The Evolving SO2 Allowance Market: Title IV, CAIR, and Beyond

Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.

This week, David Evans and Karen Palmer discuss the sulfur dioxide cap-and-trade system. While the program has been highly successful in generating substantial pollution-related health benefits at relatively low cost, the authors suggest ways to make the program still more efficient. They also consider recent regulatory initiatives, and how they may have contributed to the recent volatility in SO2 allowance prices.

During the summer commentaries will be posted once every two weeks

Recent congressional debates over a potential cap-and-trade program to combat global warming have brought renewed attention to the sulfur dioxide (SO2) cap-and-trade program established in 1990 under Title IV of the Clean Air Act. This program has brought about large reductions in SO2 emissions from the electricity sector and at a dramatically lower cost than originally anticipated, demonstrating that cap-and-trade programs can work in practice as well as in theory. However, researchers have identified potential improvements to the program and regulatory initiatives are motivating further SO2 reductions. These initiatives, in turn, have been subject to legal uncertainty that has influenced the market for SO2 allowances.

Title IV

The primary motivation for the SO2 program was to reduce ecological damages from acid rain—the deposition of sulfuric compounds into soils and waterways—in regions distant from emitting power plants. Under the program, firms are required to surrender one allowance for each ton of SO2 emitted. Firms may transfer allowances to other firms and bank them for future use. While there are few restrictions on allowance transactions, there are strict emissions monitoring requirements, which provide regulators confidence in the environmental performance of the program and affected firms confidence in the market.

The goal of the program is ultimately to cap annual emissions from electricity generators to 8.95 million tons, a 10 million ton drop from the 1980 level. Reductions to achieve this goal took place in two phases. Phase I began in 1995 and affected the 110 dirtiest coal-fired generating facilities. In Phase II, which started in 2000, most other coal-fired facilities came under the program and the allocation of allowances to Phase I sources was reduced by slightly over half. Emissions reductions have resulted largely from installation of post-combustion scrubbers and a shift from high-sulfur coal from the east to western low-sulfur coal, which was facilitated by lower freight prices following railroad deregulation.

While the program was motivated by concerns over acid rain, it has also reduced fine particulate matter concentrations, creating health benefits that are an order of magnitude greater than the costs of the program. Reductions in acid deposition have produced ecological benefits as well, but those estimated benefits are small relative to the human health benefits.

Improving Upon the Title IV Program

Despite the success of the Title IV program to date, significant improvements in SO2 control can be made along two dimensions: the level of the cap and the location of emissions.

For the current cap, the marginal cost of reducing emissions is around $150 to $300 per ton, which is well below the $1,800 to $4,700 per-ton estimates of the marginal benefit of further reductions. An annual cap that maximizes the net economic benefits of the program would be between 1 and 3 million tons and yield a $3.6 billion to $23.5 billion increase in annual net benefits.

Requiring plants that cause more damages due to their location to surrender more allowances per ton emitted than those that cause less damage would also increase the benefits of the program. The estimated annual gains from such spatial refinement are around $310 million to $940 million.

Another potential improvement to the regulation of SO2 would be to use an emissions tax approach. Given that the damage from an additional ton of emissions is roughly constant with respect to SO2 emissions levels, a tax per ton equal to the additional damage is a preferable method for controlling SO2 as the tax will always yield an emissions level that maximizes net benefits regardless of the level of control costs. This is true even if SO2 control costs change because of the regulation of other pollutants, such as carbon dioxide.

In May 2005, the U.S. Environmental Protection Agency (EPA) adopted the Clean Air Interstate Rule (CAIR), which both effectively reduces the Title IV cap and treats facilities differently based on their location. In part, the purpose of the CAIR is to reduce SO2 emissions in upwind states that contribute to violations of EPA’s primary ambient air quality standards for fine particulates in the eastern United States. The primary ambient standards are intended to be protective of human health. The CAIR SO2 program only applies to facilities in 25 eastern states and the District of Columbia. Sources subject to CAIR must surrender 2 Title IV allowances for every ton of emissions from 2010 to 2014, and 2.86 allowances for every ton thereafter.

In July 2008, the DC Circuit Court of Appeals vacated CAIR in part because the trading program could not assure protection of downwind ambient air quality; however, in December 2008, the court allowed EPA to administer CAIR while it develops a replacement program. The form of the replacement EPA will adopt is unknown, but modifying a cap-and-trade approach to meet these concerns may be both more effective and less costly than a conventional approach, like imposing emission rate standards. Furthermore, while it is possible for the allowance market to move emissions across space, it is also possible for the electricity market to do the same with an emission rate program.

The allowance price provides information regarding market conditions and expectations, and we see this in the market response to the CAIR rulings. For example, when CAIR was vacated, the price of an allowance that can be used this year (that is, the spot price) fell from $300 to $80, and on news of the decision to temporarily reinstate CAIR, the price rose from $140 to $210. Currently, 2010 allowances are trading at about half the $70 spot price, reflecting expectations that the CAIR 2-to-1 2010 compliance rate will hold in the near term. The long term suggests a different story. In March 2009 EPA auctioned Title IV allowances that can be used beginning in 2016. The clearing price for these allowances was $6.65, about two-thirds lower than the price suggested by a combination of the 2016 2.86-to-1 compliance rate and recent prices of allowances that can be used after 2010.

The CAIR rulings, current financial conditions, and depressed electricity demand help explain recent declines in the spot price. However, it is not clear why the recent auction price for 2016 allowances is low relative to the current spot price, although there are a few possible explanations. Notably, EPA has suggested that it will take about two years to develop a replacement for CAIR. If the replacement does not implicitly adjust the Title IV cap through compliance rates, as the court’s ruling seems to prohibit, then the Title IV cap would become slack. Expectations of future carbon dioxide regulation may also be influencing the allowance price. For example, EPA climate bill analyses, which include CAIR in the baseline, forecast about a 60 percent reduction in the Title IV allowance price from capping carbon dioxide, but they also predict a decline in the spot price.

Concluding Thoughts

The SO2 trading program has been a success, but there is still room for improvement. The regulation of SO2 will continue to develop over time, which is a lesson for the design of new cap-and-trade programs. An advantage of a cap-and-trade program is that the allowance price provides information about how the market views changing market conditions and the likelihood of future regulatory developments.