This is a preliminary document prepared by a subgroup of members of the National and Regional Strategies Work Group as part of the Federal Advisory Committee Act (FACA) Subcommittee process. It is not an EPA document. This document has not been reviewed by the NRS Work Group and is subject to further work group discussion. Interested people should forward their comments to a member of the National and Regional Strategies Work Group.

Economic Incentives to Implement the

Revised Ozone and PM Standards and the Regional Haze Rules

Date: February 13, 1997

Contact: Joe Belanger, Connecticut Department of Environmental Protection, representing the NRS Work Group @ (860) 424-3027 (-4063 fax)

Note: This issue paper incorporates the October 18 1996 paper "Economic Incentives and Market Mechanisms as Components of National or Regional Strategies." [It will include the attachments from the October paper, which capture some of the discussions of regional emission trading programs which have occurred in OTAG, OTC, and the Grand Canyon Visibility Transport Commission.]

Status: Draft #4. This draft incorporates the discussion of the Economic Incentives Subgroup and Economic Analysis Group on February 11, 1997.

Background

Economic incentives include emission fees, emission trading programs, grants for cleaning up air pollution, removal of subsidies for activities that worsen air pollution, fees on the sale or manufacture of products the use of which contributes to formation of air pollutants, transportation control measures, and any combination of these measures. In this paper, transportation control measures comprise incentive-based measures which reduce vehicle emissions and vehicle miles traveled in an area. The two most important types of incentive-based regulation are emission fees and marketable permits. This paper addresses issues that arise in connection with using incentive-based regulations as the core approach for implementing the revised national ambient air quality standards (NAAQS) for ozone and particulate matter, and the forthcoming regional haze rules.

Compared to direct regulation, incentive-based regulation may hold promise for achieving necessary pollutant reductions with economy, certainty and timeliness, and equity. For example, the reasons for emissions trading include: saving States' resources, less conflict with sources, letting sources determine the best/most effective control technology, focusing on emissions loading, increasing cost-effectiveness and promoting control technology innovation and diffusion.

To be effective and cost-minimizing, economic incentives for air quality management must be tailored to the conditions that are specific to the pollutant which is being addressed, and must be designed with specific goals in mind. Because of the complexity of any particular area's air pollution problem, this issue paper does not attempt to present more than a general discussion of the salient issues involved in developing incentive-based regulations for controlling ozone, particulate matter, and regional haze.

The most fundamental determinant of the desired program is the goal or set of goals that provides the purpose of the program. The basic characteristics of the program will reflect choices pertaining to: whether the program caps aggregate emissions or an emissions rate, or instead is primarily intended to just increase sources' efforts to reduce emissions; whether the program is intended to fully implement a pollutant control strategy or function as an adjunct to a strategy that isn't essentially dependent on economic incentives; whether the program is an area's approach to reducing background concentrations throughout an AOI or a local program that primarily reduces pollutant concentrations in a small area. In addition, for emission trading programs, the importance of adjusting the "currency" for source location and of imposing geographical restrictions on trading depend on the extent to which the location of a source relative to a particular receptor is one of the determinants of effect. Therefore, basic features of incentive-based regulations reflect the desired scope of the program and the technical characteristics of the pollutant of concern.

Consideration of the following will enhance the match between incentive-based regulations and the pollution problem and related equity concerns:

program scope,

regional/local nature of the problem,

type and size of sources that contribute to the problem and their location,

meteorology and geographical characteristics of the problem,

needs of small entities, and

environmental justice.

An incentive-based regulation may be an area's attainment strategy, but it is also true that some emission trading programs, for example, classic emission averaging and the classic "open-market" trading programs, are useful only when combined with other components of an attainment strategy.

In addition to limiting emissions or providing flexibility to sources, an area may also wish to use incentive-based regulation to achieve one or more of these goals:

encourage early emission reductions,

increase rule-effectiveness by allowing sources to purchase credits in lieu of delays, variances, and alternative emission limitations (AELs),

increase sources' options for complying with RACT and other technology-based performance standards,

increase options for areas that are required to satisfy vehicle inspection and maintenance requirements and reformulated gasoline requirements,

encourage emissions reductions from sources not usually subject to control requirements,

promote control technology innovation and diffusion, and

address residual nonattainment (unexpected failure to meet RFP, attain one or more NAAQS, or make desired progress in ameliorating regional haze).

Certainty in Meeting Environmental Goals

[The economics group recognizes the importance of the topic and will address it in the next version of the issue paper. Among other things to be discussed here are directionally-sound market-based programs such as emission fees and open-market trading programs, in which uncertainty is present because the planning authority can predict neither the sources who will participate nor the quantity of traded tons.]

Reducing Emission Abatement Costs Further with "Ambient-Based" Programs

Ozone, particulate matter, and regional haze are examples of air pollution problems in which the location of a source relative to a particular receptor is one of the determinants of effect. Costs may be reduced by using a more "refined" emission trading program than one in which tons are traded for tons without regard to the location of the sources. The basic emission trading program, such as the SO2 acid rain program, minimizes costs for an air pollution problem in which only the quantity of emissions matters. Different approaches may be more efficient for an air pollution problem in which both the quantity of emissions and the location of sources matter. Many approaches--including adjusting the "currency" in emission trading programs--may be used to explicitly incorporate source location into program design. While those approaches are potentially valuable, the incentive-based regulations that are most likely to be implemented in the near-term most probably will not adjust the "currency" or fee rate for the differential effects of emissions in an Area of Influence on Areas of Violation.

Examples of Economic Incentive Programs

States and air quality management districts are using, or have proposed to use, economic incentives to reduce emissions of NOx (southern California, OTC, and OTAG), SOx and SO2 (southern California and Grand Canyon Visibility Transport Commission), and VOCs (IL). Minnesota has considered using fees to reduce emissions of toxic air pollutants. The first appendix below contains additional information on these and several EPA programs.

Relationship to Other Issue Papers

Other papers prepared by FACA work groups and subgroups address specialized applications of economic incentives or special issues that should be resolved. The November 15, 1996 version of the paper Economic Incentives and Disincentives as an Adjunct to Sanctions presents potential negative and positive incentives to encourage states toward early compliance with planning requirements. The November 15, 1996 version of the New Sources: Considerations for the Implementation of New Air Quality Standard/Regulations issue paper refers to incentive-based regulation. The Monitoring Incentives Ad Hoc Work Group is preparing a paper on incentives for accelerated or more extensive air quality monitoring. The National and Regional Strategies Work Group is preparing a document on early reductions in the context of an emission trading program with banking. The Base Programs Analyses and Policies Work Group is preparing a paper on sanctions for delays and missed deadlines, and rewards for accelerated air quality planning and implementation. The economic incentives issue paper differs from the related papers by discussing the foundations of an economic incentives program.

Incentive-based regulatory programs, like all regulatory programs, exist in an organizational matrix which provides planning and implementation functions. The National and Regional Strategies Work Group is continuing to discuss institutional mechanisms that will be primarily responsible for identifying Areas of Influence and developing Regionally Integrated Plans. The Institutional Mechanisms for Development and Implementation of Regional Strategies issue paper (revision #5, January 28, 1997) makes a recommendation for the structure and function of the new institutions. As used below, the neutral term "planning authority" indicates the organization which develops the regulatory programs under discussion.

Economic Incentive Design Principles

The National and Regional Strategies Work Group has developed a set of principles that it is proposing as the basis for the design and implementation of any economic incentive contained in a regional plan: the May 17, 1996 "Statement of Principles." The second appendix below presents these principles with proposed slight modifications.

Issues and Options for Program Design

1. What are the differences/similarities of emission trading programs and emission fee programs?

The first step in implementing either program is to determine how much of a particular pollutant may be emitted. When this total allowed emission loading is determined under an emissions budget program an area must split these "budgeted" emissions among the covered sources. Under an emission fee program the planning authority must determine the emission fee that would result in only the budgeted amount of emissions being emitted. In the case of regional haze where progress rather than attainment is the objective, less precision would be required. The emission fee is determined by using marginal cost information from the regulated sources. The planning authority also decides how to use the fee revenue.

Emission trading programs include but are not limited to budget (or "cap") programs. The distinguishing characteristic of an emission budget program that allows trading is that the program sets a definite upper limit on the aggregate quantity of allowances that the planning authority grants (or sells) to the covered sources. Without banking, an emission budget program limits aggregate emissions from the covered sources. Alternatively, emission trading programs may limit an average emission rate for all covered sources. Proposals under development by the Ozone Transport Assessment Group (OTAG) would not only limit the average rate but would set the rate to limit aggregate emissions from the covered sources. Another type of emission trading program is exemplified by the Open Market Trading Guidance programs, which allow sources to generate and trade "discrete emission reductions" (DERs) but limits neither aggregate emissions nor average emission rates for entire categories of sources; environmental benefits are obtained by mandatory retirement of 10% of DERs at the time of use.

Option 1a: Emission fees (with or without redistribution of fee revenue)

Pros: Raise or lower fees as more data are received

Cons: Planning authorities may not customarily obtain the economic information necessary to justify the starting fee rate. Unless fees are rebated, in general, sources or source categories incur greater out-of-pocket costs than comparable cap-and-trade program (assuming allowances are given away to existing sources).

Option 1b: Emission budgets (cap and trade)

Pros: Emissions are directly limited

Cons: Historically, the allocation process has led to inflated emission budgets and market distortions

Option 1c: Rate-based emission reduction credit program

Pros: Planning authority does not need to determine how to allocate emission allowances to every covered source

Cons: Does not limit aggregate emissions from covered sources unless rate is automatically adjusted to reflect change in activity

Option 1d: Discrete emission reduction trading (no cap)

Pros: Planning authority does not need to determine how to allocate emission allowances to every covered source, nor does the planning authority need to determine the target, aggregate, average emission rate

Cons: Does not limit aggregate emissions from covered sources; DER retirement provision (10% deduction) is equivalent to a tax or tighter control limit for traders

2. Which sources should be included in the program?

In general the more sources included in a program the more robust the market and the more economically efficient the air quality improvement program. However source categories and sizes that have not been included in innovative programs before often do not have accurate and reliable emission measurement techniques. Depending on the measurement techniques which are available, different programs work better in different degrees, and some programs will require development of better techniques. While economic incentive programs also have the flexibility to address the special needs of small entities and to bring environmental justice concerns to bear on the choice of sources, they can also result in negative impacts on some areas of concern unless these areas are given explicit attention during program design.

Depending on the specific pollutant which is being addressed by the program as well as where the program is to be implemented, the importance of additional emissions reductions from large stationary sources versus reductions from area and mobile sources may vary. This consideration is implicitly included in the following discussion of options.

Option 2a: Cover only traditional, well measured sources (e.g., power plants)

Pros: Minimizes resources spent to develop emission measurement protocols

Cons: For many pollutants, misses a large and fast growing portion of the current anthropogenic emissions.

Option 2b: Cover all large sources

Pros: Compared to option 1, target emission level achieved at lower cost

Cons: Additional resources needed to develop emission measurement protocols; need to define "large" sources

Option 2c: Cover all sources to the extent possible, including area and mobile sources

Pros: Target emission level achieved at least emission abatement cost

Cons: Small entity concerns; greater increase in resources needed for emission measurement

Option 2d: Cover large sources and allow smaller sources to opt in

Pros: Increases profits of sources that opt in and reduces social costs

Cons: Smaller sources may not have accurate and reliable data on emissions; opt-ins don't contribute to net emission reductions, only reduction in social costs

3. What is the correct geographic size for a market-based emission reduction program?

The issue involves both the aggregate cost of achieving a program's environmental goal and the geographical integration of control strategies. Other things being equal, in general a larger geographic domain means more sources, a more robust market and a more economically efficient solution. However, with a large geographic area the emission reductions may not occur where they need to occur for local problems. Solutions include using the market based program to reduce background emissions and imposing additional controls in small localized areas. Alternatively, the target emission level for a regional program could be set lower to ensure localized problems are addressed. Finally, the geographical nesting of programs--several local programs set in a regional program--may be appropriate. Where nonattainment problems in an area are isolated, being unrelated by long range transport, separate local programs may be sufficient to bring the area into attainment.

If a program includes multiple jurisdictions, the planning authority needs to take action to ensure consistency. Ensuring consistency is likely to be less difficult if an institution that spans the Area of Influence designs the program.

Option 3a: Use a market-based program to reduce background emissions throughout the AOI, and impose additional controls in small, localized areas

Pros: May be less expensive than option 3b

Cons: Sources subject to additional controls may question equity of program

Option 3b: Reduce the target emission level for a regional program (RAMP-wide)

Pros: Administratively simple

Cons: Possibly more expensive in aggregate than a program that takes source location into account; regional program does not provide price signals to influence new sources to locate in areas where their emissions would have less effect on the AOVs

Option 3c: To determine the cost-effective geographic size, expand the set of covered sources until the expected abatement and transaction costs for the last included source just equal the expected cost-savings to the already-included sources

Pros: Minimizes the aggregate cost of achieving the objective of the program

Cons: May provide an incentive for sources to move just outside the boundary of a local program (sprawling emissions problem)

4. How should the design of an emission trading program incorporate the timing of emissions?

Ambient concentrations of criteria pollutants have episodic fluctuations. The effect of precursor emissions on the criteria pollutant may vary by hour and by day (and of course it varies by season). An exchange of allowances may not be neutral with respect to air pollutant concentrations if allowance generation and use occur at different times. Sources prefer flexibility in planning their production schedules, and profits may be decreased by either a) restrictions on the use of allowances if the restrictions alter production schedules or b) trading ratios which account for differential effects of emissions timing.

Option 4a: Allow one ton of precursor emissions to be covered by one ton of allowances.

Pros: Reduces costs to sources; simplicity

Cons: Does not ensure environmental neutrality of trades

Option 4b: Require each ton of precursor emissions during episodes and critical periods to be covered by more than one ton of allowances.

Pros: Provides a greater incentive for emission reductions during episodes and critical periods

Cons: Increases expenditures on emission abatement; because of uncertainty in predicting pollutant concentrations, may be difficult to provide advance notice to sources in time for them to respond appropriately

5. Should emission budget programs allow interpollutant trading? Should interpollutant trading of precursor emissions for one criteria pollutant be handled differently than interpollutant trading between criteria pollutants? How should interpollutant trading be managed?

Changes in levels of one NAAQS precursor pollutant affect other NAAQS pollutants. For example, changing NOx emissions will impact ozone, PM-fine, and regional haze. When one action reduces emissions of several precursors and the reductions improve environmental quality, it is relatively easy to integrate the programs. However there are situations when either an action decreases one precursor but increases others or a decrease in a precursor has the side effect of increasing the ambient concentration of another pollutant.

Current emission control programs have almost always prohibited trading between classes of pollutants. When several classes of precursors affect ambient concentrations, is it advantageous to allow the market to decide which precursors will be reduced? Current scientific tools may not support determinations of the correct ratio for interpollutant trades.

Even when not formally established, interpollutant trading can occur when two separate emission trading programs covering the same sources operate simultaneously. Assuming for simplicity that the trading program uses pollutant allowances, optimizing sources will participate in both allowance markets. Presumably, some sources will minimize emission abatement costs by purchasing one type of allowance and selling the other. Thus interpollutant trading occurs even though it is not organized by the planning authority.

The question arises as to whether formal and informal interpollutant trading achieve the same air quality, aggregate costs, and distribution of costs among the covered sources. It appears that whether the approaches are functionally equivalent depends on, among other things, any differential effects of precursor emissions on air pollutant concentrations, the significance of transaction costs in allowance markets, and the allocation of allowances. Equivalence is unlikely, but additional analysis would be needed to determine how much similarity in the outcomes of formal and informal interpollutant trading could be achieved.

Option 5a: Formally establish interpollutant trading

Pros: If trading ratio is correct, minimizes aggregate cost of achieving environmental goal

Cons: Increases complexity of program design and implementation

Option 5b: Determine the pollutant which requires the greatest reduction in precursor emissions, and set the emission budget for the "limiting" precursor at that level; emissions of other precursors are also capped

Pros: Administratively simple

Cons: Assumption of a limiting precursor has not been validated

Option 5c: Allow only single-pollutant trades

Pros: More certainty in environmental neutrality of trades

Cons: Greater aggregate cost of achieving environmental goal

6. In a program with an emission budget, how can the planning authority allocate initial allowances and allowances in future years?

One of the major obstacles to emission budgets is allocating the budget. In theory the original allocation shouldn't matter if there is a robust market. In practical terms, sources would rather have their allocations to begin with than have to go to the market and buy them. An annual auction of all available allowances is one solution. An area that chooses to allocate shares of the budget has several issues to address including how to adjust allocations for economic cycles, the impacts of other air quality programs (both reductions and increases in emissions), and sources that reduced emissions early.

Option 6a: Auction off all allowances

Pros: Treats existing and new sources uniformly

Cons: Sources incur out-of-pocket expenses to purchase allowances; requires some form of recycling of auction proceeds if costs to controlled sources are not to be increased

Option 6b: Allocate some and auction off others

Pros: Planning authority can still set aside allowances for special uses, for example, exclusive purchase by new sources

Cons: Planning authority needs to find an equitable way of making allocations

Option 6c: Allocate all allowances

Pros: Gives planning authority maximum flexibility to determine the equitable allocation

Cons: Sources may question equity of allocations; may discriminate against some sources

7. How should the planning authority treat new emissions?

Increases in emissions generally accompany economic growth. The increases can be from new power plants and factories, and from the activities of a growing population: building construction, increased vehicular traffic, etc. Planning authorities need to manage all these sources of emissions. Incentive-based regulations that are under development, in OTAG for example, may expand the options available for including the broadest spectrum of sources under effective control even in fast growing areas.

[Note: the economics group is still working on how to manage emissions from area and mobile sources.]

Option 7a: Sources purchase allowances from other sources (or pay emission fees) for all new emissions

Pros: Maintains cap on aggregate emissions (for emission trading programs)

Cons: Disadvantages new sources (for emission trading programs which grant allowances to existing sources)

Option 7b: Planning authority creates an allowance reserve exclusively for new sources

Pros: New sources have an additional option for purchasing or being given allowances

Cons: Planning authority must set price (if any) for reserved allowances, and may inadvertently introduce inefficiency into the allowance market

8. What mechanisms may be used to include area and mobile sources in incentive-based regulations?

Incentive-based regulation applied to mobile sources may encourage changes that help achieve both air quality goals and other social objectives. For example, congestion pricing--charging drivers for using a highway during the rush hour--reduces emissions and the amount of time vehicle occupants waste in traffic. When regulation achieves multiple objectives, the accurate estimation of cost-effectiveness takes into account the benefits that are ancillary to the primary purpose of regulation.

The Area/Mobile Sources Task Group of OTAG has examined approaches to include area and mobile sources in a trading program. The first appendix below contains additional information.

Option 8a: A planning authority grants emission allowances to groups that represent source categories, such as local transportation planning organizations or trade associations, and assigns the emission responsibility not to individual sources but to sources collectively. Instead of implementing an allocation-based program, the planning authority could implement a credit-based program involving these groups.

Pros: Reduces transaction costs and allows flexibility in choice of specific means to reduce emissions

Cons: Unfamiliar role for affected organizations

Option 8b: A planning authority grants emission allowances and assigns the emission responsibility to individual owners/operators of area and mobile sources. Instead of implementing an allocation-based program, the planning authority could implement a credit-based program involving these individuals.

Pros: Assigns the emission responsibility directly to the entity with the greatest influence over activity level

Cons: High transaction costs

9. How can planning authorities use economic incentives to address residual nonattainment?

Residual nonattainment refers to the unexpected failure of an area to meet RFP requirements, attain one or more NAAQS, or achieve the national visibility goal for Class I areas. Failure occurs despite efforts by the planning authority and sources to develop and implement emission reduction programs; in some cases, all known reasonable controls are not expected to result in attainment. The issue that is addressed here is not sanctions, which are discussed in another issue paper, but modifying an existing incentive-based regulation, or creating a new one, to motivate further efforts to reduce the emissions of concern.

Regulation used for this purpose allows the area to progress down new avenues for emissions reductions. Incentive-based regulation may be especially advantageous for addressing residual nonattainment because, for example,increasing an emission fee or reducing an emission budget is a straightforward way to increase sources' motivations to reduce emissions.

Option 9a: Include additional sources in existing programs

Pros: Reduces emissions from unregulated or under-regulated sources

Cons: Inclusion of sources in cap-and-trade programs may jolt the allowance market; inclusion of additional sources in emission fee programs increases administrative costs

Option 9b: Reduce emission budget in existing cap-and-trade programs

Pros: Administratively simple; potentially uniform treatment of covered sources

Cons: Covered sources may question equity of the action

Option 9c: Increase fee rate in existing emission fee programs

Pros: Administratively simple; potentially uniform treatment of covered sources; could provide additional revenues to be used for subsidizing further emissions reductions

Cons: Covered sources may question equity of the action; prediction of quantity of emission reductions may be uncertain

Option 9d: Implement graduated emission fees, or fees on emissions above a specified threshold, and use the fee revenue to obtain emission reductions

Pros: Creates a fund which can be used to subsidize sources' efforts to reduce emissions or to finance public-sector projects which reduce emissions

Cons: Public may question equity of subsidies to sources

Appendix 1. Examples of Economic Incentive Programs

RECLAIM

RECLAIM stands for the Regional Clean Air Incentives Market program. It is one of a series of reforms initiated by the South Coast Air Quality Management District (SCAQMD) in 1991. The program applies to NOx and SOx emitted by sources that produce more than four tons per day of either pollutant. RECLAIM Trading Credits (RTCs) have been allocated to sources based on adjusted peak annual emissions between 1989 and 1991. RTCs depreciate as a mechanism designed to achieve target emission levels by 2003. A limited number of significant trades have occurred, for example one valued at $1.27 million accounted for 1,700 tons of NOx up through the year 2011. Cost savings were forecasted to average $57.9 million per year from 1994 through 1999, or about 40% less cost for equivalent emission reductions.

Northeast States' Rules to Implement OTC NOx MOU

Several Northeast states (OTC members) have drafted rules to comply with the Ozone Transport Commission's September 27, 1994 Memorandum of Understanding creating a regional (OTR) NOx cap-and-trade program. This emission trading program operates only during the ozone season. During Phase II of the OTR's NOx Budget Program, which begins May 1, 1999, "budget" sources begin the ozone season subject to an individual emission cap and with an allocation of allowances in their "compliance account;" budget sources are defined as fossil fuel-fired boilers or indirect heat exchangers with a maximum rated heat input of 250 MMBtu or more, fossil fuel-fired electric generating facilities with a rated output of 15 MW or more, and opt-in sources. At the end of each year, every budget source must have a number of allowances in its compliance account that equals or exceeds the tons of NOx it emitted during the past ozone season. In all states, budget sources may bank allowances for an indefinite period, and withdrawals of banked allowances are subject to flow control. Opt-ins are allowed.

The bases for allocation proposed by the states range widely from historic emissions to target emission rates. States are also proposing to provide for new sources through a variety of mechanisms such as reserve accounts. These differences in allocation method have been of some concern to the members of the regulated community operating in more than one state.

Connecticut's Market-Based Program for NOx Reduction

Prior to the implementation of the OTC based rule, Connecticut's Market-Based Program for NOx Reduction allows sources to use emission reduction credits and averaging ("bubbling") to comply with NOx RACT and the new source review offset requirement. Shutdown or curtailment of production may not be used to create emission reduction credits (ERCs) to be used for NOx RACT compliance. Only ERCs created during the ozone season may be used during the ozone season. In order to create an ERC, a source must have taken an action after 1992 to produce a reduction in emissions. ERCs must be approved by the Department before use. From June to December 1995 (the first six months of implementation), twenty seven sources reported using 609.3 tons of NOx ERCs. One-third of the major regulated NOx sources in Connecticut chose a market-based approach to compliance. The State approved use of 11,336 NOx ERCs from two sources in Connecticut and New Jersey.

Illinois Emissions Reduction Market System

The State of Illinois is completing rulemaking for the cap-and-trade Emissions Reduction Market System, which is designed to implement innovative and cost-effective strategies to attain the ozone NAAQS in the Chicago ozone nonattainment area primarily by reducing emissions of volatile organic material (VOM) from stationary sources. In general, the sources that will be required to participate in the program have VOM emissions of 10-tons or more during the ozone season. Each season, existing sources will receive Allotment Trading Units (ATUs) from the State; a source's seasonal emission allotments are based on its pre-program VOM emissions. Participating sources may buy ATUs from the State's Alternative Compliance Market Account, which is a reserve created by mandatory deposits of 1% of sources' allotments. A process is provided to issue ATUs for emission reductions from mobile and area sources.

Area Sources: Wood Stoves (Colorado) and Grass Seed Field Burning (Washington)

Economic incentives are being used in local programs to control emissions from area sources. The town of Telluride in Colorado, which in past winters has had a PM problem, has implemented a marketable permit program to place a cap on the number of wood-burning stoves. Another example is the marketable-permits program being developed by Washington State to facilitate implementation, by easing the financial burden on farmers, of the new statewide curb on burning grass seed fields.

Area and Mobile Sources: Ozone Transport Assessment Group (OTAG)

The Area/Mobile Sources Task Group of OTAG has examined approaches to including area and mobile sources in a trading program. The key issue is how responsibility for emissions is to be assigned. By law, motor vehicle and engine manufacturers have been assigned the responsibility for designing products to meet emissions standards, which set allowable emissions rates. The manufacturers do not have control over how their products will be used or maintained. In contrast, the owners and operators of area and mobile sources, and/or government, have control over the levels of activity that determine total emissions.

The OTAG Task Group has considered inclusion of mobile sources in voluntary "opt-in" programs for the generation of emission credits, using credit generation protocols developed by the various states and/or EPA. If the responsibility for limiting the activity level rests with the party with influence over activity--the government or the vehicle owner--a system of credits could be established. For example, once the planning authority has set the target emission rate--X grams per vehicle mile traveled--emission credits would be generated by vehicles emitting less than X grams per mile, and vehicles could emit above that rate if adequate credits were purchased.

The Task Group has also considered how area and mobile sources might become part of a cap-and-trade emission trading program. They developed a three-part conceptual model for implementation which covers 1) establishing the emission target for a source category, 2) allocating the emission responsibility to all covered sources, and 3) demonstrating compliance with the allocation (the last step applies to individual sources).

The Task Group developed two examples to illustrate the use of credits or allocations to supplement a state inspection and maintenance program, and also to apply trading mechanisms to a heavy-duty engine standard. The examples illustrate how the credits would be calculated, and how the emission reduction responsibility would be allocated.

[Future additions: 1) mobile sources examples, 2) examples of fee programs (Minnesota's toxic air pollutant fee projet, Sweden's fee on SO2, RFF's study of mobile source fees in LA), 3) emission trading programs in MA, TX, and NJ]

EPA Programs

The emission trading programs that have been developed by EPA, or with its guidance, have progressively expanded the scope of trading, increasing in turn the allowed flexibility sources possess to meet their emission reduction responsibilities, and the breadth of the emission reduction goal. EPA's programs and rules encompass netting (introduced in 1974), offsets (1977), bubbles (1979), the lead trading program (1982), the emissions trading policy statement (1986), the SO2 allowance trading program (1990), Economic Incentive Programs (EIP) rules (1994), and the Open Market Trading Rule (proposal 1995).

Phase I of the SO2 emissions trading program took effect in 1995. It requires the "dirtiest" 110 electric utility coal fired power plants to reduce emissions. Phase II takes effect in 2000. It will affect all utility sources greater than 25 MW that burn fossil fuels. Phase I will lower the average SO2 emissions to about 2.5 lb/MM Btu, or about 6.9 million tons reduced annually. Phase II will lower the average emissions to below 1.2 lb/MM Btu, or about 8.95 million tons allowed annually. By early 1995, 27 major trades had exchanged 2.3 million allowances, and the price was about $170 per ton. A separate auction totaled 326,210 tons traded. In 1994, the GAO estimated almost 40% lower costs for limited allowance transfers, relative to a command and control baseline. For 2001, the projected costs for the command and control baseline were $4.3 billion, for constrained trading were $2.5 billion, and for a flexible implementation scenario were $1.4 billion.

In 1995, EPA proposed a model rule for an open market trading program. The responses to the proposal will result in a guidance document for states to use for creating a market for "discrete emission reductions" (DERs). Sources may generate and use DERs for compliance with VOC and NOx requirements in the Clean Air Act. At the time of use, DER users permanently retire ten percent of all DERs dedicated to that particular use. The open market trading guidance (OMTG) does not place restrictions on who can own or hold DERs, nor does it require government notification or tracking of DER ownership transactions.

Appendix 2. Economic Incentive Design Principles

Regional marketable permit programs or other incentive-based regulations should be structured on the following principles:

a) prevent the possibility of area-wide backsliding,

b) include the broadest possible spectrum of sources contributing to the problem, including especially mobile and area sources,

c) account for the differing temporal and geographic impact of reducing the pollutants of concern,

d) provide for evaluation and verification of environmental performance,

e) provide a consistent program across emission source types in order to ensure a common or convertible "currency" for emission trading purposes,

f) provide for transition from other emissions trading programs adopted by OTAG, OTC, and states, as necessary or appropriate,

g) provide for seamless trading across governmental jurisdictions,

h) avoid the creation of bias or market distortions,

i) reward or protect sources that accomplish innovative, early, or voluntary reductions including those later required by law (early reduction credit, baseline protection, etc.),

j) avoid delays in meeting or dilution of reduction responsibility (e.g., no delayed compliance schedules or alternative emission limitations),

k) use economic incentives or market-based mechanisms rather than command-and-control strategies (e.g., LAER) to assure that appropriate levels of emissions are achieved by new or modified major sources, and

l) provide equivalent environmental benefit as compared to command-and-control approaches. (When used as an alternative to a technology requirement, some sharing of the benefit of lower costs should be reflected in a net environmental benefit.)