**Report of James L. Johnston**

on the proceedings of the

Department of Energy's

Voluntary Greenhouse Gas Reporting System

1605(b) workshop held

December 5-6, 2002

Chicago, Illinois

**Report of James L. Johnston**

on the proceedings of the

Department of Energy's

Voluntary Greenhouse Gas Reporting System

1605(b) workshop held

December 5-6, 2002

Chicago, Illinois

**Background**

On February 14, 2002 President George W. Bush proposed a climate change
initiative focused on sequestration and reducing greenhouse gas (GHG)
intensity in energy production and consumption. The President's proposal
departed dramatically from the approach taken by the Kyoto Protocol,
where the objective is to reduce the absolute level of greenhouse gases
back to a level below the base year of 1990. By contrast, the
President's objective is to encourage voluntary greenhouse gas
reductions while at the same time avoiding serious harm to the economy.

As a first step toward implementing the President's plan, the Department
of Energy has been directed to improve the present greenhouse gas
reporting system established under Section 1605(b) of the Energy Policy
Act of 1992. Firms registering emission reductions will supposedly not
be "penalized under a future climate policy." Moreover, "transferable
credits \[will be given\] to companies that can show real emissions
reductions." Sequestration efforts will also be given credit, both
domestically and internationally, according to the directive.

On November 18-19, 2002, a workshop was held in Washington, DC to
collect information about how the existing Voluntary Greenhouse Gas
Reporting System should be modified to implement the President's
initiative. Three subsequent workshops were held in December in Chicago,
San Francisco, and Houston.

I attended the Chicago meeting and submit the following report on those
proceedings.

**Identifying Sources**

The underlying model for emission reduction is the identification of
emission sources, and for each the establishment of baseline emissions
for some year, like 1990. This is not as easy as it sounds. Among the
questions to be addressed is whether or not the corporate entity is a
U.S. citizen. Next there is the question of what defines each entity?
Equity ownership seems to be the guide here, except when there is a
partnership or joint venture and the ownership is fractionalized.
Operational control is also a complication when there is, for example, a
power pool. The types of corporate structures are even more varied for
electric utilities because of recent mergers and divestitures.

The range of possible emission sources is much wider with respect to
greenhouse gases than, say, sulfur dioxide. There are six primary
greenhouse gases. It is not clear how the trading of these gases might
exchange with one another.

The Title IV trading of sulfur dioxide under the Clean Air Amendments of
1990 was supposed to include the exchange of nitrogen oxides. The
trading arrangement was never developed, however, and NOx emissions
remain governed by what is essentially command-and-control regulation.
This is not to say the SO2 trading system is free of regulation. It is,
in fact, highly regulated, with best available control technology
required for many emission sources. Essentially, the Title IV system is
a command and control system with a trading scheme grafted on top.

The RECLAIM trading system adopted by the South Coast Air Quality
Management District in California involves several types of emissions.
The primary ones are sulfur dioxide and oxides of nitrogen and of the
two, NOx dominates. The simultaneous trading of six kinds of emissions
has never been tested.

Corporate entities often have more than one source of emissions.
Consequently, there are gains to be achieved simply from averaging
sources within an entity. Achieving such gains does not require a
full-blown emissions trading market with all of the attendant
transaction costs. It should be noted that throughout the history of the
much simpler Title IV, trading of sulfur dioxide has mainly involved
each electric utility trading with itself.

**Measuring Emissions**

Participants in the DOE's Chicago workshop discussed at length how
emissions would be measured. Possibilities include project-specific
emissions; or entity-wide; absolute levels; as estimates derived from
energy fuel consumption; or on the basis of intensity (emissions per
unit of economic activity), as is mentioned in the Presidential
initiative. The number of measurement options available severely
complicates the setting of baselines and the subsequent compliance.

It was pointedly observed at the workshop that what is being proposed is
a trading of *assignments*, not actual emission reductions. Participants
worried there might be a great deal of political input into the
assignment of base period allowances. The sulfur dioxide trading program
suffered from extensive political manipulation and that could happen
again with the proposed trading of greenhouse gas reductions.

Considerable discussion at the Chicago workshop made obvious the
difficulties of establishing a GHG trading program. Beyond the explicit
design difficulties raised at the workshop, the implicit market design
is extremely complicated, perhaps fatally so.

Voluntary exchange is by nature open-ended. Without this openness, the
possibilities for entrepreneurial innovation are quite limited.
Successful trading systems are not constrained by detailed regulation.
Indeed, markets are substitutes for regulation. [Yet the rules
determining sources and how emissions are to be measured will be
enormously complex, effectively replacing markets with bureaucracies. It
raises the possibility that transaction costs might actually be less for
a command-and-control system.]{.mark}

[]{.mark}

[History is a useful guide here.]{.mark} The oil futures and options
markets emerged in an order that matched the timing of price
deregulation. Natural gas contracts were initiated after deregulation of
wellhead prices in 1985. The trading of currencies started in Chicago
after the system of fixed exchange rates was abandoned in the early
1970s. [It seems implausible in light of this history that functioning
markets would emerge *after* the imposition of new regulations.]{.mark}

The record for trading schemes is not good with respect to energy
conservation and emission reduction. The South Coast Air Quality
Management District in California had an existing program, operated as a
joint venture by oil companies, of retiring old automobiles from the
highways and roads. It had won an award for its innovative approach to
reducing pollutants, especially oxides of nitrogen. At the time the
RECLAIM system was being established, opposition arose toward the
auto-scrapping project. Antique car collectors were concerned about
losing a source of spare parts for their restorations. The oil companies
arranged a 48-hour period after accepting an auto when the collectors
could cannibalize the vehicles for parts. That was acceptable to most
parties. Nevertheless, the District decided to impose a limit on the
number of cars that could be scrapped, and subsequent restrictions
eliminated the viability of the project entirely.

**Verifying Emissions**

Participants in the Chicago workshop discussed the challenges posed by
the need to develop credible baseline data and verify emission
reductions on an ongoing basis. The ubiquitous nature of carbon dioxide
makes it very difficult to associate emissions with any specific source.
By contrast, the sources of pollutants like sulfur dioxide and oxides of
nitrogen are comparatively easier to identify, precisely because they
are pollutants. SO2 and NOx have measurable effects on human health and
are distinct enough to be separately identified from the surrounding
environment.

The verification problem is especially difficult with sequestration
projects. The effect of growing plants and trees to absorb CO2 is
[estimated on a macro scale using computer models. Calculating local
effects may not be feasible]{.mark}. Moreover, [since CO2 moves across
the North American continent with prevailing winds,]{.mark} it is
difficult to estimate what the CO2 levels would have been in the absence
of sequestration projects. That difficulty also presents itself for
other projects that involve emission reductions, like car pools for
employees and other energy conservation efforts.

Establishing an emissions baseline is an especially thorny question with
respect to electricity generated by nuclear energy. Virtually no
emissions of any type are coincident with nuclear-powered generators.
But that has always been the case, even before any base year like 1990.
Would Congress allow emissions credit for nuclear-powered electricity
capacity already in existence before a base year? Or would Congress
allow credit only for the incremental amount displaced after the trading
program was put into place? A precedent can be found in the CAAA of
1990, where the savings in sulfur dioxide emissions were denied to
nuclear power plants.

The inherent difficulty in arranging a data reporting system for GHG
emission reduction projects suggests they defy the conventions
established for existing emissions trading systems. If such projects are
nevertheless created, it would not be surprising to see them disappear
from the trading program once it is established, or soon after, as
happened with auto scrapping in California.

**Emissions Verification**

Questions arose about how the emission reports submitted by entities
participating in a trading scheme would be verified. Participants at the
Chicago workshop thought a signed statement from the entity's technical
manager would suffice, but it is not clear such an arrangement would
satisfy government officials. Nor is it obvious what alternatives to
self-reporting would be acceptable, but Arthur Anderson and vote
counters in Florida are definitely not on the list.

Data gathering for greenhouse gas reductions would be more extensive and
more widely applicable than any other data-gathering effort with the
possible exception of income tax reporting. [Enforcement will therefore
be hugely expensive. It is worth noting that some experts believe the
cost of compliance and enforcement of the income tax exceeds the revenue
the tax collects.]{.mark}

Several participants indicated data gathering for greenhouse gas
emissions ought to be coordinated with other federal data collection
efforts. The suggestion probably reflects frustration with the
pervasiveness of current data-gathering requirements more than any
realistic hope that greenhouse gas measurement can be made to fit in
with other efforts. Moreover, any combined or "streamlined"
data-gathering effort would mean many agencies would likely review the
reported data. [This has already raised serious concerns under the Toxic
Release Inventory (TRI) program, where public release of emissions data
has caused competitive and security concerns, as well as giving
environmental groups raw data with which to frighten an ill-informed
public.]{.mark}

Another question that complicates the monitoring of a GHG trading scheme
involves entitlement to the credits. Who should receive them: the
*seller* of energy, or the *buyer*? Congress might make this decision,
or the trading parties might work out the arrangements through
contracting among themselves.

Either arrangement would be complicated and potentially costly.
Government decisions on such a wide scale would be time-consuming and
subject to delays. Standing contracts would have to be renegotiated
where they exist. But not all relationships are covered by contract.
Some are regulated by state agencies, and some are internal to a
corporate structure, especially for vertically integrated firms that
operate internationally. Formalizing all of these myriad arrangements
would be neither cheap nor easy.

Even if the many complexities of emissions verification, baseline
establishment, data quality, and entitlement to the credits could be
worked out, the ultimate measure of compliance with the national goal
would not be derived from this extensive effort. Another calculus,
called the "macro goal," will be used. Apparently, sensors placed in
some yet-to-be-determined pattern will measure the degree of overall
national compliance. That determination, in turn, will in all likelihood
affect the goals for individual emission sources. The future would seem
to involve ever-changing targets and emission assignments for
participants.

**The Promise**

President Bush has directed the Secretary of Energy to recommend reforms
to the greenhouse gas reporting system that (a) ensure that businesses
and individuals registering reductions are not penalized under a future
climate policy and (b) give transferable credits to companies that can
show real emission reductions.

What is notable, first of all, is that sequestration projects are not
included is this guarantee, if it can be called that. [Companies in
forestry, agriculture, and outdoor recreation in particular would be
wise to hold off]{.mark} betting large sums on such a long shot.

More importantly, a later directive can supercede the President's
directive by the present office holder or by a subsequent office holder.
Congress also has the authority to substantially change rules
established by the Administration.

The record of governments that currently supervise emission-trading
schemes is not encouraging in this respect. Indeed, in the CAAA of 1990
and the RECLAIM system for the Southern California Air Basin (SCAB) have
explicit provisions allowing subsequent changes or outright elimination
of emissions trading.

This is achieved by denying the allowances and credits property rights
status. Since the allowances and credits are not property, reducing
their value by changing the rules is not a "takings" under the Fifth
Amendment of the Constitution. Thus, the governments are not required to
offer compensation to the injured parties. In both of these trading
schemes, the government agency explicitly reserves the right to change
or eliminate the system entirely.

> An allowance allocated under this title is a limited authorization to
> emit sulfur dioxide in accordance with the provisions of this title.
> Such allowance does not constitute a property right. Nothing in this
> title or in any other provision of law shall be construed to limit the
> authority of the United States to terminate or limit such
> authorization. \[Clean Air Act Amendments of 1990, 405(f)\]

\- - -

> RTCs \[RECLAIM Trading Credits\] are not property within the meaning
> of the state and federal constitutions. The \[South Coast Air Quality
> Management\] District reserves the right to limit, suspend or
> terminate any RTCs, or the authorization to emit \... \[Regional Clean
> Air Incentives Market, Volume I, October 1993, page 3-19\]

It was later discovered that these reservations were not idle threats.
In April 2002, a change in the rules for trading sulfur dioxide
allowances in Philadelphia---where 80 percent of the modest trading was
taking place---all but dried up the market. During the electricity
crisis of 2000 and 2001, the South Coast Air Quality Management District
suspended the trading of RECLAIM credits among electric utilities and
replaced trading with monetary penalties for NOx emissions.

It is worth mentioning that the failed electricity market in California
was also designed by statute. All trading was confined to the spot
market. Lost were the long-term contractual arrangements where consumers
paid an options premium for price stability and the proceeds of the
premium were used by suppliers to install extra capacity in generation
and transmission.

During normal times, spot prices are usually lower than contract prices.
But during a crisis spot prices rise sharply higher than contract prices
previously negotiated. The political establishment in California
suspended the trading of electricity and successfully lobbied the
Federal Energy Regulatory Commission to roll back allowable prices. This
effectively destroyed the electricity market in California and seriously
impaired the trading of electricity in other parts of the country.

At the Chicago workshop it was pointed out the government had a severe
credibility problem because of the trading suspensions. One workshop
participant suggested the interim regime proposed by the President's
directive be guaranteed in writing by the President and/or by the
Secretary of Energy. After all, he noted, a written guarantee is being
required from firms to verify the accuracy of their emissions reporting.

The DOE representatives' response to this suggestion was very
instructive. It was pointed out that a written guarantee would not bind
the next President or even the next secretary of energy. The only
reasonable conclusion one can draw is that the no-penalty promise will
not be kept.

**What Is a Company to Do?**

The Chicago workshop made clear the many flaws associated with a system
of voluntarily reporting greenhouse gas emissions. It has all the
dangers of self-incrimination: providing the government \[not to mention
competitors and environmental groups\] with information that could be
used to reward allies and punish adversaries. In the present
anticapitalist environment, where private-sector firms are viewed with
considerable hostility, political rewards and punishments are very real
possibilities. It is obviously tempting for emitting entities to avoid
participation in such a program.

On the other hand, being absent from the political arena leaves firms
vulnerable to disadvantages built into the trading regime by
competitors, as was done when the federal government and several states
mounted an antitrust suit against Microsoft. Moreover, firms that refuse
to participate may lose a public relations advantage available to those
who voluntarily decrease emissions. However, as one private-sector
participant at the Chicago workshop observed, public relations might
justify participation in the reporting phase, but it is not a sufficient
rationale for taking part in a flawed trading system.

It was also pointed out at the workshop that alternatives exist to
emissions trading schemes. Many firms, for example, might simply
accumulate emissions credits not to trade, but to bank the credits for
application against future growth.

Moreover, other proposals for greenhouse gas emissions trading are being
proposed in Congress and by some think tanks, like Resources for the
Future. One Congressional proposal would reduce the allowable sulfur
dioxide emissions by three-quarters and devalue the banked allowances by
a similar amount.

Another proposal by a government-funded think tank would substitute a
tax for emissions trading. The think tank analysts believe it possible
to construct a tax that would achieve results similar to those of a
trading system. This devotion to taxes ranks in the same class as
Gollum's obsession with the Ring in J.R.R. Tolkien's *Hobbit*.

For a firm facing such dangers from government-funded schemes for
reducing greenhouse gases, it would seem prudent to support financial
analysts and free-market institutions not committed to government
solutions. It would be sensible as well to promote more scientific
inquiry into global warming theory. Contrary to the claims of the
political establishment, the science is far from settled.

*Jim Johnston is an economist retired from Amoco and a policy advisor to
The Heartland Institute.*