Cost-Effective Control of Urban Smog

The Significance of the Chicago Cap-and-Trade Approach

Richard Kosobud, Houston Stokes, Carol Tallarico, Brian Scott

• Publisher: Taylor & Francis
• Year: 2006
• eBook ISBN: 9781135990305
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Containing rigorous hard evidence, this book is of immense practical use to postgraduates, researchers and business communities affected by or working in environmental regulation. The author, a leading name in the environmental economics community, examines the problem of urban smog in cityscapes and the difficulty of achieving cost-effective controls.

Analyzing the key areas of urban smog, low-level ozone and volatile organic compound emissions and their impact on health and welfare of communities this text assesses and evaluates the performance of emissions trading systems and suggests alternative market designs for incentive control of pollution. Taking a well-reasoned approach to the contentious area of the use of market incentives to achieve environmental goals, it provides a study of the pioneering cap-and-trade market, particularly focusing on its poor performance in Chicago.

A perfect supplementary text postgraduates and researchers, this is also an essential read for all those interested in environmental economics.

1
Introduction

Objectives

Any comprehensive effort to describe and analyze a pioneering and innovative environmental regulatory measure based on market incentives designed to control a serious urban air quality problem deserves more than the customary brief introduction. This serious problem concerns the harms and welfare losses attributable to low-level ozone and one of its precursors, volatile organic compound (VOC) emissions. This book aims to be that comprehensive effort covering the initial contentious market design discussions, the expectations and actual performance of the regulation during the first years, the surprises and problems encountered, the search for and diagnosis of the causes of the problems, and, finally, the proposals to redesign the market to achieve improved air quality.

While each of the four authors had a special responsibility for particular chapters dealing with these topics, the separate contributions were thoroughly discussed and integrated so that the book is meant to be read from start to finish, with subsequent presentations building on prior work. Nevertheless, it is recognized that some readers may be more interested in the market performance, others in the statistical analysis of problems, and yet others in the policy conclusions. Therefore, this introduction has been prepared as a guide outlining the major topics presented in each chapter. This introduction may also be valuable for readers desiring a substantive overview before taking up the important content and details.

As a general introduction, the authors call attention to the recent development of emissions trading, especially the cap-and-trade variant, as a now well-received and potentially more cost-effective, flexible, and less confrontational choice than traditional regulations for control of environmental quality. By traditional regulations the authors refer to centralized mandating by the US Environmental Protection Agency (US EPA) of pollutant emission rates and/or control technologies. Marginal control costs are typically not equalized under this regulatory regime, frequently termed command-and-control.

By cap-and-trade market the authors refer to the decentralized design of an environmental market in which the government allocates tradable permits to emitters that reduce prevailing or historical pollution levels. The emitters, assumed to be cost minimizers, are free to trade permits, bank them, or choose control measures. The government collects a permit for each unit of pollution emitted and monitors and enforces market rules, but allows emitters to make the micro-control and permit portfolio decisions. In theory, marginal control costs are equalized across all emitters when the market is in equilibrium, leading to control costs typically below those of centralized regulation. This latter model and departures from it underlie much of this book and is explained in detail in Chapter 5.

Not long ago, the use of decentralized market incentives was hardly on the agenda of the regulating and regulated communities, and certainly not on the agenda of the environmental communities. It was to be found in the table of contents of economic journals where the theory was under serious consideration. Such studies while demonstrating the cost-effectiveness and flexibility of market incentives were not sufficient in and of themselves to have them adopted as a matter of public policy, as the authors shall explain. What mattered more were the increasing costs imposed by traditional regulations.

The national sulfur dioxide (SO₂) trading system, a cap-and-trade market, established by the US Clean Air Act Amendments of 1990 (CAAA 1990), was a major breakthrough and is now widely regarded as a success (Ellerman et al. 1997:64). Other cap-and-trade markets, for example, the US EPA-managed nitrogen oxides (NO_X) trading system is being closely monitored and now seems well on its way to a successful implementation. The European Community is developing cap-and-trade systems in an effort to reduce carbon dioxide (CO₂) emissions (Kruger and Pizer 2004:8–23). An extension to other pollutants, such as VOC emissions, seemed a natural next step. Both VOC emissions as a precursor of urban ozone concentrations and the concentrations themselves have adverse health and visibility effects and are important constituents of urban smog.

This book is focused on the market control of VOC and urban ozone because designing a market for these pollutants raises special considerations and challenges. The authors evaluate the performance of a cap-and-trade market to reduce stationary-source air emissions of VOC in the Chicago ozone nonattainment area, one of the first market systems implemented in an effort to reduce an urban pollutant rather than a regional, national, or global air quality problem. The diversity of hydrocarbons that make up VOC emissions, the inclusion of hazardous air pollutants as a subset, the wide variety and complexity of sources of these emissions with challenging problems of measurement, and the existence of a complex set of traditional regulations already in effect all created special issues and choices in designing a market system, and in formulating effective market rules and emission measurement protocols. Despite these complications, the expectations were for another success story when the new program began in 2000.

In general, the merits of a decentralized trading approach to reducing pollution have often been expressed and analyzed by economists in abstract models and a version of that analysis will be presented in a later chapter. However, there remained an unease among some observers, including many environmental groups, a number of businesses, and even some regulators, about possible problems with the use of autonomous and anonymous markets in environmental regulation. For example, environmental groups were concerned about hot spots, business participants about benchmarks and permit prices, and regulators about emissions measurement and monitoring. Many of these views were contentious and entered into the market design decisions. They also were influential in the decision by the Illinois Environmental Protection Agency (IEPA) to retain and extend traditional regulations while developing an emissions trading approach to be placed along side the former. This unique feature of the pioneering Chicago program, a dual centralized and decentralized regulation of VOC emissions, has played a major role in the cap-and-trade market design and its implementation. A detailed explanation and analysis of the consequences of this combined regulation will be one of the major objectives of this book.

The book has other important objectives. It aims to provide a detailed description of the first four years of performance of the VOC cap-and-trade market, presenting the facts given by the IEPA plus data generated by our own accounting. That is, the authors provide seasonal data on benchmark emissions, allotments of tradable permits, emissions covered by the return to the agency of tradable permits, banks, and prices of permits in addition to our estimates of expirations or non-use of dated permits. The intention is to evaluate these data to determine the extent to which the VOC cap-and-trade market has met its air quality, cost-effectiveness, and flexibility goals. Whether these goals have been met by the performance of the market will require a probing beneath the observable data. To the extent the program has fallen short of its goals, as the authors find in this research, it provides a strong motivation to search for and provide evidence on the relative importance of each cause or explanation of the shortfall as a preliminary guide to redesign of the market.

Also, it is our intention to evaluate the extent to which the cap-and-trade approach used in Chicago can be recommended to other urban areas confronted with VOC emissions and low-level ozone. To satisfy these objectives requires that the authors first provide information on the origin and design of the innovative market approach.

The political economy of the Chicago market design

As an essential background, in Chapter 2 the authors review air quality trends in the Chicago region and the currently known health and visibility impacts of VOC emissions and low-level ozone concentrations. While the body of knowledge on these impacts is by no means complete or definitive in all aspects, and a detailed benefit–cost analysis is not yet available, there is general agreement about adverse health effects and the welfare consequences of poor visibility. The authors summarize relevant knowledge about these local effects that comprise a central motivation for government to take further regulatory action.

The VOC emissions and resultant ozone concentrations from these and other precursor emissions have proved historically stubborn to efforts at control. The VOC emissions comprise many hydrocarbons that arise from numerous coatings, solvents, and glue solutions to emissions from factory processes, paints, and food and drug preparations. This multiplicity of sources translates into a wide diversity of enterprises, private and public, that must be taken into account in the design of a market program, if reductions are to be realized. The authors describe this diversity and point out the problems they create for government decisions in measuring emissions and in determining benchmark and allotment quantities as well as other market features.

The initial plan of the IEPA had been to develop a cap-and-trade market to reduce NO_X emissions, and hence concentrations, another precursor of urban ozone interacting with VOC concentrations. VOC emissions would continue to be controlled by traditional regulations. This NO_X plan would have involved a simpler market design, as the authors will explain. When it was discovered that incoming concentrations of NO_X were already high coming from regions outside the Chicago area, it was clear that a national program was required to reduce these concentrations. The IEPA then turned to the application of a market incentive program to reduce VOC emissions, which were more local in their emission sources and concentration patterns, and much more complex in their market design requirements. They too, like NO_X emissions, had posed problems for regulation: they had been stubborn in the face of controls, they were a matter of confrontation between regulating and regulated communities, and they were subject to increasing marginal control costs as more restrictive control measures were instituted.

An important part of this chapter is a detailed account of the long and contentious process of VOC market design carried out by the IEPA, a process that not only built on the theory of a cap-and-trade market but also was greatly influenced by the comments and arguments of various consultative groups, including government, business, environmental, and academic communities. The objective at this point is not to apply a theory of government environmental regulation of either the public interest or pressure group variant, but to note the positions of the various groups on particular market features.

A cap-and-trade market is built up of a number of features, each of which must function effectively for successful results. Each of these features can be specified in different ways by the regulating agency, and the particular way in which a feature is specified can significantly affect market performance. A detailed account of these features as they were decided upon in the Chicago approach can provide a guide to the anatomy of the cap-and-trade market and important information about possible design deficiencies. The authors participated in a number of early design discussions of the Chicago program, called dialogues, among concerned groups and the IEPA, which raised a long list of concerns about the design. The discussions revealed wide and often contentious differences in views about vital market features that were reconciled in a series of compromises by the IEPA, as explained in Chapter 2.

One important market design problem for the government, infrequently addressed or worked out in detail, is how to integrate the design of the cap-and-trade market program into existing, traditional regulations. Integration is easy to overlook or set aside when confronting the many decisions in designing the market. The authors find that this relationship between these dual regulatory approaches is a unique and key factor in explaining the current performance of the market as described in Chapter 2. Before the start of the market, the agency heralded this dual regulation in the final design, one of the key compromises, as combining the strengths and overcoming the weaknesses of each regulatory approach. The market system was essentially placed on top of traditional regulations in the expectation that it could function in isolation from that foundation. This dual relationship exists in most cap-and-trade markets and our research in this area could be valuable in evaluating the future performance of such markets and devising more successful ways to integrate the two systems.

The cap-and-trade market design decisions were subject to the monitoring and approval of the federal layer of environmental government. Traditional regulations are most frequently promulgated and guided by the US EPA with important implementation procedures developed by the states. A number of options are left to be initiated and developed by the states in their efforts to meet national environmental goals. So it was with the VOC cap-and-trade market that was chosen by the IEPA as an option for the Chicago ozone nonattainment area to be added to the existing traditional regulations. This option was available under the one-hour ozone concentration standard for urban areas with episodic ozone concentration exceedances at or above above 125 ppb (parts per billion). Under this standard, Chicago was a severe ozone nonattainment area. A new standard at which exceedances occurred when concentrations rose at or above 85 ppb averaged over eight hours was put in place by the US EPA, beginning in 2005. According to present classifications, under the new standard the Chicago region becomes a “moderate” ozone nonattainment area. The VOC cap-and-trade market regulatory choice continues under the new classification. However, the lower acceptable threshold for ozone concentrations suggests that a redesign of some features of the market will be in order. Redesigning the existing market in light of the new ozone goals and integrating it with traditional regulations will be a dema...

Table of contents

• Routledge Explorations in Environmental Economics
• Contents
• Figures
• Tables
• Foreword
• Preface
• Acknowledgments
• Abbreviations
• 1 Introduction
• 2 The political economy of the Chicago market design
• 3 Expectations and actual performance
• 4 Traditional regulations and market incentives
• 5 Simulated performance of alternative market model features
• 6 Explaining unanticipated market performance
• 7 Hot spots, spikes, and emissions trading
• 8 Alternative market designs
• 9 Conclusions and policy recommendations for market redesign
• Appendix A Measurement of daily ozone, precursor concentrations, and selected meteorological variables
• Appendix B Explanation of generalized least squares and generalized additive models estimation techniques
• Glossary
• Bibliography
• Index