Market for SO<sub>2</sub> emissions

By Daniel K. Benjamin

The results of the SO2 tradable emissions program are in-- and the economists were right.

Economists have long argued that tradable emissions permits are, in principle, superior to the command-and-control approach in reducing pollution. Traditional regulators have disagreed. The results of a pioneer trading program are now in, and they suggest that the economists are correct--which may not come as a complete surprise to regular readers of this column.

Command-and-control regulation generally requires that different emission sources meet the same pollution standards, whatever the cost. Yet controlling pollution from one smokestack may be far more expensive than controlling it from another. Economists contend that by trading the right to emit a specific amount of pollution, industries can conserve resources without harming the environment--because the same amount of pollutants are emitted overall. Proponents of source-specific emissions standards counter that uncertainty and ignorance preclude effective markets in emissions permits.

Paul L. Joskow, Richard Schmalensee, and Elizabeth M. Bailey (1998) studied the consequences of the Clean Air Act Amendments of 1990, which initiated the first large-scale use of the tradable permit approach. This involved control of sulfur dioxide (SO2) emissions, which are produced when utilities burn coal and oil to generate electricity. SO2 is a precursor of acid rain and other acidic depositions, and Title IV was designed to reduce such depositions. It sets an annual limit on the total number of tons of SO2 emissions from major electric utilities. Each utility must have a so-called "allowance" for each ton of SO2 it emits each year.

The SO2 allowances have some characteristics of property rights; for example, anyone is legally permitted to buy or sell allowances at market-determined prices. Because the allowances are standardized (each represents the right to emit one ton of SO2) and the major potential traders (electric utilities) are likely to be well-informed, trade should be feasible at very low transaction costs, just as we find in stock and bond markets. Moreover, these same characteristics should yield substantial uniformity in prices across trades: After all, why would the seller of an allowance accept less (or a buyer pay more) than an alternative available elsewhere in the market?

Still, this approach had never been tried on a large scale, and there was substantial uncertainty about the costs of reducing emissions (and hence the value of the allowances). As reflected in more than 200 pages of congressional testimony opposing the program, many commentators felt that trading costs would be high, and few trades were likely to occur. If so, no significant benefits would result. Such concerns convinced Congress to order the Environmental Protection Agency to "jump start" the market by offering allowances for sale each year at a nationwide auction.

As it turns out, although the EPA auctions probably helped get the trading process started, the expansion in private trades has been so rapid and extensive that the auctions are now a minor part of the market. Perhaps more importantly, the private market in allowances has proved to be extraordinarily efficient at doing what it was designed to do--move allowances to their highest-valued locations, permit equalization of control costs across sources, and generate a key source of information about the costs of reducing SO2 emissions.

Joskow et al. have found that after an initial 12-18 month period in which there were few private trades and relatively high prices for the allowances--some $250-$300 per ton--the market evolved rapidly. By mid-1994 prices had dropped below $150 per ton and the volume of private trades exceeded the volume offered in the EPA auction. Since then, prices have fallen to about $100 per ton, and private trading of allowances for more than 5 million
tons per year now dwarfs the EPA auction by a factor of 15 to 1.

This research also has uncovered two other, even more significant, facts. First, the costs of trading allowances are quite low--on the order of about 2 percent of the prevailing price. In addition, it appears that the prices at which trade takes place at any point in time are all quite close to one another. The spread between average bids and lowest winning bids at EPA auctions is only about 1-3 percent, and trading in the private market appears to be similarly concentrated around a single price at any point in time.

Because utilities can freely choose between either abating or emitting each ton of SO2, they will only pay for an allowance what it will save them in abatement costs. Equivalently, a utility will pay no more for abatement than it would pay for an allowance to emit the SO2. Thus, the existence of a common price for allowances assures us that the cost per ton of cutting emissions must be at that same level: The costs of abating SO2 emissions must be running about $100 per ton. We can now sensibly ask the question: Is it worth it?

For a variety of reasons, even the tradable emissions approach used with SO2 has serious drawbacks: Most notably, the annual cap on emissions is set by government fiat, and we have no way of knowing if the height of the cap (soon to be reduced to 9 million tons per year) makes any sense. Still, it seems apparent from the work of Joskow et al. that tradable permits offer every advantage suggested by their proponents. In particular, the findings of this research imply that the total costs of achieving the current SO2 cap are at a minimum--and surely lower than under command-and-control. Perhaps now some serious consideration will be given to environmental protection systems in which there is even less administrative control by the government.

REFERENCE
Joskow, Paul L., Richard Schmalensee, and Elizabeth M. Bailey. 1998. The Market for Sulfur Dioxide Emissions. American Economic Review (September): 669-85.


Daniel K. Benjamin is a PERC senior associate and professor of economics at Clemson University. His regular column, "Tangents-Where Research and Policy Meet," investigates policy implications of recent academic research. He can be reached at: wahoo@clemson.edu

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The effect of government policy changes on the private sector has been the unifying theme that ties together Daniel K. Benjamin's broad-scale research. He not only examines the outcomes of policy changes, but also the reasons behind the modifications.Taxes, unemployment, risk assessment, and drugs have been the focus of much of Benjamin's...
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