cap on emissions.
Implementation dates: Sources must comply
with the emission caps starting in a particular
compliance period.
Sources covered: A complete control program
must define which sectors are subject to program
requirements and, within each sector, which
emission sources are affected. For example, the
scope of an electric generating sector cap and
trade program could include all electric generat-
ing units or only electric generating units above
a certain generation capacity.
Distributing tradable allowances: Traditional air
quality permits authorize a certain amount of
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Developing a Cap and Trade Program
-------
emissions and are non-transferable. Policymakers
establishing a cap and trade program must pro-
vide for tradable permits, specifically that appro-
priate increments (e.g., allowances) are tradable
among participants in the program. The regulat-
ing authority can allocate these authorizations, or
allowances, to emit in a variety of ways, or auc-
tion them to the highest bidders. Policymakers
should also explicitly state which regulating
authority is responsible for issuing and distribut-
ing the allowances.
Banking: Policymakers might allow sources to
use allowances issued in one period for compli-
ance in subsequent periods. This arrangement is
called banking.
Trading procedures: A cap and trade program
needs consistent rules for conducting allowance
transfers, as well as a system for tracking
allowances. Policymakers should explicitly state
which regulating authority is responsible for
developing and enforcing trading procedures.
Emission monitoring and reporting: Accurate,
comprehensive emission data are a cornerstone
of a credible and effective cap and trade pro-
gram. The regulating authority must have the
authority to require standardized methodologies
for emission measurement, collect emissions
data to determine compliance, and publicize
emission and allowance data to provide trans-
parency and promote confidence in the program.
Compliance: Each affected emission source is
required to hold at least one allowance in their
account for each unit of emissions during the
compliance period. Cap and trade programs must
include provisions that authorize the regulating
authority to reconcile the emissions of each
source with the number of allowances they hold
to determine compliance.
Establishing and enforcing penalties for non-
compliance: The regulating authority must have
the authority to impose and enforce sufficient
penalties on emission sources that do not comply
with the rules of the program.
Legislation to provide legal authority can range
from a few broad sentences to many detailed pages.
The legislation may provide only general language
authorizing the use of emission trading or it may
explicitly state the rules and guidelines for a cap and
trade program.
In addition to establishing this new authority, a cap
and trade program may require appropriate amend-
ments to a country's existing legislation. For example,
fundamental legal issues (e.g., existing technology
standards or taxes) may hinder the development of a
cap and trade program if not properly addressed. Most
countries will already have some regulations that are
related to environmental performance. If existing reg-
ulations (or economic incentives) are simply in place
to collect revenues for the government (e.g., environ-
mental taxes set well below the marginal abatement
cost), then a cap and trade program can likely be
added. If there are technology standards, it may be
necessary to make certain adjustments in existing leg-
islation (e.g., replacing the technology standards with
caps of equal or greater stringency, or allowing firms
to opt out of them in favor of participating in the cap
and trade program). For further discussion on cap and
trade and potential conflicts in the existing legal
structure, see Chapter 4.
Creating an Emission
Inventory
An important step in the development process for a
cap and trade program is the creation of an adequate
source-level emission inventory. The types of data and
appropriate level of detail for the emission inventory
will depend upon the intended use of the data. The
emission inventory is likely to be useful in analyzing
and making the following design decisions:
Program applicability: The regulating authority
may use inventory data to make decisions about
which sectors to include, where to apply the
obligation to hold allowances (e.g., at the fuel
distributor or the emission source), and what
thresholds should be set to determine if a source
is affected by or exempted from the program
(e.g., production capacity).
Allowance allocations: The regulating authority
may use inventory data to analyze the effects of
different allocation options on emission sources
and to decide on a method for distributing
allowances.
Aggregate cap: The regulating authority will
need the inventory data for the affected emission
sources to analyze the potential costs and bene-
fits of different emission caps, as well as to
3-3
Developing a Cap and Trade Program
-------
assess the performance of the program once
implemented. In some cases, the emission
inventory is used to project future emissions,
either using a sophisticated computer model or
using simple assumptions about projected emis-
sion growth.
Minimum data requirements for the emission inven-
tory include: (1) individual emission source character-
istics (e.g., size, location, name-plate capacity, process
type, boiler type, fuel type); and (2) emission levels for
individual sources based on output, fuel use, and/or
emission data. These data requirements will vary
depending upon: (a) the types of sources to be regulat-
ed under the cap and trade program; (b) the pollutant;
(c) the choice of allowance distribution method; and
(d) the method for setting the overall cap.
Inventory Level of Detail
For cap and trade programs that require emission
sources to hold allowances, sources can be inventoried
at five different levels of detail: (1) the company level13;
(2) the plant level, which denotes a plant or facility
that could contain several emitting activities; (3) the
point/stack level, where emissions exit to the ambient
air from stacks, vents, or other points; (4) the
process/segment level, representing the unit operations
of specific source categories (e.g., a single boiler that
burns both coal and gas would count as two segments);
and (5) the unit level (e.g., each individual boiler)14.
Although a full comparison of the different options
is beyond the scope of this guidebook, the most sig-
nificant factors in making this decision are:
Program design considerations: The level of
detail needed for the emission inventory is often
determined by program design considerations.
For example, if the program applicability thresh-
old is based on the size of a combustion unit,
then an inventory created at the plant level will
not provide sufficient detail; additional informa-
tion at the unit level will be necessary. Similarly,
allowance allocation formulas may require a cer-
tain level of inventory data.
Cost of data collection and availability of data:
Some options may make it easier to collect nec-
essary data. For example, fuel purchase records
may be kept only at the plant level rather than
for each individual unit. Although data can be
apportioned when necessary, it may be more cost
effective to collect data at more aggregated levels
of detail, such as the plant level.
Completeness: Inventorying emissions at the
unit level avoids many of the complications that
may arise with other inventory levels (e.g., com-
plex configurations of production units and
stacks) and provides the most detailed informa-
tion about the emission sources. However, this
arrangement requires more data that may be
more difficult to compile.
Measurement Method: It is important to consid-
er whether the data gathered for the program
development stage will need to match the level
used to assess compliance once the program is in
place. If so, the regulating authority should eval-
uate issues related to emission measurement for
the various levels of detail. For example, if in-
stack measurement such as continuous emission
monitors (CEMs) is used for compliance with
the program, a stack-level inventory would be an
advantage because it would include all of the
emissions from each stack. However, for alterna-
tive measurement methods (e.g., fuel-based mass
balance approaches), using stack level data for
compliance might complicate emission measure-
ment, particularly if several units share fuel sup-
plies but exhaust through different stacks.
Program Design
Elements
In developing a cap and trade program, the regulating
authority should consider a number of design ele-
ments. Each design decision affects other aspects of
the program. Although these elements are discussed in
a specific order, the interrelationships between all the
design elements should be considered together when
making program decisions.
Measuring emissions at the company level is very complicated and is not recommended for cap and trade programs. Issues such as partial owner-
ship, mergers, and sales all effect the ability to accurately attribute emissions to a specific company.
In many cases, unit level may correspond to point/stack level, but it is possible for a unit to exhaust to multiple stacks or for multiple units to
share a single stack.
3-4
Developing a Cap and Trade Program
-------
Applicability
After deciding that cap and trade is the preferred
approach to reducing the emissions of a particular
pollutant, policymakers must determine which emis-
sion sources to include in the cap and trade program.
Ideally, all sources, sectors, and emissions would be
included for full coverage and maximum environmen-
tal effectiveness and economic efficiency. However,
measurement capabilities and costs, available control
options, administrative burdens, political considera-
tions, and other constraints may limit participation to
a subset of emission sources.
When determining the applicability of a cap and trade
program, there are several important considerations:
Contribution to emissions: Included sources
should represent a substantial portion of emis-
sions in order to appropriately address the envi-
ronmental issue of concern. To determine
whether to include sources or sectors in a pro-
gram, the regulating authority should perform an
analysis using the existing emission inventory (as
discussed in the previous section), as well as an
analysis of how future growth will change the
existing emission patterns. In this analysis, it is
important for the regulating authority to acknowl-
Figure 5. Leakage
Plants within capped area reduce pollution
by decreasing production, but import power
from a source outside of the cap.This source
increases its production and pollution and
sends electricity into the capped area,so
there is no benefit to the environment.
This is known as "leakage".
Uncapped sources
edge and, if necessary, address emission sources
that they cannot feasibly include, but that could
receive shifts in production from emission sources
constrained by the cap. Such shifts of production
from affected sources to other non-affected
sources ("leakage") could undermine the envi-
ronmental benefits of the cap (See Figure 5).
Maximizing the coverage of emissions in a cap
and trade program can optimize both the envi-
ronmental effectiveness and the economic effi-
ciency of the program. Conversely, the
environmental effectiveness of a cap and trade
program is diminished if a large percentage of
emissions are outside the cap. Although the reg-
ulating authority can implement other policies
for emissions outside the cap, the level of these
emissions is not guaranteed. Also, because
sources outside the cap do not benefit from the
economic efficiency of the trading program, the
policies to control their emissions may be rela-
tively more costly.
Availability of cost-effective control options:
Some sources included in the program should
have a range of cost-effective abatement options
to ensure the ability to achieve the reduction goal.
Variation in abatement costs promotes competi-
tion among control
options, stimulates
innovative tech-
nologies, and
helps lower com-
pliance costs.
Ability to meas-
ure emissions: As
discussed further
in this chapter,
sources that par-
ticipate in a cap
and trade program
must have the
ability to account
for their emissions
accurately and
consistently.
Alternatively, a
regulating authori-
ty may involve
independent par-
ties to measure
Capped sources
3-5
Developing a Cap and Trade Program
-------
and report emissions. If independent parties are
involved, the regulating authority should have
oversight, certification, and review procedures in
place to promote accountability. Because each
allowance has economic value, it is important to
ensure that emissions (and thus allowances used)
are quantified accurately and consistently.
Number and size of sources: The number and
size of sources participating in the cap and trade
program may affect the regulating authority's
ability to manage the program. The regulating
authority must balance the desire to maximize
the coverage of the program to increase the envi-
ronmental effectiveness and efficiency against
the ability to operate the program and enforce
compliance. If sources responsible for a signifi-
cant portion of the total emissions are not includ-
ed in the program, the program may be less
environmentally effective and less economically
efficient. In addition, excluding some significant
sources within an industrial sector can cause
sources to shift activity to those sources outside
the cap, thereby reducing the environmental
effectiveness of the program. It might not, how-
ever, be necessary to include all small sources.
Excluding some small sources may help keep the
total number of sources to a level that is manage-
able for the administration of the program.
Simplicity: It is important to avoid overly com-
plex applicability criteria. Complex criteria make
it more difficult and costly for sources and for
the regulating authority to determine which
sources the program covers. Complex criteria also
increase the likelihood of loopholes that allow
significant sources in the same industrial sector
to avoid inclusion in the program. To this end,
the threshold(s) for determining source applica-
bility should be based on source characteristics
that remain constant, such as capacity or poten-
tial to emit, rather than characteristics that could
vary from year to year, such as mass emissions or
fuel use. This will ease administration of the
program, provide greater certainty to sources,
and avoid frequent changes in an individual
source's applicability status.
Equity: The regulating authority should give
careful consideration to the economic competi-
tiveness of businesses and the effect on markets
that could result from including or excluding cer-
tain industries from a trading system. Fairness
relative to emission reduction potential is anoth-
er consideration for the regulating authority.
Point of Obligation
Closely related to the questions of which sources and
sectors are covered in a cap and trade program is the
question of where there is an obligation to hold
allowances (See Figure 6). There is a growing literature
discussing how this would apply to emissions that can
be capped at several different points in an economy,
including:
Point of emissions (Direct emitters)15: A point of
emission program focuses on direct emission
sources (e.g., electricity generators and large
industrial sources) where the pollutant(s) are
released to the atmosphere. This approach works
well if the production or combustion process
affects emissions (e.g., NOx from industrial boil-
ers) or there are available end-of-pipe controls
(e.g., SO2 from electricity generators). The U.S.
cap and trade programs obligate emission
sources to hold allowances equal to their total
mass emissions.
Upstream (Potential emitters): An upstream pro-
gram focuses on any point prior to the emission
source (e.g., fuel producers and processors such
as coal mines or oil refineries). An upstream pro-
gram does not have a direct cap on emissions.
Rather, the cap is set on the emission potential
inherent in the fuel. The restriction at the fuels
level restrains supply and can cause fuel prices to
increase relative to alternatives. This "price sig-
nal" encourages fuel consumers to reduce
demand for the fuel, either by finding more
cost-effective alternatives or creating new tech-
nologies that use the fuel more efficiently. In
this way, it operates much like a pollution tax,
but has the benefit of a cap on total emission
potential (CCAP, 1998; Kopp, et al, 1999).
Hybrid: A hybrid approach could be used to cap
some entities upstream and some entities at the
point of emissions. For example, large emitters
such as electricity generators might be capped at
the point of emissions, while emissions from
transportation might be capped upstream
(CCAP, 2000, ELI, 1997).
' In U.S. literature, this is often referred to as "downstream," while obligations at any point after the emission source (e.g., commercial electricity
consumers) are referred to as "indirect."
3-6
Developing a Cap and Trade Program
-------
Figure 6. Point of Obligation
UPSTREAM
(Fuel Producers)
Point of Emissions
(Fuel Consumers)
All Indirect
Emission Sources
DOWNSTREAM
(Indirect Emitters)
Analysts often compare upstream and point of
emission approaches on several key program parame-
ters:
In most countries, an upstream system could
capture the highest percentage of potential emis-
sions. Upstream can be particularly effective
when emissions are closely related to the fuel
characteristics or end-of-pipe controls are not
readily available. In addition, an upstream
approach may better address sectors in which
there are numerous small energy users with
direct emissions. Advocates of the upstream
approach also argue that it is economically effi-
cient because it would spread the efficiencies of
cap and trade across a larger segment of the
economy.
Most economists argue that upstream and point
of emission approaches create identical incen-
tives for reducing emissions from affected
sources' energy use because energy consumers
face higher costs from using fuels with greater
emission potential in both cases (Kopp, et al.,
1999). For example, under an upstream system,
an electricity generator would face higher fuel
prices if fuel producers were required to hold
allowances. These higher fuel prices would
encourage the generator to improve efficiency or
switch to lower-emitting fuels in the same man-
ner that the generator would be motivated to
reduce emissions if it was required to hold
allowances. However, a few analysts have argued
that a point of emission approach provides a
more direct signal to reduce emissions, because
the target is the emission source. According to
this view, an upstream system, which relies sole-
ly on price signals, may not provide sufficient
incentive to find new technologies that reduce
emissions per unit of fuel or sequester emis-
sions. In particular, an upstream system provides
little incentive for emission sources to develop
and employ post-combustion control technolo-
gies since this behavior would not be directly
rewarded (CCAP, 1998). On the other hand,
although it creates additional complexity, policy-
3-7
Developing a Cap and Trade Program
-------
makers can create incentives for post-combustion
controls by awarding credits to downstream emis-
sion sources that reduce or sequester emissions.
An upstream system may include fewer sources,
which would generally lower the administrative
burden of a program. Although this is an impor-
tant consideration, recent advances in the use of
information technologies to manage cap and
trade programs have allowed regulating authori-
ties to handle greater numbers of emission
sources without being overburdened (Kruger, et
al, 2000).
Some analysts argue that a hybrid system may be an
acceptable compromise. These analysts contend that
such a design would be desirable because it would pro-
vide similar coverage of emissions to an upstream sys-
tem, while allowing the program design to focus on the
types of emission sources that have been successfully
included in past cap and trade programs (Mazurek,
2002). Potential downsides to such an approach include
a larger number of sources than an upstream program
and added complexity from the need to avoid double
counting emissions at both upstream and point of emis-
sions sources. For example, policymakers may include
natural gas-fired electric generators (point of emissions)
and natural gas distributors (upstream) in a hybrid cap
and trade program. The regulating authority would
have to deduct fuel used by the included electric gen-
erators from the amount of natural gas distributed by
upstream sources to ensure that emissions are not
counted by both sectors.
Opt-ins
Some sectors may not meet the above criteria for inclu-
sion in the cap and trade program but have individual
sources that can meet the criteria. In such cases, it may
be desirable to allow these sources to voluntarily "opt-
in" to (participate in) the program. These sources
receive an allowance allocation and are subject to the
same requirements as sources under the cap.
Theoretically, these sources will have cost-effective
emission reduction opportunities that warrant the
expense of meeting the monitoring and other require-
ments associated with the cap and trade program. If
policymakers allow opt-ins, sources that choose to opt-
in should be subject to all the terms of the program. It
is imperative that any sources opting in employ a
measurement protocol that is equivalent in consistency
and accuracy to the methods used by the affected
sources. This ensures that the reductions achieved are
real, verifiable, and comparably valued.
Although voluntary opt-in provisions may reduce
costs to affected sources, they raise some of the same
issues associated with project-based credits discussed
in Chapter 2. Sources may decide to opt-in and take
advantage of allowance allocations that are above what
their emissions would have been if they were not par-
ticipating in the cap and trade program. In some
cases, they may opt-in and then take measures to
reduce emissions that would have occurred anyway,
regardless of participation in the program. Unless the
regulating authority can make an allowance allocation
at a level that equals "business as usual," extra
allowances will be introduced into the system and will
undermine the environmental effectiveness of the cap
and trade program. Research on the U.S. SO2
Allowance Trading Program has shown that many of
the sources that voluntarily joined the program under
opt-in provisions16 were spurred by overly generous
allowance allocation formulas. Opt-ins using these
provisions achieved very few additional emission
reductions (Ellerman, et al., 2000).
Setting the Level of the Cap
Setting the level of the emission cap is one of the most
important decisions for policymakers and the regulat-
ing authority. In theory, the most economically effi-
cient level for the emission cap is where marginal
abatement costs are equal to marginal benefits from
the reduced emissions (see Appendix A for further dis-
cussion). However, this level is often difficult to deter-
mine due to uncertain information. More generally, the
cap should be set at a level that is expected to address
the environmental and health problems of concern at
an acceptable cost.
As with other types of policies to reduce emissions,
it is desirable to use atmospheric and ecological or
health effects models to assess the impacts of different
levels of emission reductions. Models range from those
that describe links between one receptor area and one
source, to others that describe complex regional-scale
relationships. Models also can project a wide variety of
There were three provisions in the SOz trading program that encouraged voluntary entry into the program. The Substitution and Compensating
Generation provisions were used to bring Phase II units into the program during Phase I. The Industrial Opt-in provision was used to bring
industrial boilers and small generating units into the program.
3-8
Developing a Cap and Trade Program
-------
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8
impacts throughout the region. Some models
address changes over short time periods, such
as episodes, while others focus on longer time
periods, and some attempt to do both.
Usually, models focus on one part of the over-
all assessment and should be linked to pro-
duce a truly integrated assessment. Emission
models develop emission data for input into
air quality models. The output of the air qual-
ity models is then translated into impacts
using a variety of models characterizing
human health and ecological welfare and
other effects. Ultimately, selection of the best
model framework or best set of models
depends on the question being asked.
(USEPA, 2001)
In practice, policymakers will determine
the cap by considering a combination of science, eco-
nomics, and political feasibility. One approach that
policymakers sometimes use to determine the aggre-
gate emission cap is finding the "knee in the cost
curve" (i.e., the point before costs per unit of emis-
sion reduction begins to rise rapidly (see Figure 7)).
Policymakers may also want to ensure that costs are
within an acceptable range. To estimate costs and
benefits, policymakers may use economic modeling to
depict optimal control decisions.
The decision of when to implement the cap is inte-
gral to the decision on the level of the cap. Policy-
makers may need to weigh the pros and cons of opting
for a tighter cap with a later implementation date ver-
sus a less aggressive cap with an earlier implementa-
tion date. For example, it may not be feasible to set
the cap at the optimal level for the initial stage of
implementation. However, rather than delay imple-
mentation until a later date when the optimal level
may be more achievable, it may be advantageous to
begin the program as soon as possible to encourage
advances in control technology and influence invest-
ment decisions. Under such a scenario, policymakers
may establish a cap that declines over time to ultimate-
ly achieve the environmental goal. This is one of the
advantages of allowing emission sources to bank excess
allowances. It encourages early reductions, advances
control technologies, and reduces the economic effect
of the declining cap. For predictability, it is important
that policymakers or the regulating authority define
the decline in allowances in advance to provide sources
sufficient time to adjust to new cap levels.
Figure 7. Knee of Marginal Abatement Cost Curve
Marginal Abatement Cost to Emission Sources
Possible point of regulation
balancing needed emission
reduction and cost
EMISSION REDUCTION (PERCENT)
100
The level of the cap will also depend on applicabil-
ity decisions about which sources and sectors to
include in the program. In the case where policymak-
ers establish a national emission goal and develop a
cap and trade program in conjunction with other regu-
latory tools, they must determine what portion of the
goal should come from sources in the cap and trade
program (the cap) and what portion from other sectors
and sources. Ideally, a cap and trade program should
include as many sectors as possible to maximize the
cost savings from trading between sources with differ-
ent marginal abatement costs. If it is not possible to
include certain sectors under the cap and trade pro-
gram, then alternative policy instruments may be used
to reduce emissions in sectors outside the cap. Where
possible, however, these instruments should be used
to reduce emissions to levels where marginal abate-
ment costs in the uncapped sector(s) are roughly
equivalent to the marginal abatement costs in the sec-
tor^) participating in the cap and trade program.
Length of Compliance Period
The length of the compliance period should be linked
to the environmental problem and reflect operational
considerations. If the environmental problem is contin-
uous and long-term, as in the case of acid rain or cli-
mate change, the compliance periods should be
continuous, covering all months of the year. If the
problem is seasonal, as is the case with ground-level
ozone in the Eastern United States, then the compli-
ance period may be seasonal, such as the five-month
compliance period each year used in the Ozone
3-9
Developing a Cap and Trade Program
-------
Transport Region (the District of Columbia and 12
states in the Northeastern United States).
The decision of whether to assess compliance quar-
terly, annually, or less frequently should also take into
account the administrative burden imposed. A short
compliance period puts a larger administrative burden
on both the regulating authority and emission sources
but allows for swifter action to correct a case of noncom-
pliance. A longer compliance period allows more flexi-
bility for the sources to achieve compliance and reduces
the administrative burden for the regulating authority.
By lengthening the period between compliance assess-
ments, however, cases of noncompliance can persist for
longer periods of time, possibly increasing the difficulty
of correcting those problems. Most cap and trade pro-
grams determine compliance on an annual basis.
Quantifying Emissions from
Sources in the Program
One of the most important features of a cap and trade
program is that sources measure total mass emissions
(as opposed to emission rate or concentration) as accu-
rately and consistently as possible. Because the emis-
Table 3: Emissions Monitoring
Priorities
Purpose Priorities
Cap and Trade Complete and consistent
accounting of total mass emissions
Accurate and consistent measure-
ment among sources
Conservative emission estimates
(not underestimated)
Command-and- Accounting of emission rate or
Control technology installation
Project-based Reasonably accurate estimate of
Trading baseline (what emissions would
have occurred in the absence of
the project)
Accurate accounting of emission
rate and activity level
Research Best available emission data,
Inventory regardless of consistency among
sources or sectors
Consistent emission measure-
ment methodologies over time
sion measurements are the "gold standard" underlying
the traded allowances, it is important that a ton of
emissions at one source is equal to a ton of emissions
at any other source. This creates a level playing field
for participants in the program and a strong foundation
upon which a market can operate.
The emissions monitoring priorities for a cap and
trade program differ from other types of environmen-
tal regulations (see Table 3 for emission monitoring
priorities of different types of programs). In consider-
ing potential emission measurement regimes for a cap
and trade program, the following monitoring objec-
tives may be useful as a guide:
Consistency: The regulating authority should
create clear and consistent protocols for sources
to determine emissions. This means employment
of standard procedures and the use of sound
engineering practices. This arrangement can be
particularly challenging if the cap and trade pro-
gram includes sources from a variety of industrial
sectors.
Accuracy: For a cap and trade program, accurate
measurement is more important than consistency
over time. Policymakers should consider
enhancements to measurement methods or using
different methods if better approaches are avail-
able and practical. The monitoring program can
also be designed to include performance stan-
dards that reward sources that achieve better
accuracy than required. For example, for less
accurate approaches, sources should use more
conservative estimation methods that are not
biased toward underestimating emissions.
Ultimately, it is most important to avoid system-
atic underestimation of emissions.
Considerations in Choosing a
Measurement Approach
Pollutant
The pollutant to be measured, the conditions under
which it is created, and the mode in which the emis-
sions enter the atmosphere will affect the types of
emission measurement techniques available. For exam-
ple, measurement issues related to emissions of SO?,
NOx , and COz from stationary source combustion will
vary because emissions of SOi and COz are directly
linked to the combusted fuel, while emissions of NOx
also depend on the combustion conditions. Therefore,
3-10
Developing a Cap and Trade Program
-------
Typical Emissions Measurement Under the U.S. SOz Allowance Trading Program
In most cases, emission sources must continuously measure and record hourly emission concentrations of SC>2,
NOx, and CO2, as well as flow of exhaust gases with a continuous emission monitoring system (CEMS) (see Figure
8). EPA has established provisions for initial equipment certification procedures, periodic quality assurance and
quality control procedures, record keeping and reporting, and procedures for filling in missing data periods. Where
possible, incentives are provided to improve and maintain the quality of the monitoring. For example, units must
periodically undertake relative accuracy tests on their CEMS (which involves comparing the monitored emissions
from the CEMS to monitored emissions from an independent or reference measure of emissions); if the CEMS
receives a superior accuracy result, the frequency of future testing is reduced and the firm saves money. For a full
discussion of monitoring performance standards and incentives for improving accuracy through quality assurance
requirements, see Saile, 1995.
Figure 8. A Continuous Emission Monitoring (CEM) System
Data Acquisition and
Handling System
Flow
Monitor
3-11
Developing a Cap and Trade Program
-------
an appropriate measurement method for CCh, such as
mass balance based on carbon content in the fuel will
not be appropriate for NOx . Instead, accurate meas-
urements of NOx emissions from stationary source
combustion must be taken from exhaust gases.
How Emissions Enter the Atmosphere
How emissions enter the atmosphere can limit the
choice of methodology. For example, continuously
measuring actual emissions is an option only if emis-
sions are vented through a stack or other contained
area where measurement equipment can be located. In
contrast, measuring fugitive emissions (i.e., emissions
that escape directly into the atmosphere in a diffuse
manner) may depend on estimation techniques based
on inputs and defaults.
Emissions Abatement Options
The abatement options available for sources to reduce
their emissions are also a factor in the choice of meas-
urement method. It is important that the measurement
method be able to accurately capture the reductions
made. For example, measurement methodologies
based on fuel inputs (e.g., mass balance) may be
appropriate for sources that reduce emissions by
switching or conserving fuels, but it would be much
less appropriate for sources that use reduction tech-
nologies such as combustion modification or post-com-
bustion control. In choosing a standard measurement
approach, it is important to allow sources full flexibility
of compliance/mitigation options. It is also important
to consider potential technological innovations in miti-
gation approaches. Thus, it is useful to choose a
method that can measure the reductions achieved
through various reduction strategies or to specify mul-
tiple measurement options, some of which may be
allowed only for certain mitigation options.
Point of Obligation
The point of obligation will influence where and how
emissions, or their proxy, are measured. Similarly,
measurement constraints will influence where and how
the emissions are regulated. If the regulation is direct-
ed at upstream sources, such as fuel suppliers, it is not
appropriate to measure combustion emissions using an
in-stack monitor at the power plant where the fuel is
burned. Instead, the fuel supplier's compliance with
the cap and trade program should be judged based on
the amount and characteristic of each type of fuel sold,
and the monitoring method would focus on determin-
ing the total amount of each type of fuel sold.
Frequency of Measurement
Although a cap and trade program requires a complete
accounting of each unit of emissions, the minimum
frequency of measuring emissions or the parameters
used in calculating the quantity that is emitted will
need to be determined (e.g., continuous emission
monitoring, periodic monitoring, or the use of emis-
sion factors). The nature of the problem to be solved,
the potential variability of the measured parameters,
and the length of the compliance period will influence
the appropriate frequency. P'or a cap and trade program
aimed at solving a problem caused by a total accumula-
tion of emissions in the atmosphere, such as acid rain,
the frequency will be dictated by the ability to capture
variations in emissions and contribute to an accurate
estimate of total emissions. For an episodic problem,
such as ground-level ozone, more importance will be
placed on the frequency of measurement because
aggregation of emission measurements must be at fre-
quent enough intervals to investigate individual
episodes. Furthermore, greater frequency of measure-
ment is warranted when emissions, or the parameters
used to calculate emissions, have the potential for high
variability (e.g., for units that use fuels with varying
characteristics or for units in which emissions can be
affected by the way the unit or control devices on the
unit are operated). Both the U.S. SO? Allowance
Trading Program and the OTC Regional NOx Trading
Program in the Northeastern United States (which is
aimed at addressing episodic ground-level ozone)
require reporting of hourly emissions which are the
average of at least four measurements taken each hour.
Frequency of Reporting
In addition to deciding upon the frequency of meas-
urement, the regulating authority should consider how
often to receive the data. The RECLAIM emission
trading program in California uses computers to get
the source measurement data reported to the regulat-
ing authority in real time. The U.S. SO? Allowance
Trading Program, which requires sources to record
hourly data, requires sources to compile and send
emission reports to EPA on a quarterly basis even
though compliance is determined on an annual basis.
Factors to consider when setting the frequency of
reporting include: allowing enough staff time to review
the data (e.g., not waiting until the end of the year to
3-12
Developing a Cap and Trade Program
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Measuring Small, Glean Units in the
U.S. SOz Allowance Trading Program
The U.S. SOz Allowance Trading Program allows
sources that operate very infrequently or are very
small to use conservative estimations of emissions
rather than install more expensive CEMS.The pro-
gram provides limited alternatives for smaller emis-
sion sources, at which the cost of more accurate
measurement is high relative to the emissions.These
alternatives are designed to ensure that emissions
are never underestimated.The program also allows
large units that burn pipeline-quality natural gas to
use fuel metering and default emissions rates to
measure SO2 emissions because the characteristics
of pipeline-quality natural gas are very consistent
and the resulting SO2 emissions are very low.
review all data at once); giving time to sources to cor-
rect any errors found during review; and providing
timely, reviewed data summaries to the public.
Cost and Feasibility
Within a cap and trade program, there may be sources
that emit small quantities of emissions because they
are small, clean, or operated infrequently. Alternative
and less costly methodologies may be appropriate for
such sources due to the high cost of the standard
methodology. It is important to the integrity of the
trading system to ensure that less accurate methodolo-
gies are conservative in nature (i.e., the methods overes-
timate rather than underestimate emissions), as well as
to keep the number of sources treated in this fashion
relatively small. It is also important to keep in mind
that the cost of accurate emission monitoring should be
considered in light of the cost savings afforded by the
cap and trade approach over traditional approaches to
environmental protection. The added cost of accurate
measurement may be a small percentage of the savings
achieved by implementing a cap and trade program ver-
sus another form of regulation, and the resulting accura-
cy and confidence in the emission data may be well
worth the expense (Ellerman, et al, 2000).
Quality Assurance and Quality Control
(QA/QC)
Simply requiring the most accurate emission measure-
ment methodology will not ensure an effective trading
system. Effective implementation is critical. It is
essential that the measurement techniques are stan-
dardized, commonly applied to program participants,
implemented properly, and validated for individual
applications. In addition, regardless of what measure-
ment systems are used to quantify emissions, it is
imperative that any system be subject to a well-
defined and continuous quality assurance and quality
control (QA/QC) program. These QA/QC programs
should be based on national or international standards
(e.g., International Standards Organization) and must
be documented with records that can be audited.
Missing Data Substitution
It is essential to account for each unit of emissions
from a source because cap and trade programs assess
compliance by comparing the total emissions and the
total number of allowances held. In real-life situations,
however, monitored data may be unavailable because
monitoring equipment occasionally functions improp-
erly or is being tested or maintained. Therefore, there
is a need for rules to provide a standard methodology
for substituting for missing data periods.
This standard methodology should provide incen-
tives for regulated sources to keep records in good
order, to keep measurement equipment well main-
tained, and to have procedures that ensure that faulty
Quality Assurance Under the U.S.
SOz Allowance Trading Program
The U.S. SCh Allowance Trading Program requires
sources to test each continuous emissions monitor
(CEM) system in its installed location.The CEM is
tested at least annually against an independent ref-
erence method prior to certifying the CEM for use.
The independent reference method consists of
inserting a calibrated probe into the exhaust stack
and running a sample of exhaust gas through a cali-
brated analyzer to compare the reading with the
installed CEM. A bias test determines if there is any
systematic bias in the CEM readings relative to the
reference method. If the CEM systematically under-
estimates emissions, the operator may either fix the
monitor and retest it or calculate a bias adjustment
factor (based on differences between the CEM read-
ing and the reference method) that is applied to all
reported data.
3-13
Developing a Cap and Trade Program
-------
Missing Data Substitution for the
U.S. SOz Allowance Trading Program
Under the U.S. SCh Allowance Trading Program, if a
measurement device (e.g., continuous emission
monitoring system or fuel flow meter) is not operat-
ing properly or if fuel sample analysis is not available
for a particular hour, then the rules require that a
substitute value be calculated by the source.The
rules dictate the use of a substitute data algo-
rithmspecified in the regulationswhich repre-
sents a graduated response. Whether the substitute
value is calculated as an average value or a conser-
vative value depends on the percentage of time that
the monitoring system has been able to produce
and report a quality-assured value, as well as on the
length of time that the data is missing. The substi-
tute data calculation varies from a) the average of
the hour before and the hour after the missing data
periodfor missing data periods of short duration;
to b) a very conservative maximum potential value
for long or frequent missing data periods.
equipment will be replaced or repaired in a timely
fashion. To accomplish this most simply, the rules
could require a very conservative substitute value
(e.g., a value that would result in the maximum poten-
tial emissions) to be used for any hours of missing
data. Another option, which is more complex, would
be to consider the frequency and length of the miss-
ing data periods in determining a substitute value.
This way, an average or slightly conservative value is
used for short and infrequent periods of missing data
and a very conservative value is used for long or fre-
quent missing data periods.
Allowance Distribution
The distribution of allowances may be one of the
most difficult issues for policymakers when develop-
ing a cap and trade program. Distribution decisions
have economic, equity, and political ramifications.17
Gap and trade programs create a valuable asset for
those who own or control the authorizations to emit.
If emission sources receive allowances through a no-
cost allocation, they capture the gains from these valu-
able assets. Under an auction, the government cap-
tures the value of these assets in the form of increased
revenues. Some analysts have argued that the revenues
from allowance auctions can have economy-wide effi-
ciency or equity benefits if they are distributed in
certain ways (e.g., used to reduce distortionary taxes or
distributed in lump sums to households or other
groups.)18
Different types of allocation formulas can create
"winners" and "losers" among sources participating in
a cap and trade program. It is important to note, how-
ever, that the method for distributing allowances will
not affect the environmental integrity of the program
if the program is properly enforced.
The first major step in the allowance distribution
process is to decide whether the allowances will be
allocated at no cost to the emission sources (usually
based on some form of operating data), sold by the
regulating authority through an auction or a direct
sale, or distributed by some combination of these sys-
tems. To date, existing cap and trade programs have
allocated allowances at no cost to sources.
Whatever allowance distribution method is select-
ed, policymakers can include set-asides or pools of
allowances from within the cap. Existing cap and
trade programs utilize set-asides to provide allowances
for new sources or to provide an incentive or compen-
sation for certain types of behavior (e.g., early reduc-
tions, energy efficiency measures, or renewable
energy generation). This section explains the incen-
tives and decisions associated with allocations, auc-
tions, and direct sales.
Allocations
If policymakers decide that allowances will be allocat-
ed free of charge, many different methods can be used
to distribute the allowances. The regulating authority
will need to consider the following issues:
Data foundation: In general terms, there are
three different aspects of a unit's operation that
may be measured and used (individually or in
combination with performance standards) as a
basis for allocating allowances: mass emissions,
fuel (or heat) input, and production output (e.g.,
17 For a more detailed discussion of the equity, economic, and political ramifications of different distribution schemes, see Burtraw, et al., 2001 and
Ellerman, et al., 2000.
1 Fora more detailed discussion of the equity, economic, and political ramifications of different allowance distribution schemes, see Burtraw, et al.,
2001; Ellerman, et al., 2000; and Dinan and Rogers, 2002.
3-14
Developing a Cap and Trade Program
-------
The U.S. Experience with Allocations
The U.S. SO2 Allowance Trading Program uses a com-
bination of historic level of activity (heat input in
million British thermal units (mmBtu) and an emis-
sions standard, 1.2 pounds of SCh/mmBtu), as the
primary basis of a permanent allocation. This
ensures that the plants with the highest emission
rates will be encouraged to reduce the most, while
plants that already reduced emissions will need to
do less (or nothing).The RECLAIM program also uses
a combination of past activity levels and an emission
standard for initial allocations. In both programs,
total allocations are ratcheted down to match the
program cap. Further, in both programs, new units
must purchase allowances for compliance. In the
case of the U.S. SCh Allowance Trading Program,
units may purchase these allowances in the market-
place or directly from the government in the gov-
ernment-operated auction.
Regional NOx trading programs in the
Northeastern United States utilize an updating input-
or output-based allocation scheme (the methodolo-
gy varies from state to state).The treatment of new
sources in the OTC Regional NOx Trading Program
will also vary by state, but states generally include a
set-aside account to provide allowances for the addi-
tion of new sources (McLean, 2002).
quantity of electricity produced). The measures
of input and output will vary by sector, but any
of these processes could be used as a basis for
the allocation of allowances. Policymakers should
consider the character and quality of existing
data (e.g., it may be difficult to base allocations
on historic output if multiple sectors with differ-
ent products are included in the cap and trade
program) and the behavior they want to reward
(e.g., allocations based on historic emissions ben-
efit the largest and least-efficient emitters,
whereas allocations based on historic input or
output benefit those that used the most fuel or
produced the most product). Additionally, alloca-
tions could be based on the above information in
conjunction with a performance standard, control
measures, or existing control technology require-
ments, again depending upon the resources
available and the desired effect.
Reference period: The reference period for allo-
cations could be historic, current, or even pro-
jected. Though an important decision in any
allocation scheme, the relative importance of the
reference period decision increases with the
length of the allocation, as further explained
below. Allocations using historic reference peri-
ods are attractive to firms that typically have
been big emitters, or in the case of input or out-
put approaches, near their maximum capacity in
the past (whether they have subsequently
reduced these activities or not) because they are
guaranteed a relatively large allocation under the
new cap and trade regime. Using the average of
several years' data can smooth out possible irreg-
ularities (e.g., extreme weather conditions, plant
shutdowns for maintenance).
An important issue to consider when deter-
mining the reference period is how the choice
will affect sources that implemented emission
reduction measures prior to the start of the cap
and trade program. For example, if the
allowances are allocated based on historic emis-
sion levels, choosing a recent year for the refer-
ence period will penalize those sources that
voluntarily reduced emissions early. If emission
sources predict that such a choice may be made
in the design of the program, it could provide a
disincentive for sources to take early actions ben-
eficial to the environment and human health.
One way to avoid this problem is to choose an
earlier year as the reference period. However,
this may have a negative impact on the availabili-
ty or quality of the data used. Another option is
to choose an allocation method that is not based
on historic emissions, but one that may still be
based on some historic information. In the U.S.
SOa Allowance Trading Program the allocation
method uses a performance standard applied to
historic utilization (i.e., heat input). This heat
input data was readily available and did not
reward plants with high emission rates.
Allocation period: Policymakers must decide
whether allocations will be permanent or updat-
ed periodically. Because updating systems
change allowance allocations at periodic inter-
vals, entities may have an incentive to do more of
the activity that will earn them more allowances.
Therefore, updating allocations can influence
3-15
Developing a Cap and Trade Program
-------
future behavior. The time period of the interval
will affect the level of influence updating has on
future behavior. P'or example, if updating is done
annually based on output, it could provide a
strong incentive to increase output in order to
receive additional allowances. If, however, the
time period is longer (e.g., 10 years) the effect
will be considerably less. Permanent allocations,
on the other hand, provide no such incentive
because changes in behavior will not affect
future allocations.19
Length of allocation: The regulating authority
may decide to allocate allowances to emission
sources in advance of the allowance vintage peri-
od (i.e., the period in which the allowance can be
used for compliance). Having allowances allocat-
ed in advance can add liquidity to the market
because sources and other market participants
can trade future allowances. This also helps emis-
sion sources develop and implement compliance
strategies in advance of the compliance period
(e.g., a source that installs an emission control
device can sell future excess allowances to gener-
ate revenue to help offset the cost of the control).
Preserving the cap: Once policymakers deter-
mine the method for distributing allowances and
calculate the sources' allocations, policymakers
should compare the resulting total allocations
and the size of the cap. If too many or too few
allowances were created while calculating
sources' allocations, policymakers can employ a
ratchet (i.e., a formula that adjusts each source's
allocation proportionately). The resulting total
allocation will then match the number of
allowances in the cap. This ensures that the cap
is not inflated through the allocation process.'0
Incorporating new sources: Policymakers must
decide how new entrants into the program will
obtain the allowances needed to operate. In
some systems with updating allocations, new-
emission sources may receive some allowances.
In the case of permanent allocations, new units
may obtain needed allowances from the market.
In a permanent allocation system, facilities that
are shutdown continue to receive allowances
indefinitely. These allowances may then be used
by the owners of the shutdown facility to cover
emissions at new or other existing facilities that
they own, or they can sell the allowances in the
market. This system works well when there are
many facility and allowance owners and no
monopoly exists on current allowance holdings.
Alternatively, an allocation set-aside could be
created for new entrants. The set-aside could
hold a specific percentage of the overall cap to
cover growth in new sources.
Penally, some analysts have noted that both eco-
nomic theory and empirical experience suggest that
there is not a competitive barrier to new entrants that
do not receive no-cost allowance allocations in cap and
trade programs. These analysts argue that emission
sources that receive no-cost allowances allocations
have the same marginal "opportunity cost" for every
ton emitted as the marginal cost paid by the new
entrant. In support of this argument, there is no evi-
dence of entry problems for new electric power plants
under the U.S. SOa program, which requires new-
power plants to purchase allowances from the market.
There has been significant entry by new units, even
coal-fired units that do not receive a no-cost allowance
allocation (Ellerman, 2003).
Auctions
Auctions are an alternative approach to distributing
allowances. Under this approach, sources are required
to bid for the number of allowances they would like to
purchase (i.e., as opposed to receiving an initial
amount of allowances free of charge via allocations).
There is considerable research in economic literature
that supports the view that auctions are more economi-
cally efficient than allocations. Supporters of auctions
argue that auctions:
Create a source of revenue that can be used to off-
set administrative expenses or distributed to
affected groups. If the revenue is used to replace
existing distortionary taxes (e.g., labor taxes) it can
create additional economic benefits (Crampton
and Kerr, 1998). Distributing auction revenues,
however, may be politically contentious and there
For further information on alternative allocation methods, see ICF, 1999, and Harrison and Radov, 2002.
In developing the U.S. SO> Allowance Trading Program, the U.S. Congress initially allocated about 10 percent more allowances than it estab-
lished by the cap. However, it also required EPA to proportionally ratchet allocations back down to the cap level.
3-16
Developing a Cap and Trade Program
-------
is no guarantee that revenues will be used for eco-
nomically beneficial purposes.
Collect "windfall" profits that might otherwise
accrue to emission sources if allowances are allo-
cated at no charge.
Avoid politically contentious issues regarding
allocation methodology and lead to an efficient
distribution of allowances.
Provide an immediate price signal in the
allowance market.
Create an equal opportunity for new entrants
into the allowance market.
In establishing the design of an auction, the regulat-
ing authority will need to consider the following issues:
Frequency of auction: The following are factors
to consider when determining the frequency of
conducting auctions (e.g. annually, semi-annual-
ly, quarterly, biannually): (a) the lifetime of an
allowance and the length of the compliance peri-
od; (b) the administrative burden of conducting
auctions; and (c) other methods of distributing
allowances. If the auction is used in conjunction
with other allowance distribution methods and is
intended as a means to provide an early price
signal to the allowance market it may not be nec-
essary to conduct auctions as frequently.
"Spot" and "Advance" auctions: Spot auctions
refer to allowances that are sold for current use.
Advance auctions refer to allowances for a future
compliance period that are auctioned in the cur-
rent year, even though they cannot be used for
compliance until the future compliance period.
Early auctions can facilitate development of an
active future and options market, thus improving
risk allocation.
Bidding procedures: There are many approaches
to conducting auctions. The auction can be
designed so that all successful bidders pay the
same price or the price they bid. Bidding options
for conducting the auctions can be categorized as
either sealed bid, ascending bid, or declining price
auctions. Ascending bid auctions may take the
form of "ascending-clock," or English auctions.21
Generally, with sealed bid auctions, potential
buyers submit bids for a specific quantity of
allowances. The auctioneer ranks the bids by
price and, starting with the highest bids, tallies
the requested allowances until it is equal to or
greater than the number of available allowances.
The price of the last winning bid is called the
clearing price. Those who bid at least as much as
the clearing price receive allowances at that price
(i.e., uniform pricing methodology) or the price
they bid (i.e., "pay-your-bid" methodology.)
With ascending bid auctions, potential buyers
have the opportunity to increase their bids,
changing losing bids into winning bids. When
there are no more bids, the allowances are dis-
tributed to the highest bidders. Descending
price actions, also called Dutch auctions, are the
reverse of ascending bid. Generally, the auction-
eer starts with a high price for each allowance.
Potential buyers can accept the price for a specif-
ic number of allowances. The auctioneer
decreases the price until all allowances are sold.
The different auction approaches have differ-
ent effects on bidding behavior, which can thus
influence the efficiency of the allowance distri-
bution." With "pay-your-bid" pricing, potential
buyers try to bid slightly above the estimated
clearing price. Ascending bid auctions reveal
greater information about what a potential buyer
is willing to pay for allowances. This improves a
bidder's value estimates and, as a result, the effi-
ciency of the final allowance distribution
(Fischer, et al, 1998).
U.S. Experience with a Direct Sale
Set Aside
In the U.S. SCh Allowance Trading Program, a small
direct sale set aside provision was included for the
first several years of the program to provide assur-
ances to new sources that allowances would be
available for purchase.The direct sale offered a small
percentage of allowances at a fixed price of $1,500
each (adjusted for inflation), which was about two to
three times the projected allowance price (marginal
cost) at the start of the program.The direct sale was
eliminated in 1997 because allowance prices were
much lower than expected, and the allowance mar-
ket was highly liquid.
For more information about forms of auctions, see Grampton and Kerr, 1998.
For more information about the effects of bidding behavior with different forms of auctions, see Crampton and Kerr, 1998.
3-17
Developing a Cap and Trade Program
-------
The U.S. Conservation and Renewable Energy Reserve Program of the U.S. SOz
Allowance Trading Program
The U.S. SOz Allowance Trading Program featured a special set-aside of allowances as an added incentive for elec-
tric power companies to undertake demand-side energy efficiency and renewable energy generation programs.
Under the program, known as the Conservation and Renewable Energy Reserve, EPA can award allowances to
sources for actions taken before a source was required to comply with emissions limits under the U.S. SO2
Allowance Trading Program. Allowances for the set-aside were taken from the cap and were limited to a maximum
of 300,000 allowances.
Under the program, electricity generators applied for these extra allowances by submitting information to EPA
on specific energy efficiency programs or renewable energy projects. Sources were required to submit information
on energy savings or renewable energy generation, and EPA awarded allowances at a pre-determined rate one
allowance per 500 megawatt hours of energy saved or renewable energy generated.
As the first program to provide actual emission credits or allowances for efficiency and renewable energy proj-
ects, the program provides many valuable lessons. On the positive side, the program featured several elements
that reduced transaction costs including a standard award formula, a pre-approved list of eligible measures, and
standardized measurement protocols that allowed companies to use conservative default values for energy sav-
ings as a way to reduce measurement costs. On the negative side, it is unlikely that the program spurred actions
that wouldn't have happened in the absence of the program.This is largely because the award formula was too
conservative and allowances prices were too low to provide an adequate incentive for additional activities.
Auctions may also be used to distribute only a por-
tion of allowances with the remainder distributed by
an allocation method. Some analysts have proposed
beginning with an allocation system and transitioning
to an auction-based system over time (Kopp, et al.,
1999). This would increase economic efficiency over
time and decrease political opposition from emission
sources worried about the cost of allowances.
Set-asides
Another tool that can be used in allowance distribu-
tion is an allowance set-aside. Under a set-aside, the
regulating authority withholds a certain number of
allowances from within the cap for a specific purpose.
The set-aside can be a fixed number of allowances or
a percentage of the total amount of allowances.
The regulating authority can distribute the set-
aside allowances for purposes such as an incentive for
certain technologies, as a way to address equity issues,
or as a reserve for new units as explained in the earlier
section. Policymakers can create set-asides that last for
a fixed period, such as five years, after which the set-
aside expires, or it can last in perpetuity.
Policymakers or the regulating authority should also
address how excess allowances from the set-aside will
be managed if they are not distributed. Options for
managing excess set-aside allowances include cancel-
ing the allowances, saving them for future use, and
distributing them to sources through an allocation or
auction. Canceling decreases the quantity of allowable
emissions (i.e., the cap) and may therefore increase
compliance costs for sources. Saving excess allowances
for the future can provide flexibility in the future for
unforeseen circumstances (e.g., many new emission
sources in the cap and trade program) but it reduces
the number of available allowances in current years
and can lead to increased compliance cost for current
emission sources. Distributing excess allowances
through an allocation or auction is perhaps the most
common approach for existing cap and trade programs,
but policymakers must address the same issues dis-
cussed earlier in the sections for allowance allocation
and auction.
The most important aspect of set-asides is that the
allowances come from within the cap so that new
allowances do not inflate the cap and undermine the
ability to achieve the environmental goal. If a set-
aside will be used, policymakers will need to decide
the basis for awarding allowances from the set-aside
and the size of the set-aside allowance pool that will
be awarded.
3-18
Developing a Cap and Trade Program
-------
Allowance Use
Policymakers or the regulating authority must create
rules governing the use and trading of allowances.
These rules should be neutral (i.e., favoring no particu-
lar individuals or groups of market participants) and
provide for low-cost exchange among participants.
Accounting for allowances works like a banking sys-
tem. Each affected emission source should have an
allowance account for holding their allowances.
Transfers of allowances between these accounts
should be made as simple as possible, with few limits
or restrictions to impede the market. There are, how-
ever, two possible categories of restrictions on
allowance trades that may be considered temporal
and spatial.
Temporal Considerations
Allowances are typically allocated for use in a specific
compliance period. Policymakers might consider
whether current allowances can also be used for com-
pliance in future periods, referred to as "banking" (see
Figure 9). Allowing banking in a cap and trade pro-
gram creates additional flexibility for sources, encour-
ages early emission reductions, can reduce compliance
costs, and, partly for these reasons, can increase eco-
nomic and political support for the program.
Although the ability to bank allowances in a cap and
trade program can provide significant reductions early
in the program, policymakers must recognize that
banking can also delay the achievement of the emis-
sion target if banked allowances are used. Because
Figure 9. Banking Emissions
Allocated Allowances
Use of banked allowances
YEAR
banking does not delay achievement of cumulative
reductions, this tradeoff does not represent an environ-
mental concern for problems such as acid deposition
and climate change, where the environmental problem
is caused by total accumulation of a pollutant in the
atmosphere. However, for problems such as ground-
level ozone, where the environmental problem is
caused by short-term episodes of high emissions,
analysis should be undertaken to weigh the potential
effects of banking. Nevertheless, the U.S. experience
with limits on banking has shown that such limits
complicated or hindered the operation of cap and trade
programs and failed to provide apparent benefits.
"Borrowing" is another form of temporal flexibility.
With borrowing, allowances from a future compliance
period are brought forward to meet a compliance obli-
gation in an earlier period. As with banking, borrow-
ing provides compliance flexibility and can be helpful
in smoothing out spikes in allowance prices (Ellerman,
2002). For example, if prices reach a certain level,
sources might be allowed to buy allowances from the
government that would be deducted from allowances
available in future compliance periods. The potential
downsides of borrowing are that emission reductions
are delayed and there is a greater risk of future non-
compliance if an emission source cannot "repay" the
borrowed allowances. In addition, borrowing can cre-
ate an incentive for emission sources to act to disrupt
the cap and trade program's performance and longevi-
ty in order to avoid "repayment" of allowances.
Furthermore, the health and environmental benefits
of emission reductions today are delayed until the
future. All else being equal, benefits
in the near term are better than bene-
fits in the future.
There is little experience with bor-
rowing, so policymakers should care-
fully assess the potential
environmental and programmatic
effect of delaying some emission
reductions and weigh these effects
against the potential flexibility and
cost savings of borrowing. In addition,
policymakers should apply a discount,
or interest, rate on borrowed
allowances that is at least as high as
the discount rate applied to the capi-
tal the source saves by not undertak-
ing the abatement or purchasing
Actual Emissions
3-19
Developing a Cap and Trade Program
-------
Limits on Banking in the United
States: RECLAIM and the OTG
Regional NOx Trading Program
In the Southern California RECLAIM program, emis-
sion sources are grouped into two categories with
overlapping compliance periods (i.e., some sources'
compliance is based on January to December emis-
sions and others are based on July to June emis-
sions).The RECLAIM program permits sources to use
allowances to cover emissions within the period for
which they are issued, so any allowances not used
within that period effectively expire. However,
sources in one compliance period can trade
allowances with sources in the other compliance
period thereby enabling limited banking and bor-
rowing. One reason program designers chose to
limit banking was that the locality faced a severe air
quality problem and policymakers were concerned
that banking would cause potential emission spikes.
Policymakers initially allocated allowances in excess
of actual emissions by a significant amount to pro-
vide sources with flexibility.Combining these high
allocations with banking could have inflated the cap
in future years, delaying the achievement of environ-
mental goals. In practice, the absence of banking
provisions may have discouraged sources from
undertaking early reductions and may have con-
tributed to volatility in the market that required
major program revisions to address.
In the OTC Regional NOx Trading Program in the
Northeastern United States, the banking of
allowances for future use is permitted. However,
there are automatic limits imposed on the use of
banked allowances whenever the bank reaches a
certain level of allowances.These limits require that
sources using more than a percentage of their
banked allowances for compliance must surrender
allowances at the rate of two allowances for every
ton of emissions.The limits are imposed in order to
guard against the excessive use of banked
allowances in any single compliance period, while
still attempting to maintain the incentives associat-
ed with banking. What has resulted is a segmented
allowance market and a stratified price structure
which values banked allowances significantly less
than present year allowances (Farrell, et al., 1999).
allowances. In lieu of this discount rate, sources will
find it less expensive to delay abatement, invest the
capital saved, and borrow allowances.
Spatial Considerations
Because a cap and trade program allows for the flexible
use of allowances across the geographic scope of the
trading program, a common concern for a cap and trade
program aimed at reducing emissions with localized
impacts (e.g., SO? and NOx ) is that hotspots may
occur.23
Assuming that a firm's objective is to maximize
profits, those with low marginal abatement costs will
offer to sell their allowances to firms with higher mar-
ginal abatement costs. If sources with high marginal
abatement costs (i.e., net buyers of allowances) are
congregated in specific areas, those areas are likely to
experience less environmental improvements than
others (depending also on meteorology and wind pat-
terns). Furthermore, such areas could experience
increased emissions and harmful local environmental
or human health effects, even as the larger goal of
aggregate emission reductions is achieved.
For pollutants with localized impacts, an evaluation
of potential trading patterns may be useful. Potential
trading patterns can be assessed with economic mod-
els or with less resource-intensive methods such as
spreadsheet analysis. If the results indicate that geo-
graphic trading patterns will arise, it may be necessary
to assess where the largest emission reductions are
likely to take place compared to where the most sensi-
tive environmental areas are, and whether the program
will adequately address the environmental problem
(see Figure 10) or be less effective than direct controls
on sources. This involves an analysis of the source-
receptor relationship and includes predicting changes
in concentrations or deposition resulting from changes
in precursor emissions, the influence of emission
sources in one region on concentrations or deposition
in other geographic regions, and the levels of concen-
trations or deposition in certain sensitive receptor
regions.
If spatial issues are likely to arise, then the cap and
trade program will need to be designed accordingly.
u This issue is not relevant for greenhouse gas emissions since these
emissions do not have local air quality impacts, and trading patterns
will not have localized environmental effects. However, ancillary
reductions of criteria pollutants may have local benefits.
3-20
Developing a Cap and Trade Program
-------
Figure 10. Spatial Considerations
Where are emission reductions most likely to occur?
How U.S. Trading Programs Address Spatial Issues
While environmentalists initially feared the potential creation of hotspots from the U.S. SO2 Allowance Trading
Program, no such local impacts have been observed and overall air quality has improved (Swift, 2000).There are
several reasons why the trading provisions have not led to hotspots.
First and foremost, other regulatory standards (e.g., ambient air quality standards, technology and performance
requirements) protect the local air quality from excess pollution.The United States employs conventional pollution
regulations (e.g., mandated emissions limits or air pollution control equipment) that are designed to achieve health-
based air quality standards (Schreifels, 2000).The U.S. SCh Allowance Trading Program represents an additional level
of pollution control that is designed to reduce total loading of sulfur into the atmosphere. Hence, all utilities regulat-
ed under the U.S. SO2 Allowance Trading Program are also required to comply with all other requirements of the
Clean Air Actin particular, the requirement to meet the health-based National Ambient Air Quality Standards, New
Source Performance Standards, and Prevention of Significant Deterioration provisions.These requirements are inde-
pendent of the trading program and cannot be circumvented through purchase of allowances.
Second, the significance of the reductions required under the U.S. SCh Allowance Trading Program50 percent
below 1980 levelsensured that the majority of high-emitting facilities would have to reduce emissions significantly,
even with the flexibility provided by emission trading.Third, the most cost-effective emission reductions are often at
the largest, highest-emitting plants and areas with such facilities have reduced emissions more than average. As a
result, there have been significant benefits to human health and the environment (Burtraw and Mansur, 1999).
The RECLAIM program employs two trading zones.Trading is restricted so sources in the downwind zone may
not sell or trade allowances to sources in the upwind zone.
The OTC Regional NOxTrading Program in the Northeastern United States chose a different tactic.The OTC is com-
posed of three zones with varying levels of ozone problems, and thus varying levels of emission reduction require-
ments in accordance with the severity of each zone's air quality problem. In the program development phase, the OTC
conducted an analysis to determine whether trading restrictions were needed between zones to ensure reductions
were achieved. When analysis failed to provide affirmative proof that a trading ratio would influence air quality, the OTC
opted to minimize program complexity and allow unrestricted trading between zones with the caveat that the
issue may be revisited in future years as new information becomes available from implementation of the program.
3-21
Developing a Cap and Trade Program
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Figure 11. Trading Zones
FREE 1
TRADE
NON-
ATTAINMENT
AREA
Generally, there are three approaches for addressing
this issue. The first is the possibility of introducing
spatial restrictions on trading. For example, if unac-
ceptable concentrations or deposition are expected to
arise in a particular area, trading restrictions could be
imposed by introducing "zones" where net flows of
allowances into the sensitive area are prohibited or
discounted by an appropriate amount (see Figure 11).
A drawback of trading restrictions is the effect on fun-
gibility of allowances and market efficiency. Spatial
restrictions on the use of allowances mean that an
allowance is not a standard commodity that is fully
interchangeable with all other allowances. This lack of
full fungibility can diminish the economic efficiency
of the cap and trade program and can complicate the
allowance market (e.g., lead to price stratification
between allowances of different zones).
A simpler way of achieving the same effect as dis-
counting without affecting fungibility is to have a high-
er retirement rate (e.g., 1.5 allowances per ton of
emissions) in the zone of concern. This does not pro-
hibit trading or differentiate among types of allowances;
it simply makes it more expensive in such zones.
The second approach is to restrict trading between
different categories of emission sources. This
approach can be effec-
tive if the cap and
trade program includes
sources with different
characteristics that
influence the local
effect of the sources'
emissions (e.g., stack
height). For example,
the regulating authority
may restrict a tall-stack
source from trading
allowances to a short-
stack source because
the shorter stack will
likely have a greater
impact on local air
quality.
The third approach
is to adopt a "tiering"
of environmental poli-
cies, requiring sources
to comply with local
environmental quality
provisions as well as
those imposed by the cap and trade program. In its
simplest form, this allows the appropriate regulatory
authority to limit emissions of the sources identified
as contributing to the local air quality problem, while
not tampering with the allowance program. This third
approach is the one employed by the U.S. SOz
Allowance Trading Program.
Allowance Accounting
Each source that is responsible for compliance should
have an allowance account. These accounts are the
official records for allowance allocations, holdings, and
transfers and can be used to track compliance. Initial
allocations (or initial winning bids in an auction) pro-
vide the beginning balance for the allowance accounts.
Policymakers might also consider whether the pro-
gram will allow other interested parties to have
allowance accounts and hold allowances. These non-
source accounts provide the vehicle through which
organizations, such as brokers or environmental
groups, can hold and trade allowances. Brokers,
investors, and other market makers may play a crucial
role in facilitating allowance trades. Because the
allowance brokering and pooling functions are intend-
3-22
Developing a Cap and Trade Program
-------
ed to facilitate sources' efforts to maximize the cost
savings of their compliance strategies, these non-
source accounts should be integrated with the account
system for emission sources.
Allowance Serialization
Allowances can be serialized to facilitate tracking the
allowance from creation to use for compliance. There
are a number of benefits to identifying allowances by
serial number. Although tracking serial numbers
increases the administrative burden to both regulators
and industry, it provides additional transparency and
protection against accounting discrepancies. The use
of serial numbers could also facilitate record keeping
so allowance holders can track the different costs
incurred in acquiring allowances. This may be neces-
sary for tax purposes. Finally, the inclusion of serial
numbers in the allowance tracking system provides the
opportunity to analyze trading patterns and the move-
ment of allowances over time. This may be useful for
assessing the impacts of the trading program.'4 At a
minimum, allowances should be identified by vintage
(i.e., the compliance period for which they are issued)
to identify when the allowances are authorized for
compliance use.
Property Rights
The program rules must clearly define the legal rights
and responsibilities of emission sources and the nature
of allowances. Because allowances can be traded, the
rights and responsibilities of ownership must be estab-
lished so that these rights and responsibilities can be
transferred from one participant to another (AGO, 1999).
When addressing allowance use, the regulating
authority might want to consider certain property
rights issues, namely entitlements and takings. Both
can be addressed in the implementing legislation or
program rules. The type of legal system in place will
also affect whether or not allowances are perceived as
property rights.
Entitlements: Sources that have historically pollut-
ed with limited or no restrictions might argue that
they have an implied right to allowances based on
their historical emissions levels (AGO, 1999).
Takings: If the implementing institution reduces
the number of allowances at a later date, partici-
pants might argue that they are entitled to com-
How the U.S. SOz Allowance Trading
Program Dealt With Property Rights
In the SOz Allowance Trading Program, the legisla-
tion specifies that allowances are not property
rights.This provision was inserted to obviate a chal-
lenge of an unconstitutional "taking" should the gov-
ernment decide to alter the emissions cap (i.e., to
reduce the number of available allowances).
Functionally, however, the ownership rights and
responsibilities of allowances are similar to property
rights (Ellerman, 1999).
pensation from the regulating authority based on
the value of the lost allowances.
Compliance Determination
The compliance determination process for a cap and
trade program should be simple and straightforward.
Prior to implementation, the rules should clearly
specify the deadlines for reporting and for holding
sufficient allowances to cover emissions. At the end of
the compliance period, the emission sources should be
given enough time to verify emission data for the peri-
od and to submit them for compliance. This verifica-
tion period should not be so short as to cause the
emission sources to submit data that has not been
properly quality assured, but not so long as to unrea-
sonably delay compliance assessment. It should also
allow enough time for the regulating authority, once it
receives the data, to finish conducting the compliance
determination well before the end of the subsequent
compliance period, when the process will begin again.
At the end of each compliance period and during the
time when sources are assuring the quality of their
emission data, the rules should provide for a short
grace period (e.g., 60 days) so that sources can make
final allowance trades. This will allow sources to assure
that their account has allowances equal to or greater
than their emissions. The regulating authority should
specify an allowance transfer deadlinethe final date
for sources to trade allowances for use in the compli-
ance yearin advance.
It may be advisable to freeze allowance transfers
into or out of accounts after the transfer deadline until
For example, EPA has conducted analysis showing no adverse environmental impacts from trading under the U.S. SO2 Allowance Trading
Program (Kramer, 1999).
3-23
Developing a Cap and Trade Program
-------
the regulating authority completes the compliance
determination and deducts allowances for compliance.
Enforcement
Penalties for Noncompliance
Stringent penalties for noncompliance are an integral
feature of a well-functioning cap and trade program.
These should be applied automatically in cases where
a source does not have sufficient allowances to cover
mass emissions during the compliance period. In cases
where there is noncompliance with requirements of
the cap and trade program (e.g., measuring emissions,
reporting, and other requirements), the penalties
should be determined based on the nature and severity
of the violation. The penalties should be sufficiently
high to provide the appropriate incentives for compli-
ance and can take the form of allowance, financial,
and/or criminal penalties.
Excess Emission Offsets
In cases where a source does not have sufficient
allowances to cover its emissions, an allowance restora-
tion rate of at least one-to-one should be applied to
maintain the environmental integrity of the program.
Under a one-to-one rate, one allowance from the next
compliance period would be retired for every unit of
excess emissions in the current compliance period.
Alternatively, the shortage of allowances can be pur-
chased from the allowance market.
Aside from the one-to-one allowance restoration rate
to maintain environmental integrity, the regulating
authority should apply financial penalties for noncom-
pliance if the goal is to deter such behavior. The exis-
tence of a one-to-one restoration rate without other
accompanying punitive measures for noncompliance
implies that sources can, in effect, use allowances from
future compliance periods to attain their emissions
reduction target. This can result in a scenario in which
the emission cap is never attained. Hence, it is very
important that the incentives deter noncompliance.
Financial Penalties
Deterring noncompliance can either take the form of
allowance or financial penalties. With allowance penal-
ties (i.e., where a source would have to turn in a multi-
ple of its allowance shortfall at a ratio greater than
one-to-one) the aggregate cap of emissions in the next
compliance period is reduced. The environmental bene-
Penalties to Deter Noncompliance in
U.S. Trading Programs
Under the U.S. SO2 Allowance Trading program, the
penalty consists of a one-to-one allowance restora-
tion rate and a financial penalty applied at a level of
US$2,000 (1990 dollars), adjusted annually for infla-
tion, for each ton of excess emissions above
allowances held. In 1990, this level of financial penal-
ty was thought to be approximately three times the
expected market price of an allowance. Based on the
inflation adjusted penalty amount and actual mar-
ket price of allowances, this is actually on the order
of 20 times the market price of allowances, and
could, in retrospect, be too stringent. For example,
when non-compliance results from imperfect or late
data or miscalculations, these penalties may be
viewed as inappropriately punitive.
In contrast, the penalty for non-compliance in the
OTC Regional NOxTrading Program is an allowance
penalty at a ratio of three-to-one. In other words,for
each ton of excess emissions, a source must submit
three allowances to the regulating authority.
Additionally, states within the OTC have the option
of imposing financial penalties.This penalty, howev-
er, may not be sufficiently high. For example, during
1 year, the price of a NOx allowance fluctuated
between US$500 and 3,000. Some sources might
have sold allowances for US$3,000 and purchased
for US$500 at the end of the year.
fits of the program increase due to the allowances that
are deducted as a penalty, but this could lead to further
noncompliance because the necessary reductions are
greater in the following compliance period.
Alternatively, market volatility may tempt some to
speculate and intentionally be in noncompliance if they
believe the market price for allowances will drop in the
future. Furthermore, taking allowances out of the mar-
ket reduces the supply and raises the price of allowances
for all participants, not just those that are out of compli-
ance. However, this should not be a significant factor
unless there is large-scale noncompliance. For these rea-
sons, a financial penalty (in addition to the one-to-one
offset) may be preferable to deter noncompliance.
Policymakers or the regulating authority should set the
level of the financial penalties significantly higher than
the expected marginal abatement costthe expected
3-24
Developing a Cap and Trade Program
-------
market price of allowancesto create an effective deter-
rent for noncompliance. Policymakers could also create a
graduated financial penalty to reflect the severity of the
violation or the length of delay in making payment. For
example, if a source exceeded its emission cap because
of an accounting error, the penalty might be twice the
price of allowances, payable in 30 days. For a more seri-
ous violation or if the penalty is not paid in 30 days, it
could grow to several times the price of an allowance. If
the penalty is in dispute, the source could put funds
into an escrow account awaiting adjudication.
The allowance price from which the penalty is cal-
culated can be based on a projection of the allowance
price (established during the development of the pro-
gram) and adjusted for inflation. Alternatively, it can
be based on a multiple of either the actual average
price or the highest monthly price of allowances for
the preceding year in which the program was in opera-
tion. Establishing the penalty based on a multiple of
the projected market price of allowances can be diffi-
cult because different economic models often yield
substantially different estimates. However, indexing
the compliance penalty to actual prices can also be
difficult without a liquid market/exchange. In some
cases, a periodic, government-run auction can reveal
price information that the regulatory authority can use
to set the penalty level.
If a source is out of compliance with the monitor-
ing, reporting, and/or other requirements specified by
the regulating authority, financial penalties should
also be applied. These also can be graduated depend-
ing on the nature of the noncompliance (or "degree of
fault"), with higher penalties for repeat. To maintain
consistency, the penalty levels should, to the extent
possible, be defined in advance. Finally, to ensure that
the penalties are enforced in a timely manner, the
penalty rate might increase if the source does not pay
the penalty within a specified period of time.
The revenues from these penalties might be collect-
ed and redistributed in several ways. For example, they
can be collected by the national treasury and redistrib-
uted in the same way as income taxes or they can be
paid directly to the regulating authority to offset pro-
gram costs. The revenues may also be collected in a
special fund to provide resources for research and devel-
opment into abatement technology and/or environmen-
tal purposes related to the pollutant being regulated.
Regardless of the type and severity of penalties,
they should be objective and automatic. Eliminating
penalty negotiations between regulating authority and
emission source promotes impartiality and equity and
reduces opportunities for dishonest behavior. In addi-
tion, it sets clear expectations so that sources know
the consequences for noncompliance.
Criminal Penalties
The regulating authority might also impose criminal
penalties on individuals who knowingly violate any
requirements, with maximum sentences for first-time
and repeat offenders. Criminal penalties provide direct
incentives for the legally responsible individuals ("des-
ignated representatives" or owners and operators) at
the affected sources to behave responsibly. Owners,
operators, and designated representatives should be
required to sign each form that is submitted to the reg-
ulating authority for the source (e.g., allowance trans-
fers or emissions reporting) indicating that they are
liable for acts and omissions within the scope of their
responsibilities under the cap and trade program.
Other Design
Considerations
Integration of Cap and Trade
with Other Policy Approaches
There are a number of ways in which policymakers can
integrate cap and trade programs with other approach-
es for environmental policy. Command-and-control
approaches can be compatible with cap and trade, but
policymakers should identify the relationships
between the different policies and ensure there are no
contradictions or duplications. With command-and-
control, the regulating authority specifies sector-wide
technology and/or performance standards that each of
the affected sources must meet, whereas cap and trade
provides sources with the flexibility to choose the
technologies that minimize their costs.
Depending on the type of pollutant that is being
regulated by cap and trade, integration with com-
mand-and-control approaches can aid in the preven-
tion of hotspots that may result from the use of
allowances. For example, additional reductions
3-25
Developing a Cap and Trade Program
-------
through a cap and trade program could be layered on
top of existing requirements.25
Finally, with regard to integrating alternative forms
of emission trading, if the regulating authority decides
to establish more than one type of emission trading
program, each should affect distinct sectors. If
desired, allowances from a cap and trade program
could, in theory, be fully interchangeable with offsets
from project-based mechanisms or credits from a rate-
based program. However, the regulating authority
must ensure that project-based mechanisms do not
undermine the environmental integrity of the cap.
Stringent oversight, verification, and conservative
crediting methodologies need to be established to
account for uncertainties and to avoid the creation of
"anyway" tons, paper credits, leakage, or double
counting (see Chapter 2).
The United Kingdom 'Gateway'
Mechanism: Trading Between
Allowances and Credits
One mechanism that has been proposed to enable
trading between allowances and credits from rate-
based trading is the'gateway'in the U.K.'s Emissions
Trading Program for greenhouse gases. Under this
approach, sources affected by the rate-based trading
program can purchase as many allowances from
sources regulated under the cap and trade program
as they wish. However, sources regulated by cap and
trade program can only purchase credits from
sources under the rate-based program if the net flow
of units in this direction is zero.The U.K. Emissions
Trading Program is still in its infancy; hence, it is too
early to evaluate this approach. It is likely that the
transaction costs associated with undertaking these
inter-program trades (vs. intra-program trades) are
likely to be higher due to the administrative costs
associated with assessing net flows.
s For more information about layering command-and-control and market-based programs, see Schreifels, 2000.
3-26 Developing a Cap and Trade Program
-------
How to Implement
and Operate a Cap
and Trade Program
Introduction
The credibility of the cap and trade program and
confidence in the market depend on the accuracy
of emission measurement and enforcement by
the regulating authority. Because allowances, and
therefore emissions, have an economic value, sources
might misrepresent emission data if there are no con-
sequences or low probability of discovery. The regulat-
ing authority must ensure that enough resources are
dedicated to verifying emission reports and auditing
affected sources.
The regulating authority must also ensure that
allowance accounting is undertaken with the appropri-
ate scrutiny and security to avoid errors and fraud.
Computerized accounting systems for emissions and
allowances can facilitate the management of these
responsibilities.
This chapter describes the functions necessary to
implement and operate a successful cap and trade pro-
gram including tracking information on emissions,
allowances, and compliance; auditing and verifying
emissions reports; providing technical support and poli-
cy guidance to regulated sources; and costs and
resources necessary to operate a cap and trade program.
Integrated
Information Systems
Perhaps one of the most important lessons learned
from existing cap and trade programs is the need for
comprehensive, accurate, transparent, and timely infor-
mation about emissions and allowances. The regulat-
ing authority that operates the program must collect,
verify, maintain, and disseminate the data if the pro-
gram is to operate with environmental integrity, eco-
nomic efficiency, and public credibility. Computerized
information systems are the most effective method
available today to process and disseminate these data.
Using an information system to collect and manage
large amounts of data on emissions and allowances can
provide numerous benefits, including:
Increased data accuracy: Tools such as electronic
reporting and automated data quality checks
reduce errors and eliminate redundant data entry.
Reduced time and costs: Electronic reporting
and automated data quality checks reduce the
time and costs required to complete, process,
and review paper forms. In addition, the elec-
tronic storage of data can significantly reduce, or
4-1
How to Implement and Operate a Cap and Trade Program
-------
even eliminate, the costs associated with the col-
lection, transportation, storage, and dissemina-
tion of paper forms.
Enhanced access: Electronic data storage makes
it easier and faster to retrieve, analyze, and evalu-
ate relevant data on demand. Improved access to
data can also promote confidence in the trading
program by permitting emission sources and
interested members of the public to retrieve data
to ascertain compliance, evaluate a program's
effectiveness, and make informed decisions.
Data transparency can also facilitate efficient
markets, build public acceptance, and foster
credibility (Kruger, et al., 2000).
Improved consistency and comparability:
Electronic reporting and electronic data storage
encourage consistency by requiring all emission
sources to report the same information in a com-
mon reporting format. This consistency pro-
motes comparability across time and among
program participants, leading to a fully fungible
tradable commodity and efficient market.
In the early stages of a cap and trade program, the
data system may be as simple as a spreadsheet with
manual audit procedures. As an interim measure, this
approach can be reliable if volume is low, and it might
provide an opportunity to assess whether automation
is necessary and to what extent. As resources become
available and the program evolves, the information sys-
tem can be modified, expanded and, if appropriate,
automated to address the needs of the program.
A comprehensive information system should
include modules to collect, review, and manage data
on emissions and allowances and a module to deter-
mine compliance.26
Emissions Tracking Module
(ETM)
The most data-intensive component of the information
system may be the emissions tracking module, or ETM.
The purpose of the ETM is to collect, review, and
maintain relevant emission-related data from each
source. The type and quantity of data collected will
depend on the measurement requirements for the cap
and trade program. For example, a program that relies
on emission factors to calculate emissions from combus-
tion sources might require participants to report data on
the type and amount of fuel consumed, the combustion
technologies installed, and the emission factors used. A
cap and trade program requiring continuous emission
monitoring systems might collect data on measured pol-
lutant concentration and volumetric flow of exhaust gas.
Although the frequency of reporting will depend upon
the calculation method, the length of the compliance
period, and administrative requirements, it should be
frequent enough to supply sources, the regulating
authority, other market participants, and interested par-
ties with timely information about emissions and facili-
tate compliance determination.
Regardless of the method used to calculate emis-
sions, the data must be consistent, accurate, and
objective if sources, market participants, and the pub-
lic are to have confidence in the program. To facilitate
access to the data, the regulating authority can make
the emission data from the ETM available to interest-
ed parties through a publicly accessible interface (e.g.,
the Internet). The data are useful to market partici-
pants who can use them, along with allowance data, to
gauge potential supply and demand for allowances.
The public, interest groups, and academics can use
the data to evaluate the effectiveness of the cap and
trade program (e.g., emission reductions and environ-
mental effects). However, simply making data avail-
able may not be sufficient. True transparency
necessitates making the data available in a useful and
usable format (Teitenberg and Wheeler, 1998).
Determining the appropriate format will depend on
the type and quantity of data collected, as well as
their end use.
Due to the potentially large volume of data, the
regulating authority operating the program might ben-
efit by requiring all sources to submit emission-
related data electronically. Electronic submissions
improve accuracy and reduce the burden on sources
and the regulating authority by eliminating the need
for redundant data entry, facilitating automated data
quality checks, and providing immediate feedback
about data quality. In the event that electronic sub-
mission is not feasible, sources might submit data on
diskettes, compact discs, or paper forms. The regulat-
ing authority can then transfer the data to the ETM.
This manual process could be cumbersome for the
regulatory authority and prone to data entry errors.
After sources submit emission data, the ETM
should check the data for omissions, mathematical
For more information about data systems for cap and trade, see Schreifels, 2001.
4-2
How to Implement and Operate a Cap and Trade Program
-------
errors, and methodological problems. If the ETM uses
electronic reporting, it can acknowledge the submis-
sion and report the results of the quality check direct-
ly to the sources. The ETM can also perform
in-depth analysis and quality assurance checks. For
example, the system might compare the submitted
data to historical data from the source and similar
facilities to search for inconsistencies. Potential prob-
lems that the ETM identifies might be reported to
the regulating authority so an auditor can check the
data and, if necessary, request additional information
from the source. In the absence of a computerized
information system, the regulating authority should
oversee these functions.
Once the data passes the data quality check, it can
be recorded in the ETM and made available to inter-
ested parties. An automated data quality check
reduces the time and cost of data review in two ways.
First, the ETM identifies minor errors immediately
and reports to the source so they can correct the
errors. Second, the regulating authority can focus on
problems identified by the second stage of the review
in order to prioritize in-depth reviews. The automated
data quality check can also reduce processing delays
and provide interested parties with faster access to
emission data.
Allowance Tracking Module
(ATM)
The Allowance Tracking Module, or ATM, is the
accounting system for the trading program, keeping
track of account information, account holdings, and
transactions. As with other components of the system,
public access to the data is important. Market partici-
pants, including sources, brokers, and other allowance
owners, can use the data to verify transactions and mon-
itor holdings. The public, interest groups, and academ-
ics can use the data to evaluate the effectiveness of the
cap and trade program, identify barriers to cost-effective
trading, assess overall market activity, identify trading
trends, and analyze the emission implication of trades.
The potentially large volume of transactions in a
trading program may necessitate electronic submission
of transactions. As discussed earlier in the section on
submissions of electronic emissions data, electronic
submissions have many benefits, including improved
accuracy, reduced burden on the regulating authority,
immediate feedback and transaction confirmation to
participants.
The ATM can play a critical role in all allowance
transactions, including the issuance, transfer, retire-
ment, and cancellation of allowances. The regulating
authority can use the ATM to issue and distribute
allowances according to a prescribed method (e.g.,
allocation formulas, auctions, sales). A computerized
ATM can also ensure that trades are valid by reviewing
the data to verify that account numbers are correct,
the seller owns the allowances being transferred, and
the allowances are still valid (i.e., they have not been
retired for compliance or cancelled). Once the infor-
mation is verified, the ATM can deduct the traded
allowances from the seller's account and add them to
the buyer's account. If the transaction is not valid, the
ATM should notify the buyer and seller and, if appro-
priate, record the failed transaction as an acknowl-
edgement that the transaction was submitted.
The ATM, in conjunction with the Reconciliation
and Compliance Module, can facilitate compliance
assessment by retiring the appropriate number of
allowances from each account. In addition to issuance,
transfers, and retirement, the ATM can facilitate can-
celing allowances for environmental or other reasons
(e.g., administrative penalties, purchases by environ-
mental groups).
Public Participation in the U.S.
Allowance Market
The public can participate in emission trading pro-
grams by purchasing allowances. Environmental and
student groups have taken advantage of this option,
purchasing allowances with the intention of retiring
them from the system. Retiring allowances for the
environment prevents them from being used to
emit pollution. For example, in the U.S. SCh
Allowance Trading Program, these groups acquired a
total of 934 allowances in the period of 1994 to
1997. In RECLAIM, environmental activists acquired a
total of 1,925 allowances in the first year of the pro-
gram.This represented about 4 percent of the annu-
al allocation. Despite the small volume of
allowances, these transactions are symbolic of the
openness of the system and the ability of the public
to take direct action on behalf of their environment.
4-3
How to Implement and Operate a Cap and Trade Program
-------
Reconciliation and
Compliance Module (RCM)
The Reconciliation and Compliance Module (RCM) is
the vital link between the ETM and ATM to deter-
mine compliance. At the end of each compliance peri-
od, the RCM compares a source's allowance holdings
against the total emissions from the period. If the
source's emissions are equal to or less than their
allowance holdings, the source is in compliance (see
Figure 12). Conversely, if emissions are greater than the
allowance holdings, the source is not in compliance
and is subject to any noncompliance consequences and
penalties.
The RCM, in conjunction with the ATM, should
deduct the appropriate number of allowances from
each source's account. The deductions might be
made on a prescribed basis (e.g., first in, first out) or
by specific instructions as to which allowances are to
be deducted. The latter approach may be desirable for
a variety of reasons (e.g., tax consequences, forward
trade contracts).
If the source is not in compliance, the RCM
should:
Instruct the ATM to deduct all allowances from
the source's account and withhold future
allowances equal to the overage penalties.
Report the noncompliance and emissions over-
age to the regulating authority for enforcement.
Figure 12. Reconciliation
Allowances
Beginning of year
Auditing and
Verification
15,812
Auditing and verification of emission data can take
several forms. If data submitted by sources are required
in a standard electronic format, regulating authorities
can use software to audit the data and identify poten-
tial discrepancies or issues to investigate. The regulat-
ing authority can use these electronic "desk" audits to
target more in-depth audits. If sources submit emis-
sion data using paper forms, the audit and verification
will be more resource intensive. For this reason, requir-
ing sources to submit emission data in standard elec-
tronic format is strongly recommended.
When sources use measurement devices, either to
measure actual emissions or to measure some other
parameter involved in calculating emissions, such as
fuel flow, the regulating authority should review data
collected from measurement devices for reasonable-
ness. In addition, the audit should review results of
any quality assurance and quality control tests per-
formed on the measurement equipment to ensure that
the equipment is operating properly. If possible, the
regulating authority should compare submitted data to
independently obtained data.
Verification of submitted emission data should also
involve field audits visits to the emission sources
especially when sources use measurement equip-
ment. Such field audits can include observing quality
assurance tests, reviewing on-site records, inspecting
measurement equipment, and/or comparing installed
measurement equipment to independent reference
methods. Such field audits can be per-
formed on a random sample of all sources,
and/or field audits can be performed on
sources identified with potential measure-
ment or data problems during the electron-
ic desk audits.
Net Allowance
(Bought and Sold)
-3,201
Total Allowance
Available for Compliance
12,611
Deductions for
Emissions
-11,867
Allowances Remaining
(Source in Compliance)
744
4-4
How to Implement and Operate a Cap and Trade Program
-------
Auditing in the U.S. SOz Allowance
Trading Program
Under the U.S. SC)2 Allowance Trading Program, the
state and local environmental agencies, EPA regional
offices, and U.S. EPA Headquarters form an auditing
team. Where possible, regulatory officials (usually
from the local agencies) observe QA/QC testing of
emissions measurement equipment that is under-
taken by regulated sources.The purpose of the audit
is to verify that the testing is completed according
to standard procedures and accurately represented
in the reports to EPA. In addition, emissions and test
data are reported to EPA in a standard electronic for-
mat, are screened for errors, and are electronically
audited to identify potential discrepancies. Problems
found in electronic audits are used to target facilities
for field audits. Regulatory officials perform both
random and targeted field audits during which they
visit facilities to inspect measurement equipment
and on-site records to verify that the data reported
to EPA accurately reflects what is happening at the
facility. In support of this process, EPA provides train-
ing and audit software for regional, state and local
inspectors.
Technical Support for
Regulated Sources
An important element of implementing and operating
a cap and trade program is the ongoing technical sup-
port for sources. The program is more likely to be suc-
cessful if the regulating authority and emission sources
keep open lines of communication on the rules and
procedures of the program. Before implementation of
the program begins, sources may benefit from work-
shops that explain and clarify the rules of the program.
In addition, throughout the life of the program, as new
issues arise, new sources and new employees enter the
program, and revisions are incorporated into program
rules, a continued dialogue between the regulating
authority and the sources will facilitate the smooth
operation of the program.
It is wise for the regulating authority to plan work-
shops for sources after the rules of the program have
been publicly disseminated but prior to the beginning
of the program. The workshops can address all aspects
of implementation for which the sources are responsi-
ble, and should inform them about the role of the reg-
ulating authority. For example, the workshops could:
Explain the applicability criteria of the program
and address questions about which sources are
and are not affected.
Explain the allocation process, including when
and how each source will know its allocation or
the procedures for participating in an auction, if
applicable.
Address source responsibilities, such as the pro-
cedure for identifying the person who will be
responsible for making submissions and demon-
strating compliance for each source.
Discuss the requirements for measuring emis-
sions and reporting to the regulating authority.
Outline the procedures for reporting allowance
trades to the regulating authority.
Answer any questions related to the determina-
tion of compliance and potential enforcement
actions.
During implementation of the program, it might be
necessary to supplement the initial published rules of
the program with guidance documents that focus on
specific questions or clarifications regarding the rules.
It is likely that the initial rules of the program will not
cover all of the situations that actually arise.
Sources may need interpretations of the rules by
the regulating authority to help apply the rules to the
source's unique circumstances. This may be particu-
larly true for emission measurement and reporting.
The more individualized the measurement methods
and the more options available, the more questions
are likely to arise. For consistency in the program, it is
important that sources receive the same guidance.
One option to ensure consistency is for the regulating
authority to create a guidance document that includes
answers to both commonly asked questions and
unique questions. The regulating authority can modi-
fy the document as new guidance is created. Such a
document is useful as an internal reference to help
maintain consistency over time, as well as to provide
information to the public and sources.
4-5
How to Implement and Operate a Cap and Trade Program
-------
Administrative Costs
Associated with Cap
and Trade
Although cap and trade programs can cost significantly
less than more traditional policy options, the programs
require resources to operate efficiently and effectively.
Regulating authorities should consider these costs
when designing the program so they can identify
appropriate funding sources and budgets.
The smaller a cap and trade program is, the more
likely it can operate effectively and efficiently with a
simple spreadsheet or paper-based system. However,
as the number of participants or data requirements
increase, a computer-based system with automated
data processing becomes necessary. The costs of
designing and developing-'7 such a system can be con-
siderable, but the savings in staff time and error
reductions can help offset some of the expense.
Additionally, the system may undergo modifications as
program rules change, automation is enhanced, or
technologies improve.
Enforcement
Oversight and enforcement assure that sources are
accountable for their emissions and compliance with
the program requirements. The functions of oversight
and enforcement include the verification of emissions
and the enforcement of penalties for fraud or noncom-
pliance.
Additional Costs
Other costs associated with cap and trade programs
may include:
General administration.
Recording allowance trades.
Providing public access to program information
(e.g., emission reports, allowance holdings and
trades).
Monitoring program results.
Responding to questions from program partici-
pants and the public.
Operational Resources for the U.S.
SOz Allowance Trading Program
The U.S. SO2 Allowance Trading Program requires
significantly fewer administrative and operational
resources than traditional command-and-control
programs in the United States.This is due in part to
automation and the use of information systems, as
well as the fundamentally new approach whereby
administrators can focus on verification and compli-
ance rather than reviewing compliance plans, base-
line calculations, and emission reduction
transactions. Approximately 100 government staff
members nationwide play a role in the SCh or NOx
allowance trading programs.
25 to 30 federal headquarters staff members
provide policy guidance, develop and operate
the information systems to track emissions
and allowances, certify monitoring equipment,
verify reported emissions data, audit facilities,
determine compliance, and enforce penalties
when necessary. The vast majority of these
staff members perform quality assurance and
verification of emissions measurement data.
15 federal headquarters environmental staff
members assist with administration, outreach,
training, assessment, and operation of a
national network of monitors to track acid
deposition and environmental impacts.
15 federal regional environmental staff mem-
bers and approximately 40 state and local staff
members help verify the emission measure-
ments by conducting field audits at participat-
ing sources.
All federal costs for development and operation of
the U.S. SCh Allowance Trading Program amount to
less than $1 per ton of SO2 reduced (McLean, 1997).
27 EPA has created comprehensive design documentation for an integrated emission and allowance information system. This documentation is
available to interested governments through the Clean Air Markets Division.
4-6
How to Implement and Operate a Cap and Trade Program
-------
Assessment and
Communications
Introduction
This chapter describes how outreach and communi-
cations can facilitate a credible and successful cap
and trade program and discusses some of the com-
munication issues that are unique to emission trading
programs. The chapter emphasizes the importance of
transparency (i.e., the full and open disclosure of rele-
vant public and private decisions) for cap and trade pro-
grams. Finally, the chapter discusses ongoing data
collection and assessment recommended for cap and
trade programs to determine whether they are deliver-
ing the desired environmental and economic results
and to identify potential improvements. These include
environmental, economic, and market assessments.
Communicating Status
and Results
Research has shown that public acceptance of a govern-
ment policy is critical to ensure successful implementa-
tion; keeping stakeholders informed and involved helps
build trust in both the policies themselves and in the
regulating authority (Jasanoff and Wynne 1998). In
addition to simply conveying information, communica-
tion and outreach activities can help generate public
support for cap and trade programs. This support is par-
ticularly important in the case of environmental issues,
which frequently engender considerable public debate
between competing interest groups with differing val-
ues and objectives. Because there are many misconcep-
tions about cap and trade, regulating authorities
implementing cap and trade programs need to provide
complete, accurate, and balanced information on how
the program works and how it will help achieve envi-
ronmental objectives. It is also important to engage in
communication and outreach activities in the begin-
ning of the policymaking process and use these activi-
ties throughout implementation to develop credibility
for the new approach to emission control.
Multiple Audiences for
Outreach
The audience for most outreach activities is highly var-
ied, and each constituency has a unique set of con-
cerns. For example, the general public and the
environmental community may be primarily interested
5-1
Assessment and Communications
-------
in learning how the trading program affects human
health and ecosystems, particularly in and around their
own communities. The affected emission sources, on
the other hand, may need access to account informa-
tion or guidance on how to measure and report emis-
sions (see Chapter 4). The academic community might
show a preference for technical information, such as
data on long-term emission trends or prices.
Policymakers might be interested in whether program
goals are being met (e.g., whether emissions are
decreasing, by how much, and where). Policymakers
might also be interested in the program's overall cost-
effectiveness. The needs of each of these stakeholder
groups can be met through a well-designed monitoring,
assessment, communication, and outreach program.
Information for the Market
Another important role of a communication program is
to provide information to the emission sources to help
facilitate market operation. Sources need to know what
their reporting requirements are under the system, how
to comply with program rules and regulations, and
whom in the regulating authority to contact regarding
questions. Moreover, for a cap and trade system that
relies on trades recorded in near real time, it is neces-
sary for the regulating authority to provide data on
allowance availability and individual accounts.
Fortunately, recent advances in information technolo-
gy are making it possible to provide data relevant to cap
and trade programs in real time and in many highly-
useful forms (Kruger, et al, 2000). For example, before
an allowance trade is completed and money changes
hands, the party acquiring allowances may want to
know that the ATM has recorded the transaction.
Availability of this information helps keep the program
running smoothly and efficiently without long lag
times. Ultimately, transparency of information makes
the market more efficient by letting those who wish to
buy and sell allowances know who is trading and what
volume of allowances are being traded. This informa-
tion allows participants to make trading and compliance
decisions more easily and quickly than if critical infor-
mation were not available.
Public Involvement in the Design
Stage of U.S. Trading Programs
Both the U.S. SCh Allowance Trading Program and
the U.S. RECLAIM program involved the public in
their design and implementation. During the devel-
opment of the SO2 Allowance Trading Program reg-
ulations, members of the utility, coal and natural gas
industries; environmental organizations; consumer
interest groups; regulatory commissions; and mem-
bers of academia provided input through participa-
tion in the Acid Rain Advisory Committee (ARAC).
RECLAIM was also developed through the use of
advisory committees comprising representatives
from public agencies, the business community, trade
unions, environmental organizations and financial
institutions. In both instances, the involvement of
these groups early in the design process helped to
overcome misconceptions about the use of this new
instrument and to educate stakeholders on the
process of program development and implementa-
tion (Schwarze and Zapfel, 2000). In addition, it
helped facilitate implementation because it pro-
duced a cadre of knowledgeable individuals who
were committed to making the program work.
Communication Issues
Unique to Emission
Trading Programs
There are some unique communication issues associat-
ed with cap and trade programs. These programs are
sometimes met with skepticism from the environmen-
tal community and the public. Unique concerns or
misconceptions about emission trading are summa-
rized below.
"Emission trading is immoral." Some critics of
emission trading start with a philosophical oppo-
sition to what they call "the right to pollute."
Even under conventional regulation, however,
permitting establishes the "right" to emit pollu-
tion at a certain level. Sometimes this right is in
the form of an emission rate and sometimes it is
in the form of the emissions that result from spe-
cific, mandated pollution control technologies.
Unlike cap and trade, most of these traditional
mechanisms do not limit the total tonnage of
5-2
Assessment and Communications
-------
pollutants from each plant (i.e., plants can emit
more when they operate more). The market-
based incentives in cap and trade can also spur
innovation and new technologies.
"Emission trading is unfair." A second misper-
ception of emission trading is that it is unfair
because companies can buy their way out of
their responsibilities to reduce emissions.
Similarly, some have argued that emission trad-
ing favors large companies at the expense of
small companies. These arguments ignore the
fact that under a cap and trade system, compa-
nies that buy allowances are essentially paying
for emission reductions at other companies.
Moreover, small companies often benefit the
most from cap and trade because they may have
fewer internal options for emission reductions
and they may benefit from the flexibility of buy-
ing allowances. In addition, the largest and high-
est emitting facilities often have the lowest cost
per ton for reducing emissions. This was the case
in the U.S. SO 2 Allowance Trading Program,
where the highest emitting plants in the
Midwestern United States made the most signif-
icant emission reductions.
"Companies will cheat." Some believe cap and
trade will allow companies to avoid their obliga-
tions because enforcement and oversight is left to
"the market." In fact, if programs are properly
designed, accountability can be better under a
cap and trade program than under conventional
approaches. Gap and trade programs require the
creation of compliance structures that are useful
regardless of whether any trading occurs.
Participating sources must fully account to the
government for each ton of emissions according
to stringent emission measurement protocols to
ensure completeness, accuracy, and consistency
of emission data. Automatic financial penalties
can be used that are set at levels that discourage
noncompliance. The regulating authority's role in
the program is to ensure emissions are measured
accurately and that all participating sources are in
compliance. Finally, reported information on
emissions can be made available to the public on
the Internet or through other means. This trans-
parency can help build the necessary confidence
in the efficacy of the cap and trade approach.
"Trading doesn't clean the air." Critics of emis-
sion trading sometimes argue that trading does
not reduce emissions; it merely shifts the loca-
tion of existing pollution. However, this argu-
ment fails to account for the cap. Under a cap
and trade system, the overall level of emissions is
reduced and capped. The environmental objec-
tive is embodied in the cap and the economic
objective in the trade. Moreover, the larger the
overall reduction reflected in the cap, the less
concern there is about the environmental
impacts of any individual trade or group of
trades. This point is particularly relevant in
addressing concerns about hotspots that may
arise due to trading. Economic and atmospheric
modeling done in conjunction with an EPA
study of the U.S. SOz Allowance Trading pro-
gram showed that in the Eastern United States,
the difference in acid deposition with and with-
out trading was less than 5 percent. Differences
in deposition of less than 10 percent are not
expected to measurably change the acidification
of lakes and streams (USEPA, 1995).
Public Reaction to the U.S. SOz
Allowance Trading Program
Although reactions to some of the initial SO2 trades
in the United States were negative, acceptance of
emissions trading has grown as the program has
achieved environmental results. Several observers
have noted that the key to effectively communicat-
ing the benefits of the SO2 cap and trade program
to the public and environmental groups has been to
make the point that the flexibility of emission trad-
ing was tied to a significant environmental benefit
(Loeb, 1995). Essentially, the argument is that the
cost savings from the allowance trading program
were used "to buy" additional environmental bene-
fits and to therefore ease the concerns of environ-
mentalists over this nontraditional form of
regulation. Ultimately, once the emissions and envi-
ronmental results of the program became available,
the program began to receive more favorable media
treatment. In addition, a broader range of environ-
mental groups began to embrace cap and trade
(Kruger and Dean, 1997).
5-3
Assessment and Communications
-------
Glean Air Mapping and Analysis Program (G-MAP)
EPA's Clean Air Markets Division uses geographic data to assess the environmental effectiveness of the Acid Rain
Program and to help the public better understand the results and benefits of its SO2 trading prog ram. One of the
most sophisticated electronic information sources is the Clean Air Mapping and Analysis Program (C-MAP), which
allows users to assess national and regional impacts of the Acid Rain Program. C-MAP is a Web-based Geographic
Information System (CIS) assessment tool used to better understand and characterize the environmental results
and benefits of national and regional pollutant emission reduction prog rams. The geographic component of GIS
allows for a clearer understanding of the spatial relationships between emissions reductions and the associated
effects to air quality, surface water quality, acid deposition, forest health, and sensitive ecosystems.The user can
analyze national-, regional-, and state-level trends, according to the geographic and environmental area of interest.
C-MAP files are provided via the Web site and are also included in written reports (see:
www.epa.gov/airmarkets/cmap).
Figure 13. Allowance Trading Activity 1995 - 1999
1995 Acquiring Activity
1996 Acquiring Activity
1997 Acquiring Activity
1998 Acquiring Activity
1999 Acquiring Activity
Plants Acquiring
Additional Allowances
(Thousand Allowances)
<25
25-50
50-75
75-100
«>100
Plants Supplying
these Additional Allowances
(Thousand Allowances)
o < 50
50-100
100-150
150-200
> 200
1995 Supplying Activity
I
1996 Supplying Activity
1997 Supplying Activity
1998 Supplying Activity
" a
1999 Supplying Activity
For example, this map from C-MAP illustrates the geographic mean centers of SCh allowance trading (buying
activity of plants emitting more than their allocation in a given year, and selling activity of sources) for 1995
through 1999.The proximity of centers of trading each year indicates that there was no significant shifting of emis-
sions from one region to another among these units.The tight geographic correlation corroborates EPA's observa-
tions that units tend to acquire additional allowances from within their own company (or geographic region).
5-4
Assessment and Communications
-------
Independent analysis also shows that emission
trading can lead to greater human health and
environmental benefits than non-trading policies
(Burtraw and Mansur, 1999).
Modes of
Communication
By far the most effective means of communication and
outreach is the World Wide WTeb. Electronic informa-
tion can reach a vast audience at low cost. For exam-
ple, visitors to EPA's Clean Air Markets Web site28 read
more than 300,000 files every month. A well-designed
Web site should be user-friendly, rely on intuitive navi-
gation, and, ideally, undergo usability testing before it
is made available to the public. It should also be regu-
larly updated to reflect the latest program data and
developments. An up-to-date Web site can greatly add
credibility to the trading program and can be used to
provide information that builds confidence in the cap
and trade program (see box on C-MAP).
Information can also be made available to the pub-
lic via print media. Depending on available budget, a
regulating authority may prepare and distribute fact
sheets, brochures, and topical reports that can be dis-
tributed by mail. Periodic newsletters are another
effective means of keeping the public informed of the
program's status and results, including emission
reductions to date, auction results, and allowance
prices. Similarly, information can be conveyed at work-
shops and conferences.
Regardless of the mode of communication, it is
important to bear in mind that keeping the public
informed about the status and results of the cap and
trade program can help ensure the program's success
by highlighting its environmental and economic bene-
fits, facilitating market operation, and building public
and decisionmaker support. To ensure that adequate
resources are available to meet public demand for
information throughout a program's lifetime, a com-
munication function should be designed at the pro-
gram's outset, rather than on an ad-hoc basis after
results are available. Consistently available, up-to-date
information will help build public confidence in the
cap and trade program.
Continued Assessment
Environmental Assessment
A cap and trade program, by setting a quantifiable emis-
sion goal and using accurate and consistent emission
measurement, lends itself well to periodic assessment.
Reviewing emission levels will help determine how
effectively the program is operating and whether the
emission cap level has been achieved. Equally important
to program success is determining how the environment
is responding to emission reductions and whether over-
arching objectives for environmental protection are
being met. Periodic measurement of these environmen-
tal endpoints will help provide information on how well
the cap level is protecting the environment."9
The scope of the assessment is determined, to a
large extent, by the specific policy questions being
addressed. Continued assessments can include evalua-
tion of emission data, ambient air concentrations mon-
itoring data, and pollutant deposition monitoring data.
Assessment may also include an evaluation of end-
point parameters or receptors, such as changes in sur-
face water chemistry resulting in decreases in acid
deposition. Examples of environmental endpoints
include acidic levels of rainwater and sulfate deposi-
tion levels for acid rain, and ground-level ozone levels
for NOx emissions.
In order to evaluate the effectiveness of environ-
mental policies and programs, a strong commitment to
long-term monitoring programs is critical. Effective
assessment requires a full suite of monitoring capabili-
ties, including tracking stack emissions, analyzing
atmospheric concentrations of pollutants, measuring
wet and dry deposition to land and water surfaces, and
evaluating environmental impacts through surface
water chemistry and biological monitoring. These pro-
grams not only help in evaluating environmental com-
pliance and progress towards program goals (e.g.,
through tracking emissions reductions), they also
enable assessment of the effectiveness of emission
controls in addressing human health and environmen-
tal concerns. Over the long term, investment in such
program accountability mechanisms will yield great
benefits through their contribution to the credibility
of the policy.
28 The Web site's URL is www.epa.gov/airmarkets.
29 For a detailed discussion on ecological assessments and analytical tools in the context of acid deposition in the United States, see USEPA, 2001.
5-5
Assessment and Communications
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Figure 14. SOa Emissions From Affected Emission Sources
18
16
~ 14
c
° 12
c
o
= 10
_£
« 8
o
'8 6
LU 4
( l/.Jt
-
..7.90
-
.-
._9.40
I
16.09
6.79
9.30
15.73
7.03
8.70
|
nQJ
6.57
5.30
12.51
7.07
5.44
12.98
7.51
5.47
|
13.10
7.81
5.29
|
12.46
7.52
4.94
11.20
11.20
10 63
10.63
Environmental Assessment in the U.S. SCh Allowance Trading Program
Since its first year of operation in 1995, there has been extensive assessment of the impacts of the U.S. SCh
Allowance Trading Program.This assessment has been critical in evaluating the success of the program and in
building support for the cap and trade approach. Some of these results are summarized below:
Emissions: One benefit of using continuous emissions monitors is having accurate, complete, and timely emis-
sion data that can be used to quantify the overall environmental effectiveness of the program. In 2001, the second
year of Phase II, affected emission
sources achieved total SCh emis-
sion reductions of approximately
39 percent relative to 1980 levels
(33 percent relative to 1990 levels).
Compared to 2000 levels, these
sources reduced their SCh emissions
by 5 percent or 569,000 tons. Figure
14 shows the trend in SCh emissions
for all affected sources since 1980.
Air Quality: Data collected since
1988 indicate that ambient SCh con-
centrations are declining (see Figure
15).
Wet Deposition: Field data col-
lected by the National Atmospheric
Deposition Program/National
Trends Network (NADP/NTN) show
that sulfate levels in precipitation
have dropped sharply since the SCh
Emissions Trading Program began in
1995 (see Figure 16) (Lynch,etal.,
2000).
Dry Deposition: The Clean Air
Status and Trends Network
(CASTNet) measures dry deposition
of sulfur and nitrogen at approxi-
mately 100 sites. Like wet deposi-
tion, dry deposition can cause
acidification of surface waters. It is
also linked with damage to materi-
als. CASTNet data show that dry
deposition sulfate concentration
levels also have declined by approx-
imately 30 percent in the
Northeastern United States and
Mid-Atlantic (Holland,etal., 1999).
1980 1985 1990 1995 1996 1997 1998 1999 2000 2001
D Phase I sources
D Phase II sources
D all sources
allowances allocated for that year
Source: Clean Air Markets Division, EPA
Figure 15. Regional Trends in SOz Concentration Sources
1989-1991
1999-2001
>20
SO^tfjg/m
Source: EPA
I.I .1:1 .'/iJ.MUI.Iu.ni.' .
Regional trends in ambient SO2 concentrations. Percentage is the percent drop in SOz concentration in
each Region. Trends are decreasing, with most prominent trends in the Northeast and Mid-Atlantic states.
5-6
Assessment and Communications
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Surface Water Impacts: A recent study examining surface water quality in acid-sensitive regions of the United
States found that, since the beginning of the U.S. SO2 Allowance Trading Program, sulfate concentrations in lakes
and streams have declined significantly in all monitored regions of the Eastern United States, except Virginia.
Nitrate concentrations have decreased significantly in the Catskill and Adirondack Mountains and Vermont since
1990. Increasing Acid Neutralizing Capacity (ANC) demonstrates that recovery is occurring in the Adirondacks and
Pennsylvania, spurred by the sulfate reductions achieved by the program. (USEPA, 2003).
Figure 16.Trends in Wet Sulfate Deposition
1989-1991
Source: National Atmospheric Deposition Program
1999-2001
USEPA/CAMD 07/31702
Wet SCV
(kg/ha)
0
'
Source: Lynch et.al., 2000. (Units are in kilograms per hectare).
"
USEPA/CAMD 07/31/02
5-7
Assessment and Communications
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Continued Economic Assessment in the U.S. SCh Allowance Trading Program
To evaluate the scientific (and economic) effects of acid deposition in the United States, a National Acid
Precipitation Assessment Program (NAPAP) was established in 1980. After a decade of research on the causes and
effects of acid rain, NAPAP produced a comprehensive Integrated Assessment Report, published in 1991. Part of
this effort included an economic evaluation of environmental impacts in selected affected areas for which data
were available and where the valuation methods could be credibly applied.The report explicitly recognized that
there were limitations in the assessment due to a lack of proper scientific or economic data and models and that
the results did not present a full picture of the total value of the damages caused by the regional air pollutants.
A decade later, as methodologies for the economic evaluation of environmental effects improved and contin-
ued research was undertaken, more comprehensive estimates indicate that the benefits of the SCh reductions
achieved are very high, particularly the reduced health risks of premature mortality and morbidity. Estimates of the
annual health benefits alone in 2010 are in the order of 17 to 70 billion 1995 U.S. dollars per year (Ostro,et al.,
1999). An updated analysis conducted in 2000 projects annual benefits of about 50 billion 1997 U.S. dollars per
year beginning in 2010 (Watkins,2001).
In addition, recent estimates of the costs of attaining the emission reduction target have been significantly
lower than expected. In 1989, the EPA estimated annual costs of the program to participating sources at full imple-
mentation (2010) to be approximately $5.7 billion annually. A current EPRI estimate predicts annual costs of $1.6
billion in 2010. Other recent annual cost estimates have been as low as about $1 billion per year by 2010 (Carlson,
etal.,2000).
Economic Assessment
Economic assessments are useful to evaluate whether
the cap and trade program is delivering the expected
economic benefits. Assessments include a comparison
of the environmental and human health benefits (or
damages avoided) as a result of the program, and the
total costs of compliance (NAPAP, 1998; Burtraw, et al.,
1998). These types of analyses can be used for a more
comprehensive cost-benefit analysis to evaluate
whether further emission reductions and/or additional
control programs are warranted.
Market Assessment
Market assessment (i.e., tracking allowance trading
activity and prices) is another important aspect of a cap
and trade program. The volume of activity (i.e., the
number of transactions that occur) indicates whether
the market for allowances is liquid and whether it is
working effectively to minimize the economic costs of
achieving the emission reduction target. Of particular
importance is a measure of the number of allowances
traded in "arm's-length" transactions, or trades that
occur between unaffiliated companies. It is these
trades that have market significance (Kruger and
Dean, 1997) and demonstrate that an allowance market
has developed.
Program Refinement
Once a cap and trade program has been implemented,
assessment of the program is valuable to ensure its
effectiveness. It is important not only to assess the envi-
ronmental and economic effectiveness of the program,
but also to assess the implementation. Policymakers
should consider whether these procedures could be
improved or if they could be more cost-effective.
After gaining some experience of program imple-
mentation, policymakers should consult with the
emission sources, as well as use the experience from
the sources to assess whether changes are warranted
in the implementation rules and procedures. In addi-
tion, input should be solicited from other stakehold-
ers. Based on such input, it can be determined
whether the program would benefit from refinement
and if so, a process and timetable can be established.
It is important to minimize disruption in the program
and realize that some changes, even if they would
have been a better choice from the start, are not worth
implementing because of the disruption they would
cause. The sources, as well as the regulating authority,
have learned the rules and any changes, even improve-
ments, might require more time on their part to learn
and implement. On the other hand, it is very possible
that there will be changes where the benefits will out-
weigh the disruption caused by change.
5-8
Assessment and Communications
-------
Rule Revision Based on
Implementation Experience in the
U.S. SOa Allowance Trading Program
Under the U.S. SO2 Allowance Trading Program, EPA
initiated a stakeholder process after the first few
years of implementation to solicit input on the
implementation and experience with the emissions
measurement requirements of the program.The EPA
office responsible for the design and implementa-
tion of the program led the stakeholder process.The
process involved the regulated power plants that
were implementing the requirements, the state and
local environmental agencies that help EPA perform
field audits of affected facilities, and environmental
groups interested in the integrity of the program.
Based on the input from the stakeholder process,
EPA developed a revised set of emissions measure-
ment rules and procedures aimed at streamlining
the process for both the sources and the regulators.
While maintaining or improving the quality of the
emissions data and the integrity of the program, the
revised rules clarified sections that were unclear or
misleading, increased the cost-effectiveness of the
rules, and addressed real-life situations that were not
envisioned when the rules were first written. EPA
released the revisions in draft form to interested
stakeholders and requested comments on the revi-
sions, which were incorporated, as appropriate,
before finalizing the revised rules. Once the revised
rules were finalized, EPA provided an additional year
before requiring their use.This gave sources time to
learn and implement the new rules.
5-9
Assessment and Communications
-------
-------
Glossary of Terms
Acid deposition: The process by which acidic particles,
gases, and precipitation leave the atmosphere. More
commonly referred to as acid rain, acid deposition has
two components: wet and dry deposition.
Acid rain: The result of sulfur dioxide (SOz) and nitro-
gen oxides (NOx ) reacting with water in the atmos-
phere and returning to earth as rain, fog, or snow.
Broadly used to include both wet and dry deposition.
Acid Rain Program: The regulatory program created
under the U.S. Clean Air Act to reduce acid rain. It
employs a cap and trade framework to reduce SOz
emissions from electric power plants. The Acid Rain
Program is also known as the U.S. SOz Allowance
Trading Program, the U.S. SOz cap and trade program,
and the U.S. SOz emission trading program. The Acid
Rain Program also requires reductions in NOx emis-
sion rates from coal-fired power plants.
Additionally: A determination of whether emission
reductions from a project would have occurred under
normal business conditions (i.e., in the absence of a
crediting program).
Affected source: A facility that produces emissions and
is subject to the provisions of an emission control regu-
lation.
Allowance: An authorization to emit a specific amount
of a pollutant under a cap and trade program. For
example, in the U.S. SOz Allowance Trading Program,
one allowance is the authorization to emit 1 ton of
SOz. Allowances are used for compliance and can be
traded among sources participating in the cap and
trade program.
Anyway tons: See "Additionality."
Arm's length transactions: Allowance transactions
between companies that are unaffiliated with one
another.
Ascending bid auctions: An auction in which both
price and allowance quantity are determined through a
process of open competition. Each bidder has full
information about the current clearing price and can
update their bids to increase price or change quantity,
changing losing bids to winning bids. Those willing to
pay the most win the allowances.
Glossary-1
Glossary of Terms
-------
Banking: A form of temporal flexibility that gives
sources the opportunity to save unused allowances
and/or offsets for use in a later compliance period.
Broker: The person who acts as an intermediary
between a buyer and a seller, usually charging a com-
mission.
Bubble: A regulatory term that applies to the situation
when a company combines a number of its sources in
order to control pollution in aggregate; under a bubble
facility operators are allowed to choose which sources
to control as long as the total emissions from the com-
bined sources is less than or equal to the amount each
source would have emitted under the conventional
requirement
Cap: The overall emission limit that a group of affect-
ed sources cannot exceed under a cap and trade pro-
gram. May also be referred to as the aggregate
emission quota, level, target, or budget.
Cap and trade: A market-based policy tool that estab-
lishes an aggregate emission cap on total emissions
from a group of sources and creates a financial incen-
tive to reduce emissions. The emission cap is
expressed as allowances distributed to individual emis-
sion sources that must surrender allowances to cover
their emissions. The program provides the flexibility
for sources with low-cost reductions to reduce even fur-
ther and sell allowances to others with higher costs of
control, resulting in achievement of the environmental
goal at lowest cost.
Clean Air Act Amendments (CAAA) of 1990: A reau-
thorization of the Clean Air Act passed by the U.S.
Congress in 1990. The CAAA, which included provi-
sions for the U.S. SO? Allowance Trading Program,
strengthened the ability of EPA to set and enforce pol-
lution control programs aimed at protecting human
health and the environment.
Command-and-control: A policy tool in which the reg-
ulating authority establishes the necessary emission
reduction or applicable emission limit for specific
sources, typically by setting a source-specific emission
rate standard or mandating the installation of specific-
emission reduction technology.
Credit: Under a rate-based trading program, credits can
take the form of an authorization to emit a specific
quantity of emissions (e.g., 1 ton) when an emission
source achieves an emission rate below the specified
performance rate. Under a project-based trading pro-
gram, once certified by an authorized expert to ensure
the emission reduction is real, additional, and long-
term, a credit is an authorization to exceed a rate or
other pre-existing standard by a specific amount (e.g.,
1 ton).
Crediting period: the number of years during which an
emission reduction project is eligible to receive credits
for actual emission reductions.
Designated representative: Under the U.S. SO>
Allowance Trading Program, the individual who repre-
sents the owners and operators of an affected source
and performs allowance transfer requests, emission
reports, and all correspondence with EPA concerning
compliance with the U.S. SO Allowance Trading
Program.
Downstream: A type of cap and trade system in which
affected sources are those facilities or consumers after
the point in the product cycle where the emissions
actually escape to the atmosphere. For example, elec-
tricity consumers are downstream from the emissions
that occur at the electricity generator.
Emission target: The level of allowable emissions in a
cap and trade program. See also "cap."
Environmental integrity: The ability of an emission
control policy, such as an emission trading program, to
achieve its environmental objective (e.g., reduce or
limit emissions to a specific quantity).
Flue gas desulfurization (FGD): Post combustion con-
trol technologies designed to remove SO? from flue
gases. FGD technologies can be grouped into two gen-
eral categories of wet and dry processes. In the most
common type, a wet limestone scrubber, the flue gas
enters a large reaction vessel (spray tower or absorber),
where it is sprayed with water slurry containing lime-
stone. The calcium in the slurry reacts with the SOz to
form calcium sulfite or calcium sulfate that is removed
from the reaction vessel and the water is removed. The
thickened waste can either be disposed of or used to
produce a by-product such as gypsum.
Fuel flow meter: An instrument that measures the vol-
ume or mass of fuel burned.
Fungibility: The interchangeability of allowances,
credits, and/or offsets, assuming that each represents a
Glossary-2
Glossary of Terms
-------
consistently measured and standardized unit of emis-
sions.
Ground-level ozone: The occurrence in the tropo-
sphere (i.e., at ground level) of a gas that consists of
three atoms of oxygen (O.5) and is formed through a
chemical reaction involving oxides of nitrogen (NOx ),
volatile organic compounds (VOC), heat, and light. At
ground level, ozone is an air pollutant that damages
human health, vegetation, and many common materi-
als and is a key ingredient of urban smog.
Hotspots: Geographically and temporally concentrated
pollution levels that exceed desired emission levels or
ambient air quality standards. Under some circum-
stances, hotspots may result in conjunction with an
emission trading program if appropriate safeguards are
not designed into the program (e.g., a stringent cap).
Leakage: Occurs when economic activity is shifted as
a result of the emission control regulation and, as a
result, emission abatement achieved in one location
that is subject to emission control regulation is offset
by increased emissions in unregulated locations.
Marginal abatement cost (MAG): The amount of
money a source will need to spend to reduce the next
ton of emissions of a specific pollutant.
Mass balance approach: An emission estimation
method in which inputs and outputs are compared to
calculate the emissions of the relevant pollutant.
Net buyer Under a cap and trade program, an
allowance trader that acquires more allowances than
they sell.
Nitrogen Oxides (NOx): Gases produced during com-
bustion of fossil fuels in motor vehicles, power plants,
industrial furnaces, and other sources. NOx is a pre-
cursor to acid rain and ground-level ozone.
Offset An emission reduction of a specific quantity of
a pollutant (e.g., 1 ton) verified through a project-
based trading program. An offset can be applied to reg-
ulatory emission limits as an authorization to emit that
specific quantity of pollutant. See also definition of
"credit."
Ozone Transport Commission (OTC) Regional NOx
Trading Program: A NOx cap and trade program
adopted by jurisdictions (states and the District of
Columbia) in the Northeastern United States to
address ozone transport in that region.
Paper credits: Generated under project-based trading
programs if the emission baseline for a project is set at
a level greater than the one at which the source actual-
ly operates. If such a baseline is used to calculate the
quantity of credits or offsets generated by the project,
the resulting credits or offsets do not reflect real emis-
sion reductions. Similarly, paper credits could also
occur under a rate-based trading program if the per-
formance standard is set at a level above which a source
actually operates.
Performance standard: A quantity of emissions allowed
per unit of heat input or product output.
Permanence: A concept associated with project-based
trading that refers to whether carbon stored in the
biosphere (i.e., carbon sequestration and sinks) might
later be emitted to the atmosphere (e.g., by a forest
fire). Permanence should be addressed so that offsets
awarded for carbon stored in a tree which later burns
down are not used to allow extra emissions elsewhere.
Point of emission: A type of cap and trade system in
which affected sources are those facilities where the
emissions actually escape to the atmosphere. For
example, the U.S. SOz Allowance Trading Program is a
point of emission program because the affected
sources are electric generating units that combust fos-
sil fuel and emit pollutants into the atmosphere. This
kind of program is often referred to as a downstream
program in the United States and a midstream program
in Europe.
Project hose An emission source that hosts a project to
reduce emissions and generate offsets under a project-
based trading program.
Price signal: An indicator of what people or businesses
are willing to pay for allowances or what firms are will-
ing to accept as payment for their surplus allowances
(or credits). Transactions, whether auctions or sales,
provide a signal of the price that emission sources and
other market participants are willing to pay for
allowances.
Ratchet: A procedure that adjusts each source's alloca-
tion proportionately so that the total allocation matches
the number of allowances in the overall cap. This sys-
tem promotes environmental integrity by ensuring that
formulas used to determine allocations do not inflate
the cap.
Glossary-3
Glossary of Terms
-------
Rate-based trading: A trading approach in which the
regulating authority determines an emission rate per-
formance standard (i.e., an amount of emissions
allowed per unit of heat input or product output) for a
sector (e.g., tons/kWh) and allows sources that over-
and under-comply with the standard to trade credits.
(The rate difference needs to be multiplied by each
sources1 utilization to establish a tradable mass emis-
sion based credit or offset.)
Scarcity value: The economic value of an allowance or
credit due to the limited quantity available.
Scrubber A post-combustion control technology utiliz-
ing a sorbent to remove SO from the emission stack.
See also "Flue gas desulfurization."
Stationary source combustion: The process of burning
fuel by a source, such as a boiler, that is in a fixed loca-
tion (i.e., not mobile).
Source: An entity that releases airborne pollutants into
the environment.
Sulfur dioxide (SOz): A gaseous pollutant that is pri-
marily released into the atmosphere as a by-product of
fossil fuel combustion. The largest sources of SOz are
power plants that burn coal and oil to make electricity.
Trade: An exchange of allowances, offsets, or credits
for cash or other considerations under an emission
trading program.
Trader Anyone who buys or sells allowances.
Transaction costs: Financial costs associated with a
transaction under an emission trading program. The
costs are usually related to identifying, verifying, and
certifying emission reductions. These may include
partner search costs, travel and communication, negoti-
ation activities, legal and contracting costs, potential
litigation costs, ex-post challenges, opportunity costs
associated with delays and uncertainties, and other
related costs.
Upstream: A form of cap and trade where the obliga-
tion of compliance is placed 'upstream' of the actual
emission sources (e.g., at the fuel producer), such that
the affected sources under the program are not the
facilities where emissions actually escape to the atmos-
phere.
Vintage: Represents the first year, or compliance peri-
od, in which a particular allowance can be used for
compliance in a cap and trade program.
Glossary-4
Glossary of Terms
-------
Acronyms
ARAC Acid Rain Advisory Committee
ATM Allowance Tracking Module
CAAA Clean Air Act Amendments
GEMS Continuous Emission Monitoring System
CH4 Methane
C-MAP Clean Air Mapping and Analysis Program
CO? Carbon Dioxide
DAHS Data Acquisition and Handling System
ELI Environmental Law Institute
EPA U.S. Environmental Protection Agency
EPBs Environmental Protection Boards
ETM Emissions Tracking Module
FGD Flue Gas Desulfurization
GHGs Greenhouse Gases
ISO International Standards Organization
MAC Marginal Abatement Cost
MMBTU Pounds per million British Thermal
Units
MSD Marginal Social Damage
NAPAP National Acid Precipitation Assessment
Program
NOx Nitrogen Oxides
OTC Ozone Transport Commission
QA/QC Quality Assurance/Quality Control
RCM Reconciliation and Compliance Module
RECLAIM Regional Clean Air Incentives Market
RFF Resources for the Future
SIP State Implementation Plan
SOz Sulfur Dioxide
TEV Total Economic Value
USD U.S. Dollar
Acronyms-1
Acronyms
-------
-------
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"Response of Surface Water Chemistry to the Clean
Air Act Amendments of 1990," EPA620-R-03-001.
Washington, DC, 2003.
Watkins, 2001: Watkins, A. "Outdoor Pollution: Acid
Rain," Environmental Health Secrets. L. Kemp
Williams and R. Langley (eds.), Lippincott,
Williams, Wilkins, Philadelphia, PA, 2001.
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The Optimal
Level of Pollution
According to economic theory, excessive levels of
pollution occur due to so-called "market fail-
ures," such as the public goods nature of envi-
ronmental quality, imperfect information, and other
factors. Hence, according to economic theory, govern-
ments should intervene to provide the correct incen-
tives for pollution control. Determining the optimal
level of pollution control requires an analysis of the
level of the environmental externality that is being
generated as a result of an economic activity. An exter-
nality is defined as a cost or a benefit that is not being
properly accounted for by either the producers or the
consumers of the activity. For example, consider the
case of a firm located upstream that is emitting pollu-
tion into a nearby stream. As a result, ecosystems
downstream may be adversely affected (e.g., fish popu-
lation decline, decline in recreational fishing and
swimming, adverse health effects from contaminated
drinking water). These are all examples of negative
externalities (i.e., costs). If these effects are not reflect-
ed in the firm's production costs, and hence in the
market price of the economic activity, the firm will
emit a level of pollution that is above the social opti-
mum. Generally, two conditions need to prevail for an
external cost to exist: (1) an activity by one party caus-
es a loss of welfare to another party; and (2) the loss of
welfare is uncompensated.
Figure A-l depicts the socially optimal level of pol-
lution. The Marginal Social Benefit (MSB) curve
shows that initial emission reductions provide greater
benefit than subsequent emission reductions.
Pollution abatement, however, costs less for the ini-
tial reductions but each additional (or marginal) unit
of pollution control costs more than the previous unit.
Thus, the Marginal Abatement Cost (MAC) curve is
steeper as the quantity of emission reductions is
increased.
The optimal level of pollution control occurs where
MAC = MSB. Hence, to achieve this level, the regu-
lating authority would want to limit the aggregate
level of emission reductions to the level Q*, which
reflects the marginal cost associated with that level of
economic activity, P*.
A-1
The Optimal Level of Pollution
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Figure A-1. Economically Efficient Control of Pollution
CAPANDTRADE
o
a.
01
CL
O
U
Marginal
Social Benefit
Marginal
Abatement
Cost
Quantity of Pollution Reduced
The Economics of
Emission Trading
Cap and trade programs are superior to the more tradi-
tional command-and-control approaches for environ-
mental regulation because the emissions
targetestablished via the capis achieved at a mini-
mum economic cost through the trading of the
allowances. The regulating authority determines the
total allowable level of emissions and issues allowances
for this amount (ideally Q* in Figure A-1 above). The
allowances are then allocated to the sources, which are
allowed to trade with other sources in the allowance
market. In this way, firms with low marginal abatement
costs will opt to reduce emissions beyond the number
of allowances they hold and sell the excess allowances
to firms with higher marginal abatement costs. Thus,
marginal abatement costs across all sources are equal-
ized and the costs of attaining the environmental target
are minimized.
A-2
How to Develop a Cap and Trade Program
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Example Assessment
of the Potential For
Cap and Trade
Case Study of SOz in the United States: Assessing the Potential for Cap and Trade
Questions for Consideration A Case Study of SO2 in the United States
ENVIRONMENTAL SCIENCE ISSUES
What is the nature of the
environmental problem?
What is the geographic scope of
problem?
Can emission sources be linked to
the environmental problem or
health issue?
Emissions of SO2 and sulfates damage human health, ecosystems, visibility,
and materials (e.g., buildings and monuments (NAPAR 1991)). During the
1980s, the most pressing concern was the impact of acid deposition on lakes
and streams.Today, there is more research linking sulfate particles to human
health problems and mortality (USEPA, 1995). New studies also show links
between acidic deposition and forest damage.
Acid deposition was greatest in the northeast United States and Canada, but
other regions of the United States had some impacts and emissions were
known to travel from west to east across the country. Electric utilities operate
in more than one state so national coverage was important to minimize gen-
eration and emission shifting outside of the control area.
A decade of research collected by the National Acid Precipitation Assessment
Program (NAPAP) quantified the transformation and long-range transport of
sulfate particles (NAPAP, 1991 ).The largest emission sources were located in
the Midwest and found to impact downwind areas.
B-1
Example Assessment of the Potential For Cap and Trade
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Case Study of SOz in the United States: Assessing the Potential for Gap and Trade
Questions for Consideration A Case Study of SO2 in the United States
What are the major sources of
emissions?
In 1980, electric utilities were responsible for more than 70 percent of total
SO2 emissions in the United States (NAPAP, 1991).
Are there accurate measurement Technology existed to accurately measure emissions but was not widely
methods for the sources identified? applied.The trading program required continuous emission monitors for all
coal-fired boilers in the program,and all sources were required to provide a
complete accounting of emissions.
What are emission projections
from each sector?
ECONOMIC ISSUES
Are there available emission
reduction options?
Do different sources face different
costs?
What do different marginal costs
imply about where to expect
reductions?
What are the overall costs and
benefits?
Are there any adverse
environmental implications to
using emission trading?
Are there sufficient sources for a
fluid market?
Emission projections showed that emissions from the utility sector alone would
increase to nearly 20 million tons by 2010 if action was not taken (NAPAR 1991).
A variety of cost-effective technological, fuel switching, and energy efficiency
options existed.
Sources faced a wide range of compliance costs and control options (e.g.,
installing scrubbers, switching fuels, increasing energy efficiency).
Generally, the highest emitters had lowest costs to reduce emissions (on a
cost per ton basis). In the United States, most of those sources were located
in the Midwest and Ohio River Valley.
Economic models were used to estimate the costs of different alternatives.
The cost of emission trading was estimated to be significantly lower than tra-
ditional approaches.The NAPAP report estimated significant benefits, but
were not initially monetized.
Analyses were undertaken to predict which sources are likely to be buyers of
allowances and which sources are likely to be sellers of allowances. Estimates
of the location of emission reductions and trading activity can then be made.
This information can be used to predict trading activity and air quality
impacts.There are also ways to incorporate specific requirements to prevent
problems, like"hotspots."
The electric power sector contained over 2,000 sources including coal burning,
natural gas, oil and wood-fired sources (serving generators larger than 25 MWe).
INSTITUTIONAL AND TECHNICAL ISSUES
Is there sufficient enforcement
authority to make a trading
program work?
Automatic penalties for not holding enough allowances were established.
These penalties were set at $2,000 per ton, with annual increases to reflect
inflation. Allowances for the following year are confiscated for every ton
emitted over allowance levels.The CAAA has additional criminal and civil
penalties of up to $25,000 a day per violation.
B-2
Example Assessment of the Potential For Cap and Trade
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Case Study of SOz in the United States: Assessing the Potential for Gap and Trade
Questions for Consideration A Case Study of SO2 in the United States
Is there an infrastructure to
measure, report, and manage
source specific emission data?
Are there adequate resources to
manage emission data?
Is there a system and central
authority that can be used to
determine compliance?
Does legal authority exist for an
emission trading program?
How can an emission trading
program be integrated with
existing policies?
What developments are occurring
in the affected source sector?
The existing infrastructure was not sufficient to provide the needed accuracy
and handle the volume of data in a timely fashion. EPA established standard
measurement and reporting protocols for affected sources.Tracking systems
were developed for unit specific (i.e., boiler-level) emission data and for
allowance transfers. Data are available to the public on the EPA Internet site.
Approximately 75 percent of administrative resources in the U.S. SO2
Allowance Trading Program are devoted to measuring, tracking and quality
assuring emissions. An electronic emission tracking system was developed to
receive emission data electronically directly from sources.
In the United States new systems were created (emission and allowance
tracking systems) to determine compliance. Authority for determining
compliance was part of the legislation, and EPA historically had been respon-
sible for a variety of compliance and enforcement actions.
New legislation was developed for the SO2 Allowance Trading Program
Title IV of the! 990 CAAA.
Title IV of the CAAA requirements was separate from existing regulatory
programs and written to interface smoothly with other policies. Sources still
have to comply with existing ambient standards and permitting require-
ments for SO2.
Energy power restructuring has proceeded as the U.S. program has been
implemented. Cap and trade is compatible with a competitive energy sector.
OTHER CONSIDERATIONS
Are there any social or economic
factors limiting fuel choices?
Are the needed emission
reductions politically acceptable?
Is emission trading politically
acceptable?
Concerns about unemployment in the coal mining industry were a
significant factor in the United States.
The process for assessing policy approaches to address acid rain involved
many government agencies. After the Act was passed, there was an extensive
stakeholder process, including an Acid Rain Advisory Committee, to solicit
input into implementing regulations. Outreach is continuously needed to help
educate the public about the environmental benefits of emission trading.
B-3
Example Assessment of the Potential For Cap and Trade
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&EPA
United States
Environmental Protection
Agency
Office of Air and Radiation Clean Air Markets Division (6204N)
EPA430-B-03-002
www.epa.gov/airmarkets
June 2003
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