The US sulphur dioxide cap and trade programme and lessons for climate policy

Robert N. Stavins, Gabriel Chan, Robert Stowe, Richard Sweeney, 12 August 2012

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The sulphur dioxide (SO2) allowance-trading programme established under Title IV of the 1990 Clean Air Act Amendments (CAAA) was the world’s first large-scale pollutant cap-and-trade system. ('Allowance trading' and 'cap-and-trade' are synonymous.) The stated purpose of the Acid Rain Program was to reduce total annual SO2 emissions in the US by ten million tons relative to 1980, when total US emissions were about 26 million tons. In a departure from conventional environmental regulation, the legislation did not prescribe how power plants would reduce their SO2 emissions. Instead, with a phase-in beginning in 1995 and culminating in 2000, the statute capped aggregate SO2 emissions at the nation’s 3,200 coal plants and created a market for firms to buy and sell government-issued allowances to emit SO2. By 2007, annual emissions had declined below the programme’s nine million ton goal (a 43% reduction from 1990 levels), despite electricity generation from coal-fired power plants increasing more than 26% from 1990-2007 (EPA 2012; EIA 2011).

In economic theory, a cap-and-trade scheme can be cost effective, meaning the aggregate costs of pollution reduction are minimised. Because each company (or facility) has flexibility to choose the course of action that costs it the least to achieve environmental compliance (broadly speaking, either reduce its own emissions or buy more allowances to cover its emissions), investment flows to where it is least costly to abate. The marginal cost of pollution abatement becomes equalised across all regulated entities, and, in aggregate, the mandated environmental target is achieved at lowest cost.

Although compliance costs of the acid rain programme – as implemented – may have exceeded those associated with the cost-effective ideal, they ‘were significantly below estimates generated by government and industry analysts in the debate leading up to the CAAA. In 1989, before the programme went into force, the US Environmental Protection Agency (EPA) estimated the total cost of implementing the Acid Rain Program at $6.1 billion. Eight years into the programme, in 1998, the Electric Power Research Institute (EPRI), an industry organisation, and Resources for the Future (RFF), an independent think tank, estimated that total implementation costs would be between $1.1 billion and $1.7 billion (NAPAP 2005).

Several factors – some exogenous to the programme, which we will not discuss here – explain the large gap between initial programmatic-cost expectations for the SO2 allowance trading system and later assessments of actual costs. One might have been the failure of early analysts to fully recognise the fundamental cost-effectiveness of such a market-based approach. In addition, early estimates surely failed to incorporate adequately the incentive provided by the price set on SO2 emissions for technological innovation in both scrubbers and power-plant operation, which reduced costs over the period (Burtraw 2000; Popp 2003; Lange and Bellas 2005).

What made the Acid Rain Program work?

To a close approximation, regulated entities in a cap-and-trade system will face the same incentives to reduce emissions, regardless of the how allowances are initially allocated and, specifically, how many allowances a given firm holds at the outset (Montgomery 1972). What matters with regard to firms’ decisions to trade or abate are marginal abatement costs, and these are generally unaffected by the initial allocation of allowances.1 Indeed, members of Congress fought intensely to increase the share of freely allocated allowances that would go to utilities in their home districts, in part as a means to sell the Acid Rain Program to constituents. In the end, the distribution of free allowances to individual firms was largely based on historic rates of emissions ('grandfathering'), but allowed for considerable political horse-trading at the margin –awarding a few more allowances to a particular plant in a particular district – to win support for the overall policy. The literature on the SO2 allowance trading system identifies the free allocation of allowances to the economic 'losers' in the SO2 allowance-trading programme – high-sulphur-coal-intensive power companies in the Midwest – as an essential factor in the programme’s enactment.

Unlike most earlier pieces of landmark environmental legislation, the CAAA of 1990 was not precipitated by a ‘crisis moment’ (the most memorable was the Cuyahoga River catching on fire, leading to the Clean Water Act), which may have given policymakers greater latitude to implement a flexible and entrepreneurial policy, rather than resorting to a more rigid traditional approach. In many observers’ views, the Acid Rain Program flew ‘under the radar’, in terms of the attention it received both from the public and environmental advocacy groups, most of which were more concerned about changes to other portions of the Act, unrelated to the SO2 trading programme (Chan et al. 2012).

What can the Acid Rain Program teach us about climate policy?

The Acid Rain Program, while not without flaws, is viewed as a success by almost all measures. Certainly it demonstrated that broad-based cap-and-trade systems can be used to achieve significant emissions reductions, that firms can navigate and regulators can enforce the compliance requirements of such systems, and that giving the private sector flexibility to pursue a range of abatement options can simultaneously protect the environment, stimulate innovation and diffusion, and reduce aggregate costs.

The recent climate debate has taken place in a political context that is much different than that of the CAAA of 1990. Deep ideological division dominates today’s dialogue; the two major political parties were much less ideologically polarised in 1990. The large bipartisan majorities of 1990 appear much less likely today. Recent hostility toward cap and trade in US climate legislation may reflect the broader political environment of the climate debate more than it reflects the substantive merits (or demerits) of market-based regulation. In other words, congressional hostility toward greenhouse-gas cap and trade appears to have been collateral damage in a wider set of policy and ideological battles.

Ironically, the cap-and-trade model seems especially well suited to addressing the problem of climate change, in that emitted greenhouse gases are evenly distributed throughout the world’s atmosphere. Emissions reductions anywhere make identical contributions to helping alleviate the problem, and there are no pollutant concentration hot-spots. The sheer number and variety of greenhouse gas-emissions sources heightens the practical difficulty of developing a comprehensive and effective command-and-control approach, and magnifies the cost savings that could be achieved by enlisting the market to find the least costly abatement options.

The stakes for a broad-based GHG policy – economic, political, and environmental – are much higher than they were for SO2 policy in 1990. While the debate over federal policy to address climate change is currently in hiatus, the lessons of the SO2 allowance-trading programme will prove useful and relevant to future deliberations about climate change policy when the time arrives for serious reflection and action.

This column summarises the Harvard Environmental Economics Program policy brief “The SO2 Allowance Trading System and the Clean Air Act Amendments of 1990: Reflections on Twenty Years of Policy Innovation”, published in revised form as Chan et al. (2012). 

References

Burtraw, D (2000), Innovation Under the Tradable Sulfur Dioxide Emission Permits Program in the US Electricity Sector, Discussion Paper 00-38. Washington, D.C.: Resources for the Future.

Chan, G, R Stavins, R Stowe, and R Sweeney (2012), “The SO2 allowance-trading system and the Clean Air Act Amendments of 1990: Reflections on 20 years of policy innovation”, National Tax Journal, 65:419-452.

EIA (2011), Annual Energy Review.

EPA (2012), Air Markets Program Data.

Hahn, RW and RN Stavins (2011), “The effect of allowance allocations on cap-and-trade system performance”, Journal of Law and Economics, 54(4):S267-S294.

Lange, I and A Bellas (2005), “Technological change for sulfur dioxide scrubbers under market-based regulation”, Land Economics, 81(4):546-556.

Montgomery, D (1972), “Markets in licenses and efficient pollution control programs”, Journal of Economic Theory, 5(3):395-418.

NAPAP (2005), National Acid Precipitation Assessment Program Report to Congress: An Integrated Assessment, National Science and Technology Council, Committee on Environment and Natural Resources.

Popp, D (2003), “Pollution control innovations and the Clean Air Act of 1990”, Journal of Policy Analysis and Management, 22(4):641-660.


1 For more on the independence of the market equilibrium in a cap-and-trade system of the initial allocation of tradable allowances, see Hahn and Stavins (2011) and Robert Stavins’ blog post based in part on that paper.

Topics: Environment
Tags: cap and trade, climate change, sulphur dioxide

PhD student at the Kennedy School of Government, Harvard University

Albert Pratt Professor of Business and Government at the John F. Kennedy School of Government and Director of the Environmental Economics Program, Harvard University

Executive Director of the Harvard Environmental Economics Program

PhD student at Harvard University