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Mitigation Lessons from SO2 Market

The traditional approach to reduce pollution had been “command and control” regulation until the SO2 market came along. In the command and control method, a government determines a pollution target and decides on how much each polluting agent has to reduce pollution. This is usually done by setting a uniform emissions rate for a class of emitters (such as a fixed rate for electric utility company per ton of coal used) or by mandating a specific type of pollution-control equipment (such as a scrubber, regardless of the technology being used). This “one size fits all” approach ignores the heterogeneity of types of technologies that exist in the industry and, as a result, the cost of compliance would vary considerably across plants of different vintages.

Why did the Environmental Protection Agency (EPA) target the electric utilities for their SO2 emissions? Electric utilities accounted for about 70 percent of SO2 emissions in 1990. Coal-fired electric generation units accounted for 96 percent of this total, and oil-fired units accounted for the remainder. The other 30 percent of emissions were accounted for by a wide variety of industrial/commercial/residential boilers, smelters, paper mills, and other process oriented sources.[1]

The SO2 market operating in the US since 1995 became the first cap-and-trade market to operate successfully in the world. There are lessons to be learned from that for the CO2 market. Therefore, we take a closer look at the SO2 market.

In 1990, the Clean Air Act Amendments established the Title IV Acid Rain Program (ARP). The amendment (in the Title IV) of the Clean Air Act mandated requirements for the control of acid deposition—also known as acid rain.[2] The Clean Air Act Amendments of1990 set a goal ofreducing annual SO2 emissions by 10 million tons below 1980 levels. To achieve these reductions, the law required a two-phase tightening of the restrictions placed on fossil fuel-fired power plants.

How does one go about creating such markets?

First, to set the parameters, the legislators have to come together to pass certain laws. The political economy of such rule-making is messy. Any new legislation produces winners and losers. In the case of SO2 it was no different. There were states that produced coal and were net exporters to other states. There were states that produced and used coal for power generation but did not export either to other states. In addition, there were states that did neither but were affected by acid rain for being located in the neighborhood. West Virginia, a large coal producer, was a clear loser.[3]

Second, regulators have to set up regulatory parameters based on the laws enacted. They have to anticipate whether such regulations would produce perverse reactions, or produce unintended negative consequences somewhere else. Essentially, they have to produce regulation to properly internalize the externality we discussed in Chapter 6. Third, once the regulation is set forth, institutions have to be built for permit exchange. There has to be constant vigilance to prevent fraudulent activities. Additional legal institutions might be necessary for such new activities to take place.

Finally, a new legion of traders has to be trained and the buyers and the sellers of the permits have to be educated. At every stage, a number oflawyers will have to be involved to make sure all the transactions are admissible.

Phase I of the process began operating in 1995. It was targeted to 263 units at 110 coal-burning electric utility plants located in 21 Eastern and Midwestern states of the United States. An additional 182 units were added to Phase I of the program as substitution or compensating units, bringing the total of affected units to 445 in Phase I.

Prices of the traded permits in SO2 market 1994-2012

Figure 7.1 Prices of the traded permits in SO2 market 1994-2012

Source-. Environmental Protection Agency

The idea of the market was simple. The EPA would auction permits (each representing one ton of pollution). Then, private companies would trade these permits in a specially created product at the Chicago Board of Trade. Once the permits were auctioned, they were resold in the private market. The price was determined by demand and supply not just in the spot market but also by the expected future value of each permit. Thus, expectation plays a vital role in the market for permits (see Figure 7.1 for the market prices).

In the first 12-18 month period, there were a handful of traders. The price was in the $250-$300 per ton range. By the end of 1994, the price had dropped below $150 per ton and the volume of private trades exceeded the volume offered in the EPA auction. The prices had fallen to about $100 per ton by 1998, and private trading of allowances for more than 5 million tons per year had eclipsed the EPA auction by a factor of 15 to 1. The costs of trading allowances were 2 percent of the prevailing price.

The prices of traded permits were very close to one another. For example, the spread between average bids and lowest winning bids at EPA auctions was 1-3 percent (of the price) and trading in the private market appeared to be similarly concentrated around a single price.[4] The program also spurred innovation in the technology of power plants. All the new plants installed scrubbers to reduce SO2 emissions.

The technology also had a spillover effect. It reduced other harmful emissions such as NOx, mercury, lead, and microscopic particles. Another innovation was in the mining techniques for extracting lower-sulfur coal seams. These were known methods but not in wide use. Another low-cost modification came from blending low-sulfur and high-sulfur coal. The industry standard did not allow large-scale blending for it was believed that the boilers would not function correctly. That beliefturned out to be wrong. This allowed large-scale blending without costly modifications to the equipment. This new practice was propelled by the SO2 cap-and-trade program.

The ARP also generated innovations in the management practices ofthe utilities. It encouraged the utilities to seek to streamline the fluctuation in the input cost through activities in the futures markets for coal and oil. As a result, the utility companies were able to reduce their overall cost of production.

Phase II began in 2000 with more stringent annual emissions limits imposed on large, higher emitting plants. It also set restrictions on smaller, cleaner plants fired by coal, oil, and gas, encompassing over 2,000 units in total. The program incorporated existing utility units serving generators with an output capacity of greater than 25 megawatts and all new utility units.

In Table 7.1, we reproduce the winners of the permits auctioned by the EPA in 1995. There are names that we expect for such bids, such as Duke Power and Virginia Power. They are companies that were buying permits for their own use. However, there are names ofseveral law schools and law societies, and the Pollution Retirement Center. They were not buying these permits for profit or speculation. They were participating in the market for the explicit purpose ofreducing the number ofpermits that other market players could have so that in the aggregate there would be less pollution. In the end, they did not make much of a difference in the market as they were very minor players. They did not affect the market price or quantity in any significant way. However, this practice highlights the possibility that in other circumstance, other entities can enter the market and change the market dynamics.

In 2003, following the success of SO2 trading, the NOx Budget Trading Program (NBP) started in nine states. The NBP was a cap-and-trade program that required emissions reductions from power plants and industrial plants in the Eastern US during the summer months. The program was to last until 2008. Meanwhile, the Bush Administration tried but failed to tighten the SO2 emissions through the Clear Skies Act. It died at the committee level in the Congress.

The Bush Administration then came up with the Clean Air Interstate Rule (CAIR) in 2005. The purpose was to lower the SO2 emissions to a level 70 percent below the 2003 level. The CAIR tried to achieve this by reducing the cap by two- thirds in some of the states that were not part of the original ARP—it intended to include 28 Eastern States plus the District ofColumbia by replacing the entire ARP with CAIR. The target was interstate transport of pollution from upwind states to downwind states.[5] This action had a clear impact on the SO2 price in the market. It

Table 7.1 Winning bidders for the 1995 SO2 permits

Bidder’s Name


Percent ofTotal


Duke Power Company





PECO Energy Company





Cantor Fitzgerald Brokerage, L.P.





Virginia Power



USD 800,000

Canterbury Coal Company



USD 520,000

Detroit Edison Company



USD 386,712

Allowance Holdings Corporation



USD 280,800

Hoosier Energy REC, Inc. Ratts Unit 2SG1



USD 68,000

Marine Coal Sales Company



USD 67,500

National Healthy Air License Exchange



USD 18,350

Sam Peltzman Revocable Trust



USD 7,050

INHALE/Glens Falls, NY Middle School



USD 3,171

CATEX Vitol Electric Inc.



USD 1,584

University of Michigan Environmental Law Society



USD 1,000

Environment Law Students Association



USD 410

Hamline University School of Law



USD 350

New England School of Law



USD 350

Electric Software Products David Gloski



USD 300

Electric Software Products Alexander Long



USD 300

Thomas M. Cooley Environment Law Society



USD 200

Duke University School of the Environment



USD 176

Michael S. Hamilton



USD 170

Pollution Retirement Center



USD 160

L.J. O’Callaghan, Sr.



USD 153

University of Maryland School of Law



USD 150






Source: (accessed January 11, 2013).

Bidder’s Name Quantity Percent of Total Cost

shot up nearly threefold. However, the entire structure of the CAIR was based on the so called “good neighbor policy” interpretation of the Clean Air Act Clause §110(a)(2)(D)(i)(I).[6]

Not surprisingly, a number of states (principally Michigan, Minnesota, and North Carolina) were opposed to the CAIR. In July 2008, the United States Court of Appeals for the District of Columbia Circuit declared that the CAIR cap-and-trade method was fundamentally flawed, concluding that the EPA focused on region-wide emission reductions and did not adequately factor in each state’s significant contribution to air pollution issues. It declared that the methods for determining SO2 and NOx pollution were not objective. The Court held that the EPA lacked authority to remove the Acid Rain Program allowances through CAIR.

To salvage the situation, the EPA finalized the Cross-State Air Pollution Rule (CSAPR) to replace CAIR. This rule responded to the court’s concerns and fulfilled the “good neighbor” provision of the Clean Air Act by addressing the problem of air pollution that is transported across state borders. The court decision of 2008 and the subsequent maneuver by the EPA to resurrect the SO2 market through other mechanisms failed. Predictably, the price of SO2 permits went down to virtually zero. The introduction of the CSAPR did not fare much better. In another lawsuit, the CSAPR was also struck down in August 2012.[7] The Courts decided that the EPA failed to show that the “downwind states” are different from “upwind states.” In addition, the EPA did not give the affected states enough time to come up with their own solution.

In spite of the recent setback suffered by the EPA with respect to SO2 emissions, there is no doubt about the overall success of the program. We will discuss three dimensions of success.

First, the program managed to reduce the SO2 emissions much faster than what was originally stipulated by the EPA. This dimension is illustrated by Figure 7.2. Overall SO2 emissions were reduced from about 23,000 tons per year in 1990 to less than 7,000 tons per year in 2011. One common criticism of this reduction examines the reduction in emissions between 1970 and 1990. During that period too there was a reduction in SO2 emissions. Therefore, it is argued that the reductions during the two decades after 1990 were going to happen with or without the Acid Rain Program.

To understand the impact of the ARP, we need to examine exactly from where such a reduction in SO2 emissions came. Recall that ARP was directed squarely at the power utilities. In Figure 7.2 we examine two separate sources— the utilities and others. In 1990, the utilities accounted for two-thirds of all the SO2 emissions. The electric utilities were the principal source of reductions during the following two decades. The rest did not have much of a reduction. This evidence gives us a clear indication that the SO2 reduction was not simply a “natural” reduction with better technologies from all sources. The ARP was indeed the catalyst for such a change.

Thousands of tons of SO2 emitted 1970-2012

Figure 7.2 Thousands of tons of SO2 emitted 1970-2012

Second, the EPA has documented the geographical distribution of sulfate deposition in the US between 1989 and 2011.[8] From Illinois, Indiana, Ohio, Pennsylvania, all the way up to Maine, the sulfate deposit has been reduced at least by half in most states. In some states, the reduction has been over 70 percent. There is no doubt that this reduction was caused by the Acid Rain Program.

Third, as a consequence of the reduction in pollution in the Midwestern and Northeastern states of the United States, where nearly 40 percent of the US population lives, large benefits have been accruing due to: (1) health impact; (2) improved land value for agriculture; and (3) ecological impact. The value of such benefits has been calculated by the EPA. We demonstrate the impact in Figure 7.3.

Figure 7.3 shows monetized value of cumulative benefits coming from the SO2 reduction program. The value is measured in terms of reduction of lost lives, reduction of respiratory diseases, improved recreational facilities, and ecological improvement, among other things. Estimated median value of such gains for 2000 was 700 billion dollars, rising to 1,300 billion dollars in 2010, and to 2,000 billion dollars in 2020. They also estimated the minimum and maximum gains for each of those years as we illustrate in Figure 7.3. These are extremely large gains. To get an

Monetized benefits 2000-2020

Figure 7.3 Monetized benefits 2000-2020

idea of the magnitude, the US GDP for the year 2011 was estimated at 15,000 billion dollars.

The SO2 experiment shows that cap-and-trade can actually work in real life. While the gains in terms of morbidity and mortality were not well understood at the time when the plan was implemented, it became clear later. These additional benefits eclipsed the original benefits posited when the implementation was being debated in the US Congress.

  • [1] Environmental Protection Agency, “National Air Pollution Emission Trends 1900—1998” (2000) (accessed January 3, 2013).
  • [2] The following document sets out quantitative requirements of sulphur dioxide, nitrous and nitricoxides, and quantitative requirements, along with permit requirements a decade into the future: CleanAir Act, Title IV (Acid Deposition Control) (accessed April 5, 2013).
  • [3] For an in-depth discussion of the political economy of SO2, see Paul L. Joskow and RichardSchmalensee, “The Political Economy of Market-Based Environmental Policy: The U.S. Acid RainProgram” (1998) 41 Journal of Law and Economics 37.
  • [4] Paul L. Joskow, Richard Schmalensee, and Elizabeth M. Bailey, “The Market for Sulfur DioxideEmissions” (1998) 88(4) American Economic Review 669.
  • [5] Testimony of Brian McLean, Director, Office of Atmospheric Programs Office of Air AndRadiation US Environmental Protection Agency before the Committee on Environment and PublicWorks Subcommittee on Clean Air and Nuclear Safety United States Senate (July 29, 2008) (accessed January 11, 2013).
  • [6] A discussion is available in EPA, Status of CAA 110(a)(2)(D)(i)(I) SIPs Final Rule TechnicalSupport Document (July 2011) (accessedJanuary 11, 2013).
  • [7] EMEHomer City Generation, LP v. EPA and others, D.C. Cir. No. 11-1302 (December 30, 2011) (accessed January 13, 2013).
  • [8] See Three-Year Wet Sulfate Deposition 1989—1991 and 2009—2011 (accessed April 1, 2013).
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