Clifford S . Russell Resources for the Future Washinaton. D.C. 20036
Controlled trading of poIIution permits How might these economic incentives for environmental protection work in practice?
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Environmental Science
Technology
The triple threat of continuing stagflation, increasing energy prices, and deepening antagonism toward government regulatory activity gives a new urgency to our continuing debate over the wisdom of the environmental legislation of the 1970s, and its implementation. Readers of this journal will easily remember the catalog of complaints lodged against that legislative and regulatory record. For example: the absence of incentives to technological innovation; the inflexibility of the system in‘ the face of economic growth and change; the disregard, implicit or explicit, of economic efficiency in meeting ambient quality targets; the implied requirements that comprehensive and detailed information on individual pollution sources be available to EPA; and EPA’s need to make fine technical judgments in writing technology-based standards. The points at issue are familiar. but the new economic situation and changing political climate seem to have shifted the balance of power among the debaters and to have raised the possible stakes. To oversimplify, environmentalists have been put 00 the defensive while their opponents attack. And both sides sense that the battle will be over more fundamental matters than regulatory calendars and review, economic impact statements, and limitations on hearing participation; sweeping changes in philosophy and approach are possible. Sensing this shift, a number of persons within EPA, the environmental groups, and the research world have been casting about for policy innovations that would address some of the most glaring flaws of the existing system without requiring that we abandon its goals or turn our backs on a decade of effort and experience. This search has led a remarkable number of people to turn to one or another version of an economic incentive system that might be given the generic name “controlled trading of permits to pollute” (I). The idea of creating and distributing marketable permits to pollute and allowing those permits to be traded by polluters (and possibly environmentalists) can be traced back a t least to
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1981 American Chemical Society
Dales (2). Many important and interesting things were subsequently said about tradable permit systems by such authors as Montgomery (3), DeLucia ( 4 ) , Tietenberg ( 5 ) , and Rose-Ackerman ( 6 ) . But it is fair to say that the idea was even more firmly locked in the economists’ curio niche than were effluent charges, which at least received periodic airing on Capitol Hill and which were parts of pollution control systems in Europe ( 7 ) . It would be fascinating someday to unravel the ball of accident and design that has led in the past two or three years to the reversal of this order of prominence; to the establishment within EPA of a group devoted to advancing the cause of “controlled trading”; to the rapid increase in the quantity of ongoing research on the subject; and to the establishment of related experiments in several regions of the US. As this paper was completed, the Maryland Economic Development Administration proposed a statewide system of marketable permits (8). Certainly fundamental importance must be attached to the EPA innovations known as “offsets” and the “bubble policy.” Each of these represents a step toward flexibility and economic efficiency. And while their origins may have been in efforts to squeeze out from between a political rock and a legal hard place, their mere existence made it clear that incremental changes under existing law could be used to attack the most obvious defects in the edifice we had built. In addition, it was far from trivial that sOme industrial spokesmen endorsed the bubble ( 9 ) , that many firms actually played the offset game (IO), and that some environmentalists began advocating similar procedures for dealing with other, related difficulties (11). Whatever the political history, we are today faced with serious proposals for a bewildering array of variations on the controlled-trading theme. General and specific claims about the virtues of each variation are made; general and specific. warnings and objections are also advanced. It is too early to say which problems are real and which are merely figments of economic or bureaucratic imagination. But it is at least possible to bring together some results, to separate questions of theory from those of fact, and to make clear some of the things controlled trading cannot do. How it works At its simplest, the idea of tradable permits involves a public (political) decision on the amount of pollution the
region or society is willing to tolerate, the definition and distribution of rights to produce that much pollution, and the encouragement of a market in those rights in which a price would be established. This price would act as a signal to existing and potential polluters, stimulating some version of static economic efficiency and continually spurring the development of improved control technology. It is when we try to define our terms more carefully and to make our hypothetical system fit reasonably well with the existing laws and regulations, not to mention the political realities, that we create complexity. The easiest Bystem to understand, and the earliest suggested, is the regional emission-rights market. The total allowable emission load for a region is the public decision. Rights to emit that total (or the total less some margin for error or government influence on growth) are auctioned (or issued free) to dischargers, who may then trade those rights to others. The functioning of the market equalizes marginal costs of emission reduction so that the total allowed load is produced at lowest possible cost. In addition, regional growth could “automatically’’ be accommodated by market trades. But this system is not always consistent with the maintenance of ambient standards. Even if the initial emission ceiling were determined from such a standard and an air quality model, subsequent trades could lead to violations of the ambient standard as dischargers were shifted around the region. (Location shifts would not be a problem if there were perfect mixing of discharges in the environment. For example, the locations of hydrocarbon and NO, sources may not matter in the context of a regional smog problem.) In addition, the system seems to abandon the technology-based emission standards being developed under current law. A more sophisticated system would issue rights to pollute at particular monitoring points. The number of rights issued for a point could be made consistent with the ambient standards by requiring each source in the region to hold a portfolio of rights for all the points affected (according to an air quality model) by its discharge. Assuming that a decentralized market in such rights could be sustained, it would produce the lowest cost of emission reduction necessary to meet the ambient standard. But operation of a such a complex set of markets poses practical problems. Moreover, there are difficulties in fitting such a system into the framework of technology-based
emission standards. A compromise between these first two suggestions is the zone-discharge permit system, in which permits to discharge are tradable only within sub-regional zones. The idea is to marry the simplicity of emission trading with some protection for ambient standards. Other compromises include systems of emission rights tradable only in accordance with “trading ratios,” which define the relative effects of two sources at a given monitoring point. Such a ratio would connect each pair of potential trading partners in relation to each ambient monitoring point; the ratio implying the strictest conditions would govern the trade. When the point of departure is the technology-based emission standards rather than ambient quality, the systems take such forms as the “tradable emission reduction assessments” (TERA), and the banking and trading of emission reduction certificates. The former is aimed at nonattainment areas; the emission reduction assessments are those required-beyond the “normal” reductions implied by technological guidelines-in order to get the region into attainment. Under this scheme, these extra efforts would be tradable so that a source with high marginal cost for reducing emissions could pay for the extra effort to be made at sources with low marginal cost. A very similar system has been suggested for water pollution control where maintenance of stream quality standards requires greater effort than would be defined by BAT (12). Bankable and tradable emission reduction certificates (13-15) would extend the existing offset policy by allowing for a delay between an emission reduction and the effective demand for an offset. In both these systems, the maintenance of ambient quality standards would depend on the specification of trading equivalences so that emission reductions or extra emission reductions could not be traded pound for pound between any pair of discharge allocations, but only at ratios reflecting relative effects on ambient quality. A slightly different approach to coping with growth is the emission density zoning proposal, in which allowable emission densities (e.g., tons of SO2 per acre, or presumably pounds of BOD per mile of shoreline) would be defined for all the parcels of land in the region. These “density permits’’ would subsequently be tradable, subject to restrictions aimed at preventing “hot spots” (ambient quality standard violations), through excessive concentration of density rights. (There would Volume 15, Number 1, January 1981
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also have to be restrictions on characteristics of the emission arrangement, such as stack height, exit-gas temperature, and velocity.)
How it pays off It should be clear from the brief descriptions above that a complete assessment of the theoretical and practical advantages of controlled trading can only be done on the basis of careful analysis of the peculiarities of each system. And even then we could never really pick a “best” system, because they do not share the same goals. Some aim principally at providing a circumscribed property right that will form the basis for a continuing market; others concentrate on the improvement of methods for the initial distribution of some right created implicitly by the existing system. Some of the systems depart from NAAQS and related PSD rules; others begin at the discharge side and include more or less stringent constraints with the purpose of preventing (at least) the worst possible violations of ambient standards. But to the extent that any decentralized trading among sources is actually allowed and feasible, there will be a tendency toward least-cost distribution of the burden of meeting the public policy requirement (either ambient standards or a regional emission total). Trading will also continually spur technological innovation in emissionreduction technology, will allow for adaptation to economic growth and change without government agency intervention and without violation of the ambient or emission constraints imposed, and will reduce the information and judgment load on federal and state environmental agencies. On the practical side, there are related advantages. Trading systems depend on private decisions only to determine prices, not to determine ambient effects or emission totals; this will be comforting to those who mistrust markets and find effluent or emission charges undesirable because they appear to leave the really important decisions to polluters who may be stupid, stubborn, or perverse. On the other hand, the trading systems get the government out of the business of determining how regions can grow and which firms and industries will obtain the benefits of growth. Most important, controlled trading would be an incremental change to the existing system: Congress, EPA, industry, or environmentalists would not be asked to scrap everything they have invested during the past 10 years. 26
Environmental Science & Technology
How it doesn’t work It is easy, especially for economists, to become so enthusiastic about these marketlike systems as to leave the impression they will solve all our pollution problems. But of course they cannot; pollution has characteristics that make it impossible for these controlled trading systems to develop into complete and reasonably self-regulating markets. Most fundamentally, controlled trading cannot banish politics and political decisions. Whatever quantity is to be allowed, and hence tradable, must be decided on by the political process. (Though there is a small chance that environmental groups could alter these quantities in a market system by buying up rights and retiring them.) The method of initially distributing the implied permits or rights must be a political decision, too. If these created assets really do have nonzero prices (as is always assumed), whatever method we choose will make some people (regions, firms) better off and some worse off. For example: Free distribution to existing sources of tradable permits to discharge pollution, written on the basis of acceptable permits under existing laws and regulations, would be a windfall to existing polluters-at the expense of “potential sources’’ such as expanding industries. Conversely, if the initial distribution of rights were via an auction, existing sources would suffer a loss, as they would have to purchase what they now get free. Another problem is the incentive for dischargers to quarrel with EPA or state agency determinations-for example, to take the agency to court over the determination of the initial permit. This means that delay would still be a feature, at least initially, of our environmental quality program. Administrative and judicial appeals of agency decisions take time even if the dischargers play the game with good will. Controlled trading would not relax the need for pollution control agencies to monitor emissions and be prepared to punish violators of permit terms. There is no incentive, as there is in a normal market in private goods and services, for the buyer of a permit to see that the seller actually reduces his discharge. The buyer and seller of a permit can both discharge the permitted amount without doing each other any harm. The same ton of copper, the same trademark, or the same office premises cannot be used by both buyer and seller (without at least severely inconveniencing each other); only in markets for unsharable (pri-
vate) goods and services does the buyer have an incentive to enforce the terms of the sales contract against the seller. It is even possible that the monitoring job of public agencies will become more difficult under a controlled trading system. It will be necessary to keep an up-to-date registry of permit terms reflecting trades and to make sure that the inonitoring arm of the agency always has up-to-date information on what it is supposed to be monitoring. There is also a special difficulty in monitoring a system with permits defined as ambient quality decrements. In such a system, direct monitoring of permit compliance will be impossible, and acceptable rules will have to be worked out for monitoring discharge as a surrogate for permit performance. (This is because the contributions to pollution at ambient quality monitoring points cannot be directly identified with specific dischargers. Only by using a dispersion model and a discharge measure can one source’s contribution be estimated. And if there are nonlinear reactions involved, the task becomes impossible.) Finally, adopting some version of controlled trading would not help us draw the regional boundaries for environmental quality regions. The above discussion has made the implicit assumption that we can design a tidy system of regions within which permits will be tradable and between which there will be no transboundary effects. This assumption is, of course, unwarranted, and the questions raised by the possibilities of interregional trading will only make the difficulties inherent in regionalization more obvious. For example: Where there is currently significant transboundary transport of pollution, we could enlarge the region to allow all sources to trade with each other. But the bigger the region, the more likely are “hot spot” problems if emission permits are the chosen trading vehicle.
How do we find out? The last section contained four general features of our environmental quality management system that controlled trading will in principle not affect-or that it might even make more difficult. In addition there are many specific cautions and questions in the controlled trading literature which have to do with these systems and about which it is often difficult to make unequivocal comments based on theoretical arguments. Several of these are worth discussing: It is easy to say that controlled
trading is just an extension of the current system (especially for air pollution), but it is likely to beverydifficult to obtain agreement on the details of that extension. The flavor of the difficulties can be found in a critique of the bubble policy by Dubrowski and Herzberg ( 1 6 ) . They point out, for example, that peculiarities of state implementation plans may imply that some sources get “rights” to emissions they do not produce because their boilers burn oil or gas but have permits based on use of coal. Such details would plague any attempt to define and distribute fully tradable rights. Many students and advocates of controlled trading are concerned with the “thinness” of the resulting markets. Some regions may be dominated by just a few large sources who could act as monopoly buyers or sellers in the regional rights market. A related problem foreseen by some is the possibility that if a single industry dominates a particular region, the existing plants could conspire, implicitly if not explicitly, to keep out competitors. Another concern about thinness, even where there are many potential buyers and sellers, IS that there will simply be too little change over time to free up permits or to increase demand for +hem
It is difficult to say much about market thinness in the absence of experience with real markets, but some suggestive data on the number of sources of air pollution, with actual emissions greater than 50 tons/y, by county, have been put together by Repetto ( 1 7 ) . These data show that although many counties (which are, after all, only subunits of air quality control regions) have zero or one large source, 40-50% of all counties have more than one large existing source of SO2 or particles or both. Indeed, hundreds of counties have IO or more sources of one or the other pollutant. An exercise we have undertaken at Resources for the Futurespeaks to the matter of change over time. We calculated, for the steel, paper, and petroleum-refining industries in the I 1 -county Delaware River Estuary Region, the changes in permit use for three water pollutants (BOD, total suspended solids, and ammonia) that would hnue resulted from growth, changing technology, and changing product mix over the period 1940-78. These calculations assume that the plants existing in 1940 would have owned permits defined by the EPA permit-writing rules, that building of new sources would have required the plant to obtain permits equal to those defined on the new-source rules, and
that contraction or disappearance of the plant would have brought to market the associated permits. The results of these calculations, summarized in Table I,show that growth would have dominated a market for permits during this period of expansion. (Of course, our calculations inevitably reflect the reality that the strict requirements of the 1970s did not apply during most of the period and that pollution was zero-priced.) But below the decadal excess demand for permits, there was, for almost every decade and every
pothetical changes in p r, and petroleum Ind
.
pollutant, a substantial number of permits freed up by plant closings, capacity -contractions, product mix changes, or other causes. These figures suggest that in a complex industrial region the normal play of economic and technological forces will produce the potential for significant number of trades. Whether the potential sellers will actually sell will depend not only on their own perversity but also on their view of the permanence and stability of the controlled tradingsystem itself. No one will be anxious to sell if
its required by the steel,
...
achieving decrease
. ..
No. of plants
requiring increase No. of plants
achieving decrease . .
Gross increase
m m c i i n g he tab
Peboleumrafh
Petroleum refining:40 CFR419
Volume 15, Number 1. January 1981 27
there is a significant probability of getting caught out by a switch back to a nontrading arrangement. Concerns about ambient quality and market thinness, and distrust of markets more generally, have led advocates of controlled trading along many different lines of “control.” A recurring theme is the limited-term permit, which, by expiring every five years, for example, would allow the public agency “flexibility” in adjusting the number of allowable permits without the complications of the “taking”issue. What this would mean for industry support-flexibility looking like arbitrariness from that side of the desk-is open to question. Others are willing to contemplate permanent rights but not private trading of these rights. They see periodic public auctions or a government “pollution rights marketing board” as the answer to such problems as trades designed merely to evade monitoring. Again, permits defined as rights to decrease ambient quality at specific monitoring points or over specific areas seem to present special trading problems. Even if all the other sources of difficulty, such as market thinness, are assumed away, it is still possible that a truly decentralized market in ambient quality rights will not bestablethat is, an equilibrium might not emerge from trading, even though potentially there might be a set of rights prices that would constitute an equilibrium. This possibility is disturbing because it has been shown that the equilibrium for such a market involves the most efficient set of discharge reduction activities for the chosen ambient standards (3). But if such an equilibrium could only be approached via government-directed trading, one of the greatest advantages of controlled trading-the greatly reduced information requirements of public agencies-would be wiped out. Controlled trading holds real promise of reducing some of the most disturbing deficiencies of our existing system of pollution management. Moreover, there is hope that this promise is backed up. by. .practical. political advantages and by growing Political support. We should be careful, however, not to expect too much. As in other policy areas, we cannot have all the good things at once. Static efficiency may be purchased at the price of heavy government involvement in the markets. A workable system supplying Some continual spur to technical advance may require that we accept the possi28
Environmental Science (L Technology
bility of some violations of ambient quality standards. But many of the doubts and questions about controlled trading cannot be assessed or answered until we have tried it. And here we come up against another serious difficulty: W e can only obtain answers if the system is taken seriously and the rights are viewed as real assets and are traded according to their real value. But a n experiment cannot, by its nature, provide the necessary assurances, and actions taken (or not taken) are more likely to reflect the prospect of a return to the existing system than valid plays of the controlled trading game. Therefore, we must put a premium on research that offers evidence relative to our doubts, and steel ourselves to a long-term trial of this option in some pollution field having fairly simple characteristics: for example. one in which a large number of firms (and municipalities perhaps) discharge pollution in such a way that the activity’s location is not important in determining its ambient effects. One such possibility may be Ocean dumping of sewage treatment sludge, for discharge is then divorced from activity location and is made essentially uniform by definition of permitted spoil areas. Another possibility is the control of conservative water pollutants such .as salt and phosphorus (12). These initial applications should of course be observed closely, but not so closely that our observation interferes with the functioning of markets. We then might be in a better position to say something about problems of writing the intial permits, of market thinness, of monitoring and enforcement, and about the prospects for environmentalist participation. This would be a firmer base for extension of the system to more complex situations-especially ones in which location matters.
(2) Dales. 1. “Pollution. Property and Prices”: University olToronto Press: 1968. (3) Montgomery. David. 1972. “Markets in Licenses and Efficient Pollution Control Programs.” Journoiof Economic Thewry, V ID~C.)pp. 395-418. (4) DeLucia. Russell. “Evaluation 01 Mnrketable Effluent Permit Systems”: Office 01 Research and Dcvclapmcnt. U.S. EPA. Washington. (5) Tietenberg. Thomas H. 1974. “The Design 01 Property Rights lor Air-Pollution Control,’’ Public Poiicy Vol. 22 (Summcr) pp. 27507L.
(6) Rose-Ackermnn. Susan. 1977. “Market Madels for Water Pollution Control: Their Strengths and Weaknesses.” Public Policy Vol. 25 (Summer) pp. 283-406. (7) Johnson, Ralph and Gardner Brown. 1976. “CkaninK UPEurovc’s Watcrs”(New York Praeger Pubiishersj. ( 8 ) Woshingron Posr. 1980. “Maryland Proposes that Firms Buy and Sell Air Pollution Rights.” (30 July) p. A . I . (9) Enuironmenral Hrolrh Lnrer. “Armco Steel Endorses EPA’r ‘Bubble’ Concept, Says it Works.” Feb. I S . 1980.p. 5. ( I O ) Lirall. Richard A. 1980. Air Pollulion OfJrers (Washington: The Conservation Foundation). ( II) Rauch, Robert J. No date.“Air Pollution Issues for the 1980‘s.” (Washington, D.C.: Environmentnl Defense Fund) xerox (12) David. Martin et 31. 1980. Worer Re. .SUUICC.S Rrsearch 16(2). p. 263-70. ( I3) The Urban Institute. 1979.“Balancing the Objectives of Clean Air and Economic Growth: Regulated Markets in Emission Reductions.”.A report prepared lor Experimental Technology Incentives Program, National Bureau o l Standards (Washington. D.C.:The Urban Institute) June (14) ICF. Inc. 1980.“Concept Paper: Emission Reduction Banking and Trading Systems..” Dralt. (Washington. D.C.: ICF. Inc.) ( 15) “Emissions Banking and Trading Systcl] Becomes a Regulatory Program at EPA, AirlWaler Pollution Report. May 19. 1980. p. 194. (16) Dubrowski. Frances; Herzberg. Peter. “Comments 01 the Natural Resources De-
Wari>an. D.C..‘NRDC’and SLDF.
(17) Repato. Robert. 1979.“Economic Systems lor the Allocation of Entitlements to Degrade Air Quality in Clean Air Areas Under Prevention olSignilicant Detcrioration Rules.“ (Cambridge, Mass.: Harvard Schwl o l Public Health) unpublished.
Acknowledgments I am grateful to the Alfred P. Sloan Foundation for its support of research on
marketable permits in environmental management. The views expressed here are, however, my own and not those of either the foundation or Resources for the Future. Thanks are also due to Charles Paulsen for research assistance. and to Blair Bower, Emery Castle. Allen’ Kneese, and Jeff Vaughn for comments on an earlier draft. None of them bear any responsjbility for remaining or inadequa.
Clifford Russell received a ph.D. in economics from Haruard Uniuer.sify in i 968. Since then he has been employed ar c,es, Resources for the Future, working prinripally on fhe economics of enuironmenral quality. H e has .wrirren on linear prozramming models of industrial pollution ~~f~~~~~~ control. regional modeling for rhe analysis ~ of enuironmenra/po/icy ~ ~ l ~ quesrions. . and the ( I ) WoFhingronposr. 1980, “Federal ~ tors circle the wagons: (25 ~ “ 1 ~ ) use of efluenr charges in pollurion conp. E.I. rrol.
