1. U.S Experience with SO2 and NOx Trading November, 2004 Brian McLean U.S. EPA

2. Cap and Trade An alternative to traditional regulation and credit trading— not simply a trading feature added to existing regulation Certainty that a specific regional emissions level is achieved and maintained More regulatory certainty, compliance flexibility and lower permitting and transaction costs for sources Fewer administrative resources needed by industry and government –Government focused on setting goals & assuring results Incentives for innovation and early reductions Can be compatible with other mechanisms Lower costs make further improvements feasible

3. Limited Supply of allowances (cap) Economic value for allowances Economic incentives to reduce emissions Demand for allowances Why Cap & Trade Works Emissions cap –Limits emissions to achieve & maintain environmental goal –Provides market value and certainty Monitoring –Establishes integrity of currency –Assures accountability & results Trading –Allows companies to choose compliance options –Minimizes costs through compliance flexibility With the cap, allowances allocated, and monitoring, government approval of compliance choices and trades is not required

4. Allowable Emissions Actual Emissions Without Acid Rain Program National SO 2 Trading Program Goal: Reduce acid deposition Target: Reduce SO 2 emissions from electric generators by 8.5 million tons (50% below 1980 levels) Flexibility: Trading and banking of allowances

5. Multi-State NOx Programs Goal: Reduce summer ozone/smog levels Target: Reduce NOx emissions from electric generators and industrial boilers by 1 million tons (70% below 1990 levels) Federal government sets state caps, states allocate allowances Trading and banking OTR Trading States Additional NOx SIP Call States OTR State dropped in NOx SIP Call

6. Federal and State Roles Under NOx Programs

7. Allocating Allowances Many ways, none perfect –auction or free (size, emissions, or utilization; input or output; historic or future; permanent or updating) –set asides (new sources, renewables, demand side efficiency) Considerations: environmental, economic (macro, equity), allowance market Provide as much certainty as possible –allocate several years into the future

8. Emissions Measurement Goals for SO 2 and NO x Programs Complete accounting with no underestimation Simplicity, consistency and transparency Incentives for accuracy and improvement Cost effectiveness Flexibility for small sources –36% of units must use Continuous Emissions Monitors (CEMS) –Accounts for 96% of total SO2 emissions Electronic reporting, feedback, and auditing Public access to data

9. Quality Assurance and Verification by EPA Certification of emissions monitoring systems Stringent daily, quarterly and annual QA checks and tests Conservative data substitution for missing data –Provides incentive for monitoring –Monitors running over 99% of the time Near 100% electronic auditing of emissions data Random on-site field audits and witnessing of QA tests

10. Public Access to Hourly Emissions Data

11. Allowance Registry Official record of allowance transfers Each allowance has a serial number Parties reach agreement, then authorise EPA to transfer allowances or transfer online Registry is not a trading platform

12. Public Access to Allowance Data Type of transfer (auction, private) Seller name and account info Buyer name and account info Confirmation date, serial numbers and total allowances transferred Internet query capability

13. Compliance & Enforcement Annual reconciliation: Compare emissions with allowances Penalties for non-compliance –SO 2 Program: Automatic offset (deduct allowance from next year’s allocation) Automatic financial penalty ($2,900/ton of SO 2 ) Possible civil and criminal penalties –NO x Program 3 allowances surrendered for each ton from next year’s account (no automatic monetary penalty) Possible civil and criminal penalties 99.9% compliance rate for both SO 2 and NOx programs –penalties have ranged from $3,000 to $1,500,000

14. Environmental Accountability TIME/LTM (Surface Water Monitoring) Measuring Results –Changes to deposition and water quality Comparing to Goals –Are additional actions needed?

15. Major Reductions in SO 2 and Acid Rain SO 2 emissions from power plants down by 5.1 million tons since 1990 Acid rain reduced by 25 – 40% Wet Sulfate Deposition Average 1989 - 1991 Wet Sulfate Deposition Average 2000 – 2002 11.9 Million Tons of SO 2 Actual Emissions Final Cap 15.7 10.2 17.3 89.0 11.2 10.6

16. Low Compliance Costs Source: Carlson, Burtraw, Cropper, Palmer Competition among emission reduction options Continuous incentive for innovation Banking provides timing flexibility Allowance price provides benchmark for decision making Trading not restricted

17. Active Allowance Market Over 165 million allowances transferred through almost 27,000 transactions since 1994 Approximately 45% of transfers are arms length trades Over 80% of transfers are handled online Low transaction costs

18. NOx Program Results · OTC states reduced emissions: –70% from 1990 levels, –33% from 2000 levels. Over 1.5 million allowances transferred through almost 8600 transactions since 1998 Ozone Season NO x Emissions

19. Largest Reductions Occurred at Plants with Highest 1990 Emissions Plant-Level 1990 SO2 Emissions and SO2 Emissions Changes by 2001-03 The red line represents the expected change in SO2 from 1990 levels if each plant achieved the same percent reduction as the entire universe of affected sources did in aggregate (32.6% reduction). This assumes that there are no new plants with emissions since 1990.  Decreases tended to be large, while increases tended to be small (and smaller plants)  353 facilities decreased emissions by 6.5 million tons  274 facilities increased by 1.2 million tons).* * This only includes facilities with emissions in 1990. It does not include new sources or sources that did not operate in 1990.

20. Spatial Distribution of Emission Changes – Blue circles: sources that reduced emissions more than 1,000 tons. – Orange squares: sources that increased emissions more than 1,000 tons. – Size of symbols proportional to magnitude of change in emissions. – Hollow circles: emissions did not change more than 1,000 tons. SO2 Emissions Changes Between 1990 and 2001-03 (Acid Rain Sources)

21. Lesson: To Trade or Not to Trade… Can the problem be addressed with a flexible approach? –Local or regional problem? –Episodic or cumulative problem? Can emissions be measured accurately and consistently? Do abatement costs differ among facilities? Is there an appropriate number of sources? Do the necessary governmental and market institutions exist?

22. Lesson: Program Compatibility Cap & trade programs should complement, not contradict, existing environmental regulations An unambiguous legal framework defining the relationship between cap & trade programs and other policy instruments should be established before a trading program begins Hybrid approaches may be appropriate Programs are less confusing, less expensive, and more likely to succeed if they are simple

23. Lesson: Government Focus Achieving a specific environmental objective Supporting the allowance market by –Ensuring the integrity of the allowance, i.e., the authorization to emit –Minimizing administrative costs

24. Recent Policy Trends Trend #1: From experiment to mainstream Trend #2: Increased public acceptance Trend #3: Increased activity at the State level Trend #4: Looking beyond U.S. borders

25. Trend #2: Increased Public Acceptance Media’s reaction to trading in 1992 –“Why not set up a national Murder Inc. as a murder-rights clearinghouse? Time to subject random violence to free-market discipline.” (editorial in The Nation) –“What’s next, the L.A. Police Department trying to buy civil rights credits in Wisconsin?” (quote from A.P. wire story) –“Why applaud a deal that lets companies buy pollution rights? People will die.” (op. ed. In USA Today) Situation in 2004 –Acclaimed by “policy elite” –More positive media coverage –More NGO’s support (but not all)

26. Trend #3: Increased Activity at the State and Municipal Level Southern California (RECLAIM) program for SO 2 and NOx Western States (WRAP) using cap and trade as backstop for regional haze Chicago VOC cap and trade program New Hampshire NO x program Connecticut and New York non-ozone season NO x programs Massachusetts and New Hampshire have power sector caps on CO2 Regional GHG cap and trade initiative (RGGI) in Northeastern States

27. Trend #4: Looking Beyond U.S. Borders U.S.- Canada Feasibility Study announced in July 2003 –Evaluate impacts of cross border trading (SO2 and NOx) –Assess differences in key design elements (e.g., monitoring, registries) –Describe legal and regulatory infrastructure U.S. – Mexico at earlier stage of cooperation –Joint workshops on emissions trading –Capacity building on inventories, economic modeling –Experimental project-based trades along border region Supporting efforts in other countries

28. For More Information Visit the clean air markets web site to view –Emissions data –Allowance transfers –Information on the acid rain program and ozone transport programs –Program rules and guidelines –Studies and reports http://www.epa.gov/airmarkets/