# T o ols of the Tr ade

A Guide t o D esigning and Oper ating a C ap and T r ade P r ogr am f or P ollution C o ntr o l

# T o ols of the Tr ade:

A Guide T o D esigning and Oper ating a C ap and T r ade P r ogr am F or P ollution C o ntr o l

Unit ed Stat es En vir onmental P r ot ec tion A genc y O ffic e of Air and R adiation EP A430-B-03-002

www .epa.go v/airmark ets June 2003

# T able of C o n t en ts

A c k n o wlegments

................................................................................................................. ...........................................................................................ii Chapt er 1: Intr oduc tion

......................................................................................................... ...................................................................................1-1 In tr od uction

................................................................................................................... .....................................................1-1 P urpose ........................................................................................................................ ........................................................1-1 Structur e ...................................................................................................................... ........................................................1-1 Cap and T r ade

.................................................................................................................. ..................................................1-2 Chapt er 2: Is C ap and T r ade the R i ght T o ol?

..................................................................................... .................................................................2-1 In tr od uction

................................................................................................................... .....................................................2-1 Gener al Assessmen t Iss ues ...................................................................................................... ..........................................2-1 Comparison of Cap and T r ade and Other P olicy Options

........................................................................... ...................2-5 Chapt er 3: D e v eloping a C ap and T r ade P r ogr a m ................................................................................... .......................................................3-1 In tr od uction

................................................................................................................... .....................................................3-1 G uiding Principles

............................................................................................................. .................................................3-1 Establishing Legal Authority

................................................................................................... .........................................3-2 Cr ea ting an Emission Inve n tor y ................................................................................................. .......................................3-3 Pr ogr am Design Elemen ts ........................................................................................................ ........................................3-4 Other Design Consider a tions

.................................................................................................... ......................................3-2 5 Chapt er 4: Ho w t o Implement and Oper at e a C ap and T r ade P r ogr a m ................................................................. ...............................4-1 In tr od uction

................................................................................................................... .....................................................4-1 In tegr a ted Inf orma tion Sy stems ................................................................................................. .......................................4-1 Auditing and V erif ica tion

...................................................................................................... ............................................4-4 T

echnical Support f or Regula ted Sources

........................................................................................ ................................4-5 Administr a t i ve Costs Associa ted with Cap and T r ade

............................................................................. .......................4-6 Chapt er 5: A ssessment and C ommunications

........................................................................................ ..........................................................5-1 In tr od uction

................................................................................................................... .....................................................5-1 Communica ting Sta tus and Re s ults

............................................................................................... ...................................5-1 Communica tion Iss ues Unique to Emission T r ading Pr ogr ams ....................................................................... .............5-2 Modes of Communica tion

......................................................................................................... .........................................5-5 Con tinued Assessmen t ........................................................................................................... ...........................................5-5 Glossar y of T e rms.............................................................................................................. ............................................................................Glossar y-1
A c r o n yms ....................................................................................................................... ...............................................................................A c r o n yms-1 Ref e r enc es ..................................................................................................................... .............................................................................Ref e r enc es-1 Appendix A: T he Optimal L e v el of P ollution

...................................................................................... ..............................................................A-1 The Economics of Emission T r ading

.............................................................................................. ................................ A-2 Appendix B: Example A ssessment of the P o t e ntial F or C ap and T r ade

............................................................... ...................................B-1

ii T able of C o nt ents

# A ck no wledgmen ts 

# T he U

. S. Envir onmen tal Pr otection Agency (EP A) would lik e to acknowled ge the many indi vid ual con tributors to this documen t , without whose eff orts this guidebook would not be comple te. Although the comple te list of e xperts who ha ve pr ovided technical and editorial s upport is too long to list her e, w e would lik e to thank some k e

y con tributors and r e vie w ers who ha ve pla y ed a signif ican t r ole in de veloping this guidebook. In particular , w e wish to ackno wled ge the eff orts of the staff of the Clean Air Mark e ts Di vision (C AMD) of the U

. S. EP A – the di vision r esponsible f or oper a ting the U .S. SO 2 Allo wance and Ozone T r ansport Commission (O T C) NOx B u d g e t T r ading P r ogr ams. Many staff con tributed to this guidebook, including Rona Birnbaum, Ke vin Culligan, K a tia K a r ousakis, Stephanie Grum e t , Richa r d Haeube r , Melanie LaCou n t , Sasha Mackle r , Brian McLean, Be th Murr a y

, Sam Napolitano, and Shar on Saile. Special men tion is d ue to Jennif er Macedonia and Mar y Shellabar ger who did much of the planning and de velopmen t of this guidebook. Joe Kruger and Jer e my Schr eif els compiled and edited the comple ted documen t . This guidebook benef ited immensel y f r om the commen ts and s uggestions of a panel of e xternal r e vie w ers, including Dallas B urtr aw , Resources f or the F utur e; Andrzej Blacho wicz, Cen ter f or Clean Air Policy; T o mas Chmelik, Czech Ministr y of Envir onmen t; A. Denny Ellerman, Massachuse tts Institute of T echnology; Erik Haites, Ma r ga r ee Con s ulta n ts; Blas **Pérez** Henr **í** quez, Un i versity of Cali f ornia-Ber k el e y; Stan Kola r , Ce n ter f or Clean Air Policy; Nancy Seidman, Massachus e tts Depar t me n t of E nvi r onme n tal P r otection; Ji n tian Y ang, Chinese Research Academy of Envir onmen tal Sciences; and Pe ter Zapf el, Eur opean Commission. W e w ould lik e to thank each of them f or their insightful commen ts and s uggestions. W

e w ould also lik e to thank the staff a t ER G f or gr aphics and pr od uction s upport .

iii A ck no wledgements

# 1 In tr oduc tion

In tr oduc tion 

# T o ens ur e a cleaner , healthier envir onmen t , governmen ts ar e incr easingl y using mark e t-based pollution con tr ol appr oaches, s uch as emission tr ading, to r e d uce harmful emissions. The theor y of emission tr ading and the poten tial benef its of mark e t
based incen ti ves r e la ti ve to mor e tr aditional envir onmen tal policy appr oaches ar e w ell established in economic and policy liter a tur e. Un til r ecen tl y , how e ve r , pr actical applica tions of emission tr ading pr ogr ams ha

ve been r e la ti ve l ylimited. In 1 990, the United Sta tes enacted legisla tion to implemen t a compr ehensi ve na tional s ulfur dio xide (SO 2 ) pr ogr am using a f orm of emissions tr ading called “cap and tr ade.” The U .S. SO 2 cap and tr ade pr ogr am has pr oven to be highl y eff ecti ve f r om both an envir onmen tal and an economic standpoin t . The s uccess of this pr ogr am and others tha t f ollow ed has spurr ed in ter est f r om policymak ers, r egula ting authorities, and business and en vir onmen tal organiza tions. T o d a y

, emission tr ading mechanisms ar e incr easingl y consider ed and used wo rld wide f or the cost-eff ecti ve mana gemen t of na tional, r egional, and global envir onmen tal pr oblems, including acid r ain, gr ound-le vel ozone, and clima te change. 

# P u rpose This guidebook is in tended as a r e f e r ence for policymak ers and r egula tors considering cap and tr ade as a policy tool to con tr ol pollution. It is in tended to be s uff icien tl y generic to appl y to v arious pollutan ts and envir onmen tal concerns; how e ve r , it emphasizes cap and tr ade to con tr ol emissions pr od uced f r om sta tionar y source combustion. In the United Sta tes, SO 2 and NOx ar e con tr olled with cap and tr ade pr ogr ams. These pr ogr ams pr ovide many illustr a t i ve e xamples tha t ar e described within this te xt . 

# Struc tur e This guidebook is organized as f ollow s : • The in tr od uction e xplains the policy tool kno wn as cap and tr ade. • Chapter 2 pr ovides guid ance on ho w to de termine if cap and tr ade is the right solution f or a particular pr oblem and describes ho w it v a ries f r om other policy options, including other f orms of emission tr ading

.

1-1 Intr oduc tion• Chapter 3 e xplains the pr ocess f or de veloping a cap and tr ade pr ogr am. • Chapter 4 e xplains ho w to implemen t and opera te a cap and tr ade pr ogr am. • Chapter 5 discusses ho w to assess the r e s ults of a cap and tr ade pr ogr am and communica te them to the public. • G lossar y of T erms and Acr onyms con tains def initions of the terms and abbr e v ia tions used thr oughout this guidebook. • Ref er ences con tains a list of articles and papers cited in this guidebook. • The Appendices con tain additional technical and r e f e r ence inf orma tion. Specif ic e xamples ar e pr ovided thr oughout the te xt . These e xamples dr aw on the e xperience f r om cap and tr ade pr ogr ams, including the U .S. SO 2 Allo wance T

r ading P r ogr am (also kno wn as the Acid Rain P r ogr am), the Regional Clean Air Incen ti ves Mark e t (RECL AIM) in Southern Calif ornia, the Ozone T

r ansport Commission (O T C) Regional NOx T r ading P r ogr am in the Northeastern United Sta tes, and the United Kingdom’s emission tr ading pr ogr am f o r carbon dio xide (CO 2 ). These e xamples w e r e selected to illustr a te v arious aspects of cap and tr ade and ar e not in tended to endorse con tr ols on a specif ic pollutan t . 

# C ap and T r ade Cap and tr ade is a mark e t-based policy tool f or en vir onmen tal pr otection. A cap and tr ade pr ogr am establishes an a ggr ega te emission cap tha t specif ies the maximum quan tity of emissions authorized f r om sources included in the pr ogr am. The r egula ting authority of a cap and tr ade pr ogr am cr ea tes individ ual authoriza tions (“allow ances”) to emit a specif ic quan tity (e.g., 1 ton) of a pollutan t . The total number of allow ances equals the le vel of the cap. T o be in compliance, each emission source must s urr ender allowances equal to its actual emissions. It ma y bu y or sell (tr ade) them with other emissions sources or mark e tparticipan ts. Each emission source can design its own compliance str a tegy – emission r e d uctions and allow ance purchases or sales – to minimize its compliance cost . And it can adjust its compliance str a tegy in r esponse to changes in technology or mark e tconditions without r equiring governmen t r e

vie w and appr ov al. 

## H o w a C a p a n d T r a d e P r o g r a m W o r k s 1. T he r egulating authorit y sets a cap on t otal mass emissions f or a gr oup of sour c es f or a fix ed c omplianc e period (e .g ., 1 y ear). 2. T he r egulating authorit y divides the cap int o allo wanc es , each r epr esenting an authorization t o emit a specific quantit y of pollutant (e .g ., 1 t on of SO 2 ). 3. T he r egulating authorit y distribut es allo wanc es . 4. F or the c omplianc e period , each sour c e measur es and r e por ts all of its emissions

. 5. A t the end of the c omplianc e period , each sour c e must surr ender allo wanc es t o c o v er the quantit y of the pollutant it emitt ed

. I f

a sour c e does not hold sufficient allo wanc es t o c o v er its emissions , the r egulating authorit yimposes penalties

. 

# En vir onmen tal C e r tain t y Cap and tr ade pr ogr ams off er a number of ad v a n t a ges over mor e tr aditional appr oaches to envir onmen tal r egula tion. First and f o r e most , cap and tr ade pr ogr ams can pr ovide a gr ea ter le vel of envir onmen tal certain ty than other envir onmen tal policy options. The cap, which is se t b ypolicymak ers, the r egula ting authority, or another governing bod y , r epr esen ts a maximum amoun t of allowable emissions tha t sources can emit . P enalties tha t e x ceed the costs of compliance and consisten t , eff ecti ve enf orcemen t de ter sources f r om emitting be y ond the cap le vel. In con tr ast , tr aditional policy appr oaches s uch as command-and-con tr ol r egula tion gener all y do not establish absolute limits on allowable emissions but r a ther r e l yon emission r a tes tha t can allow emissions to rise as utiliza tion rises. With cap and tr ade pr ogr ams, e ven ne w emission sources ma y not incr ease the limits on emissions. The r egula ting authority ma y r e quir e ne w en tr an ts to purchase or r ecei ve alloca ted allo wances f r om the total allo wable emissions se t b y the cap (see Chapter 3 f or a description of diff er en t wa y s tha t ne w en tr an ts ma y be tr ea ted). Thus, the emissions tar ge t is main tained and the price of an allo wance can adjust to r eflect the incr eased demand f or allo wances. A cap and tr ade pr ogr am ma y also encour a g e sources to purs ue earlier r e d uctions of emissions than w ould have other wise occurr ed, which can r e s u lt in

1-2 Intr oduc tionthe earlier achie vemen t of envir onmen tal and human health benef its. This is a r e s ult of tw o primar y dri vers: f irst , the cap and associa ted allo wance mark e t cr ea tes a mone tar y v alue f or allo wances, pr oviding sources with a tangible incen ti ve to decr ease emissions. Second, a cap and tr ade pr ogr am can incorpor a te the fle xibility of banking (see Chapter 4) to pr ovide sources with an additional incen ti ve to r e d uce emissions earlier than r equir ed. Banking allo w s sources to carr y over unused allo wances f or use in a la ter compliance period when ther e might be mor e r estricti ve r equir emen ts or higher e xpected costs to r e d uce emissions. Essen tiall y , banking gi ves sources some flexibility in the timing of emission r e d uctions (i.e., tempor al fle xibility). This is in addition to fle xibility gi ven to sources in the loca tion a t which the y mak e emission r e d uctions (i.e., spa tial fle xibility). Another envir onmen tal ad v a n t a ge of cap and tr ade is impr oved accoun tability. P articipa ting sources must full y accoun t f or e ver y ton of emissions b y f ollo wing pr otocols to ens ur e comple teness, accur acy, and consistency of emission meas ur emen t . This s y stem contr asts with most envir onmen tal pr ogr ams tha t base compliance on periodic inspections and ass umptions tha t equipmen t is functioning and the source is in compliance be tw een inspections. Accur a te meas ur emen t of emissions and timel y r eporting ar e critical to the s uccess of a cap and tr ade pr ogr am and the in tegrity of the cap. After emissions d a ta and allow ance tr ansaction inf orma tion ar e r eported,


### F igur e 1. C ost M inimiza tion W ith T r ading the r egula ting authority can pr ov ide de tailed or s ummar yinf orma tion to the public (e.g., on the In terne t). This tr anspar ency , or access to inf orma tion, can pr ovide conf idence in the eff ectiveness of the pr ogr am. 

# M inimizing C o n t r ol C osts In addition to the envir onmen tal benef its of adopting a cap and tr ade pr ogr am, signif ican t economic benef its also s upport the use of s uch a mechanism. Cap and tr ade pr ogr ams pr ovide sources with fle xibility in how the yachie ve their emission targe t , which is uncommon under tr aditional envir onmen tal policy appr oaches. The cap establishes the emission le vel f or emission sources; the sources, how e ve r , ar e pr ovided with the fle xibility of choosing how the y wa n tto aba te their emissions. Each source can choose to in vest in aba temen tequipmen t or energy eff iciency meas ur es, to s witch to fuel sources with no or r e d uced emissions, or to shutdown or r e d uce output f r om higher emitting sources. The r egula ting authority does not need to appr ove each source’s compliance choices because the cap, accompanied b yemission meas ur emen t and r eporting r equir emen ts, enable the r egula ting authority to f ocus on assessing compliance r e s ults (i.e., ens uring tha t each source has a tleast one allowance f or each unit of pollution emitted). Cap and tr ade pr ogr ams also allow sources to tr ade allowances, pr oviding an additional option f or compl ying with the emissions targe t . Sources tha t ha ve high marginal aba temen t costs (i.e., the cost of r e d ucing the ne xt unit of emissions) can purchase additional allowances f r om sources tha t ha

ve low marginal aba temen t

Initial Emissions

Allo wable limit (cap)

Abat ement C ost: $100/t on Reduc tion: 5 t ons Abat ement C ost: $80/t on Reduc tion: 7 t ons Abat ement C ost: $120/t on Reduc tion: 3 t ons

P o ten tial tr ansfer of 2 allo w anc es for $80-$120 each 3 tons 5 tons 7 tons 10 tons 10 tons 10 tons costs. In this wa y

, both bu y ers and sellers of allowances can benef it . Sources with low costs can r e d uce their emissions below their allowance holdings and earn r e venues f r om selling their e x cess allowances – a r e

wa r d f or be tter envir onmen tal per f ormance. Sources with high costs can purchase additional allowances a ta price tha t is low er than the cost to r e d uce a unit of pollution a ttheir f acility (see Fi gur e 1). This outcome is consisten t with the “polluter pa

y s” principle.

1-3 Intr oduc tionA w ell designed cap and tr ade pr ogr am can also pr ovide con tinuous incen ti ves f or innov a tion in emission aba temen t . Because of the v alue a ttached to allo wances. The v alue cr ea tes an economic incen ti ve to invest in r esearch and de velopmen t f or emission aba temen t options tha t can further r e d uce the costs of a ttaining compliance. Finall y , the cost-minimizing f e a tur e of cap and tr ade has long-term en vir onmen tal benef its. Driv ing down the cost of r e d ucing a unit of pollution means tha t policymak ers and r egula ting authorities can se t targe ts tha t r e d uce mor e pollution a tthe same cost to socie ty . This s y stem mak es it economicall y and politicall y f easible to achie ve gr ea ter en vir onmen tal impr ovemen t .

1-4 Intr oduc tion

# 2 Is C ap and T r ade the R igh t T o ol?

In tr oduc tion 

# C ap and tr ade can be an eff ecti ve tool to addr ess air pollution. How e ve r , it is not appr opria te in all situa tions or f or all envir onmen tal pr oblems. P

olicymak ers should consider a number of importan t iss ues bef or e deciding whe ther cap and tr ade is appr opria te. Prior to de veloping a cap and tr ade pr ogr am, policymak ers and other e xperts should de termine whe ther the na tur e of the envir onmen tal pr oblem, as w ell as the institutional capacity and political situa tion, is cond uci ve to the s uccessful establishmen t of s uch a pr ogr am (Benk ovic and Kruger , 2 0 0 1). This section begins with a brief discussion of some of the gener al iss ues tha t must be assessed f or any type of emission r e d uction pr ogr am. Ne xt , the section e

xamines whe ther cap and tr ade can addr ess a particular envir onmen tal pr oblem. F inall y , it compar es cap and tr ade to other types of policies including diff er en t f orms of emission tr ading

. 

# G ener al Assessmen t Issues Bef or e making a decision about an emission r e d uction progr am, policymakers should assess a number of science, technology , and other iss ues. F or e xample, r egar dless of the type of progr am chosen, policymak ers must understand the na tur e of the en vironmen tal or health problem of concern, the pa th w

a ys of e xpos ur e, the location and ma gnitude of the sources tha t con tribute to the problem, and the emission r e d uctions necessar y to addr ess the problem. Similarly , policymak ers should ha

v

e ans wers to technical and economic questions s uch as the cost , a v ailability , and per f ormance of con trol technologies. Although a full discussion of these questions is be yond the scope of this manual, Appendix B s u mmarizes how some of these questions we r e addr essed under the U

. S. SO 2 Allow ance T r ading Progr am. Once policymak ers ha ve a thor ough understanding of these iss ues and questions, the y can de termine whe ther cap and tr ade is an appr opria te tool to addr ess the pr oblem. The f ollowing sections outline some of the k e

y consider a tions used to de termine whe ther cap and tr ade will be an eff ecti ve pr ogr am f o r a particular situa tion.

2-1 Is C ap and T r ade the R ight T o ol?

# Is F l e xibilit y A p pr opria te? Cap and tr ade is pr emised on the notion tha t r egulators do not need to dir ect the type or loca tion of specif ic emission r e d uctions within a r egion. Instead, these pr ogr ams se t an over all targe t and le t “the mark

e t” de termine wher e to mak e the most cost-eff ecti ve r e d uctions. In some cases, how e ve r , it does ma tter wher e an emission r e d uction is made. F or e xample, some to xic emissions ma y ha ve primaril ylocal health impacts in the ar ea immedia tel y s urr ounding a f acility

. Allowing s uch a f acility to bu y allowances f r om other similar f acilities in the ar ea ma y not full y addr ess the risks caused b yits emissions. It ma y mak e a situa tion worse b ycausing a “hotspot” if the cap does not r equir e s uff icien t r e d uctions to minimize or pr e ven t local impacts. In s uch a case, it ma y be necessar y , f

r om a public health standpoin t , to impose source-specif ic con tr ols and limit the fle xibility inher en t in an emission tr ading pr ogr am. In gener al, the mor e a pollutan t is unif orml y dispersed over a lar ger geogr aphic ar ea, the mor e appr opria te it is f or the use of cap and tr ade. E ven when the loca tion of emissions does ma tter , cap and tr ade ma y be eff ecti ve if the envir onmen tal goal can be me t thr ough emission r e d uctions in a gener al r egion. F or e xample, a cap and tr ade pr ogr am can r e d uce total loadings of a pollutan t in to the a t mospher e, particularl y if these pollutan ts ar e emitted b y many sources and tr ansported over a large geogr aphic r egion. This was the case in the United Sta tes with the SO 2 Allowance T r ading Pr ogr am, which is in tended to r e d uce acid deposition in the Eastern United Sta tes and Canad a. Similarl y , cap and tr ade pr ogr ams can addr ess ambien t air quality pr oblems b yr e d ucing back gr ound le vels of pollution tha t con tribute to ad verse air quality . F or e xample, if ther e ar e pr e v ailing winds, it ma y be necessar y to include emission sources upwind of the polluted ar ea tha t could pr e ven t downwind ar eas f r om mee ting their ambien t air quality stand ar ds. The NOx cap and tr ade pr ogr ams in the Northeastern United Sta tes w e r e designed to r e d uce long-r ange tr ansport of NOx emissions tha t lead to the f orma tion of gr ound-le ve l ozone. Bef or e designing cap and tr ade pr ogr ams to addr ess emissions tha t ar e not unif orml y mix ed, it is necessar y to cond uct an assessmen t of the possibility of hotspots. Chapter 3 con tains a discussion about wa y s to assess the poten tial f or hotspots and ho w to de velop policies to avoid them if necessar y. In s uch cases r egula ting authorities ma y need to limit emissions a t specif ic sources or limit tr ading to ens ur e tha t the pr ogr am does not cr ea te hotspots and tha t it achie ves the envir onmen tal objecti ves. It should be noted, ho w ever , tha t if a pr ogr am r equir es too many tr ading r estrictions to avoid hotspots, a mor e conve n tional r egula tor y appr oach to addr ess the pr oblem might be pr ef er able. 

# Do Sour c e s Ha v e Differ en t C o n t r ol C osts? Cap and tr ade pr ogr ams mak e the most sense when emission sources ha ve diff er en t costs f o r r e d ucing emissions (Ne w ell and Sta vins, 1 9 9 7). These cost diff e r ences ma y r e s ult f r om the a ge of the f acilities, a v ailability of technology , loca tion, fuel use, and other f actors. In the U .S. SO 2 Allowance T r ading Pr ogr am, ther e was consider able di versity in emission r e d uction costs because of diff er ences in the a ge of pow er plan ts and the pr o ximity to low s ulfur coal s upplies (Sta vins, 1 9 9 8). Wher e costs ar e diff er en t , ther e is “r oom f or a deal,” because sources with high marginal aba temen t costs ha ve an incen ti ve to bu y allowances f r om sources with low marginal aba temen t costs. Conversel y , if aff ected sources tend to be r ela ti ve l yhomogenous, their marginal aba temen t costs ma y be appr o xima tel y equal and ther e is little incen ti ve f or tr ading . In this case, a cap and tr ade pr ogr am is not lik el y to yield a signif ican tl y mor e cost-eff ecti ve outcome than mor e tr aditional types of r egula tion. T able 1 is a compila tion of SO 2 marginal con tr ol costs f or sources in T aiyuan, China. The d a ta w e r e used to assess the f easibility of using cap and tr ade to r e d uce SO 2 emissions. This type of anal y sis is critical to de termining the merits of using cap and tr ade as a policy instrumen t . 

# A r e T her e Sufficien t Sour c es? In gener al, cap and tr ade pr ogr ams should include enough sources to cr ea te an acti ve mark e tf o r allowances. If ther e ar e too f e

w sources, ther e ma y be f e

w opportunities f or tr ading . In addition, e ven if ther e ar e cost-eff ecti ve tr ading opportunities in a pr ogr am with f e

w sources, a mark e twith f e

w tr ansactions could mak e poten tial sellers r eluctan t to part with their e

x cess allowances. These poten tial sellers could be concerned tha t if business conditions change and the y need mor e allowances in the futur e, the y will ha ve diff iculty purchasing them. The y ma y instead hoar d e

x cess allowances e ven though it might not appear to

2-2 Is C ap and T r ade the R ight T o ol?

## T a b l e 1 : C o s t
- E f f

e c t i v e n e s s o f S O 2 

## C o n t r o l M e a s u r e s i n T a i y u a n , C h i n a C o n t r o l S our c e C ost/ton (US$) T r eat post-c ombustion gas T aiyuan Distric t Heating $60 F lue gas desulfurization (FGD) East ern Mountain P o w er Plant $80 L o w er sulfur c oal (~1.3%) T aiyuan #1 and #2 P o w er Plants , T

aiyuan Ir on & St eel $100 FGD (simplified) T aiyuan #1 P o w er Plant * $240 Limest one fuel additiv e C oal G asification Plant $130

* In addition t o unspecified c osts paid thr ough a gr ant fr om the go v e rnment of Japan. Sour c e : RFF , 2001 the ymust f ollow na tional policies but ar e given consider able autonom y in implemen ta tion. 2 T

o the e xten t tha t the r egion of a cap and tr ade pr ogr am covers mor e than one jurisdiction, the authorities should main tain some consistency in k e

y design elemen ts of the pr ogr am. T o ens ur e tha t the allow ances ar e consisten t and fungible acr oss jurisdictions, cap and tr ade pr ogr ams r equir e common design elemen ts, including stand ar ds f or de termining applicability , emissions meas ur emen t and r eporting, r ecor dk eeping, enf orcemen t , and penalties f o r be in their economic in ter est to do so. Additionall y , with f e

w er sources, ther e ma y be a concern tha t larger sources ma y e x ert mark e tpow er and withhold allowances f r om the mark e tto dri ve up prices of allowances. Ther e is a tr adeoff, howe v

e r , in tha t the mor e numerous the sources, the mor e comple x and costly the cap and tr ade progr am ma y be to establish and oper a te. F o r e

xample, a cap and tr ade progr am f or v ehicles could be administr a t iv ely costly if ther e w as a need to meas ur e and r eport emissions and enf orce compliance a t the v

ehicle le v

el. 1 T echnological adv ances, howe v

e r , ar e making it possible to cost-eff ectiv e ly e

xpand participation in cap and tr ade progr ams (e.g., computerized d a t a tr acking s ystems, impro v

ed emission meas ur emen t technology (Kruger , e t al., 2 000)). 

# Is ther e A dequa te A uthorit y? Another importan t question governmen t off icials must consider is whe ther the r ele v a n tgovernmen t en tity has s uff icien t jurisdiction over the geogr aphic ar ea wher e the ywould implemen t the cap and tr ade pr ogr am. In man y coun tries, r egional or local authorities ar e r e sponsible f or implemen ting en vir onmen tal pr ogr ams. Often, non-compliance (Kinner , 2 0 0 2). Thus, pr ogr am designers should ans wer the f ollowing questions: • W ill pr ovinces and municipalities be r esponsi ve to dir ecti ves, s uch as monitoring r equir emen ts, imposed b y the na tional governmen t or w ould the y cooper a te to f orm a collecti ve eff ort to de velop s uch r equir emen ts? • Does the cen tr al governmen t , or coalition of local governmen ts, have the capacity to enf orce compliance pr ovisions and penalties thr oughout the en tir e tr ading r egion? Other design elemen ts, s uch as alloca tion me thodologies f or assigning the initial distribution f o r allo wances, might be left to the pr ovinces or municipalities since the alloca tion me thods have little envir onmen tal impact

. 3 

# A r e ther e A dequa te P olitical and Market Institutions? F

or the tr ading componen t of a cap and tr ade pr ogr am to work, a coun tr y must ha ve some of the same institutions and incen ti ves in place as those r equir ed f or any type of mark e tto function. These include:

1 Other envir onmen tal policy tools, or alterna ti ve l y , the compliance obliga tion and allowance alloca tion a tthe vehicle manuf actu r e r , fuel r e f iner or distributor le vel, ma y be mor e appr opria te in this case. 2 F or e xample, China’s pr ovincial Envir onmen tal Pr otection Boar ds ha ve the main r esponsibility f or running air quality and other envir onmen tal pr ogr ams. Similarl y , in Slov akia ther e ar e 7 9 local districts tha t implemen t envir onmen tal and other pr ogr ams. 3 Allowing diff er en t pr ovinces or municipalities to ha ve diff er en t alloca tion schemes ma y ha ve distributional economic impacts, s uch as f a voring f irms within an ind ustrial sector in one r egion of a coun tr y over another . This r e s ult could ha ve economic eff iciency eff ects i f pr od uct mark e t s ar e not per f ectl y compe titi ve .
2-3 Is C ap and T r ade the R ight T o ol?• Ade ve loped s y stem of pri v a te con tr acts and pr operty rights (see Chapter 3 f or discussion of pr operty rights iss ues associa ted with emission tr ading). • A priv a te sector tha t mak es business decisions based on the desir e to lower costs and r aise prof its. • Agovernmen t cultur e tha t will allow pri v a te businesses to mak e decisions about “how” to achie ve objecti ves with a minimum of in ter ve n tion. As with all envir onmen tal pr ogr ams, a cap and tr ade pr ogr am r equir es adequa te enf orcemen t to ens ur e tha t emission objecti ves ar e me t . In addition, f or an allo wance mark e t to de velop, mark e t participan ts must be conf iden t tha t sources will meas ur e and r eport emissions corr ectl y , the r egula ting authority will ve rify compliance, and, if ther e is non-compliance, the r egula ting authority will assess s uff icien t f inancial penalties. Thus, cap and tr ade pr ogr ams will have gr ea test s uccess in coun tries wher e rule of law is r espected and enf orcemen t is consisten t , impartial, tr anspar en t , and independen t of political consider a tions (EDf and RSHE, 2 000). In addition, once r egula tions ar e implemen ted, the y should be changed onl y thr ough tr anspar en t and f air pr oced ur es. P articipan ts should clearl y understand f r om the beginning ho w the pr ogr am w orks and ho w r egula ting authorities will meas ur e and enf orce compliance. In ter est in a tr ading pr ogr am will diminish signif ican tl y if f irms belie ve tha t rules ar e unf air , arbitr ar y , or unpr edictable. E ven if a coun tr y does not y e t have all of the a ttributes described above, it ma y still be benef icial to de velop the inf r astructur e necessar y f or a cap and tr ade pr ogr am in ad v ance of mor e compr ehensi ve economic changes (Ellerman, 2 0 0 2). As cen tr all y planned economies mak e the tr ansition to become mor e mark

e t orien ted, the y ma y also tr ansf orm their envir onmen tal pr ogr ams to become mor e eff icien t . E ven if conditions ar e not y e t ripe f or tr ading, the structur e of a cap and tr ade pr ogr am ma y impr ove envir onmen tal per f ormance. In particular , the emphasis on car eful mass-based emission meas ur emen t and accoun ting ma y impr ove envir onmen tal accoun tability of sources. F

or e xample, r ecen t e xperimen ts in Slov akia (CC AP , 2 0 0 1) and Chile (Mon ter o, e t al., 2 000) have indica ted tha t the alloca tion pr ocess associa ted with cap and tr ade has ser ved as an incen ti ve f or mor e comple te and accur a te emission inve n tories. 

# A r e Measur emen t C apabilities Sufficien tly A ccur a t e and C onsisten t? In considering whe ther cap and tr ade is an appr opria te tool to addr ess an envir onmen tal pr oblem, policymakers should consider whe ther sources cove r ed b ythe pr ogr am can meas ur e emissions with s uff icien t accur acy and consistency to s upport the cap and tr ade policy tool. (F or a discussion of emission meas ur emen t priorities and iss ues f or a cap and tr ade pr ogr am, see Chapter 3.) Unlik e many types of envir onmen tal r egula tion wher e r egula ting authorities jud ge compliance b y adher ence to de tailed technology or pr ocess specif ications, cap and tr ade pr ogr ams r equir e a pur el y per formance-based test f or compliance. Ultima tel y , meas ur ed emissions dicta te how many allowances a source must s urr ender a tthe end of the compliance period. Thus, the meas ur ed emissions dicta te how many e xtr a allowances a source ma y be able to sell or how many additional allowances a source ma y need to bu y . If one source uses a less accur a te emission meas ur emen t me thod than another , and consequen tl y under estima tes its actual emissions, it could s urr ender f e

w e r allowances than necessar y to offse t its emissions. If this scenario occurr ed, the emission goal (or cap) would not be me t . In addition, facilities with opportunities to r e d uce emissions be y ond r equir ed le vels would lose some of the economic incen ti ve , because the underr eporting sources need f e

w er allowances f o r compliance and will ther ef or e either incr ease the s u ppl y or decr ease demand f or allowances.

2-4 Is C ap and T r ade the R ight T o ol?

# C omparison of C a p and T r ade and O ther P olic y Options A number of diff er en t policy tools can be used to addr ess envir onmen tal concerns. These include: • Economic-incen ti ve appr oaches, s uch as envir onmen tal tax es and emission tr ading

. • C ommand-and-con tr ol appr oaches, s uch as technology mand a tes or emissions r a te stand ar ds. • Non-r egula tor y appr oaches, s uch as volun tar y a g r eemen ts and eco-labeling

. Ultima tel y , the policymak er’s objecti ve should be to achie ve the optimal le vel of pollution con tr ol to adequa tel y pr otect human health and the envir onmen t a t a minimum cost to socie ty. 

# Market-Based A p pr oaches v s . C ommand-and-C on tr ol Regula tion F

or manyair pollution pr oblems, command-and-contr ol (or dir ect r egula tion) ma y be the best course. F o r e

xample, wher e r egula ting authorities can iden tify a specif ic f acility as the source of a public health pr oblem, limiting its emissions ma y be the simplest and most eff ecti ve solution. Also, in the tr ansporta tion sector wher e fuel char acteristics can ha ve a dir ect impact on the eff ecti veness of engine technology , it ma y be best to dir ectl y specify fuel par ame ters, s uch as s ulfur con ten t , to permit f irms to design engines in the most cost-eff ecti ve wa y to r e d uce harmful emissions of particula tes or other pollutan ts s uch as NOx, h y dr ocarbons, and carbon mono xide. Command-and-con tr ol r egula tions often w ork best when: • Emission r e d uction e xperience is limited and e

xpertise is concen tr a ted among r egula tors. • Solutions ar e clear or ther e ar e f e

w options f o r r e d ucing emissions. • Monitoring total mass emissions is not f easible. • Emissions have serious local health impacts, and tr ading might mak e s uch hotspots w orse. • Emissions ar e to xic, and the desir ed emissions le

vel might be zer o. With command-and-con tr ol, the r egula ting authority typicall y establishes a r equir emen t to install a specif ic type of emission r e d uction technology. Although sources ma y achie ve a certain le vel of emissions per unit of hea t input or pr od uct output using the technology , incr eased utiliza tion and ne w emissions sources can thr ea ten the ability to achie ve and maintain an emissions tar ge t . Older sources tha t have been e

x empted or “gr andf a ther ed” f r om strict emissions con tr ols might also thr ea ten the ability to achie ve and main tain an emission tar ge t . This thr ea t can aff ect the ability to achie ve an envir onmen tal and/or human health goal. F

or some envir onmen tal pr oblems, ho w e ve r , specific r equir emen ts ma y cost mor e than fle xible policy appr oaches and inhibit innov a tion. These types of envir onmen tal pr oblems ma y w ork w e ll f o r a tr ansitional applica tion of incen ti ve-based appr oaches or economic instrumen ts, s uch as tax es or a cap and tr ade pr ogr am. Such pr ogr ams ma y be pr ef err ed to encour a ge mor e economicall y eff icien t solutions. If pr operl y designed, economic incen ti ves can harness mark e t f orces to w ork to wa r d envir onmen tal impr ovemen t . B y in ternalizing pollution con tr ol costs the y can mak e pollution r e d uction in the economic in ter est of the f irm and pr omote innov a tion. It is also possible and, in some instances, benef icial to use a h ybrid appr oach wher e command-and-con tr ol policies ar e implemen ted side-b y-side with a cap and tr ade pr ogr am. Command-and-con tr ol policies, if not overl y r estricti ve, can establish a backstop or saf e ty ne t to adequa tel y pr otect human health and the envir onmen t (see Chapter 3). 4 

# C ap and T r ade v s . En vir onmen tal T a x e s Envir onmen tal tax es ar e another signif ican t mark e t
based instrumen t f or r e d ucing pollution. The ma jor diff er ence be tw een cap and tr ade and envir onmen tal tax es is tha t cap and tr ade imposes an absolute r estriction on the quan tity of emissions allow ed (i.e., the cap) and allow s the price of emissions to adjust to the marginal aba temen t cost (i.e., the cost of con tr olling a unit of emissions). An envir onmen tal tax se ts a price f or a ton of emissions and allow s the quan tity of emissions

4 F or a discussion of in tegr a ting cap and tr ade with other instrumen ts, see Schr eif els, 2 000 and Ellerman, 2 0 0 2

.
2-5 Is C ap and T r ade the R ight T o ol?

### F igur e 2. E c onomically Efficien t C o n t r o l of P ollutionCost per Unit of Pollution

M a r ginal Social Benefit

Quantit y of P ollution Reduc ed A c tual Mar ginal Aba t emen t C ost C AP AND TR ADE T A X

Expec t ed M a r ginal Abat ement C ost P*

Q tr adeCost per Unit of Pollution

M a r ginal Social Benefit

Quantit y of P ollution Reduc ed A c tual Mar ginal Aba t emen t C ost

Expec t ed M a r ginal Abat ement C ost

P*

Q tax

T heor etically , e n vir onmental tax es or cap and tr ade will pr o vide the same lev el of en vir onmental pr ot ec tion. Ho w e v e r , if polic ymak ers ha v e inc omplet e or imper f e c t inf ormation about c osts and benefits , r esear chers cr eat e new c o ntr ol t echnologies , or unf or eseen dev elopm ents arise , cap and tr ade pr o v ides c e r taint ythat the lev el of emissions will not incr ease bey ond the emission cap

. Ho w e v e r , ther e ar e no ass ur anc es about the c ost of the pr ogr a m. An en vir onmental tax does not pr o vide c e r taint yabout emissions , but it does establish a limit on the c o st of the pr ogr am t o ensur e that the pric e of emitting a unit of pollution does not ex c eed the tax lev el. In the sec ond gr aph, the ac tual mar g inal abat ement c ost is higher than expec t ed leading t o f e w er emission r educ tions (i.e ., higher emissions) f or the tax pr ogr a m. I f the ac tual mar ginal abat ement c ost w e r e lo w er than anticipat e d , the emission r educ tions f or the en vir onmental tax pr ogr am w ould be gr eat er than f or the cap an d tr ade pr ogr am (and c osts w ould be higher.) to adjust to the le vel a twhich marginal aba temen t cost is equal to the le vel of the tax (See Fi gur e 2). 

## En vir onmental C e r taint y There is e xtensiv e discussion in economics liter a ture about the re la tiv e merits of cap and tr ade and en vironmen t al taxes. 5 In situa tions where grea ter en vironmen tal certain ty is needed, cap and tr ade progr ams are preferable because the cap sets an emission goal tha t sources must meet . With taxes, the regula ting authority must establish a tax per unit of emissions. Ho we v

e r , d ue to imper f e ct inf orma tion (e.g., regarding mar ginal aba temen t costs and price sensitivities) and technological changes, setting the tax a t the le v

el required to a ttain the emission tar get becomes diff icult and uncertain. 6 Moreo v

e r , under a regime of en vironmen tal taxes, ne w en tr an ts in to the polluting activity will lead to increased emissions. With cap and tr ade, regula ting authorities can require ne w en tr an ts to purchase allo w

ances directly f rom the mark et

or the regula ting authority can pro vide allo w

ances f rom set-asides tha t are within the cap. Thus, the emission goal can be main tained. 

## P r ic e C e r t aint y In situa tions wher e price certain ty is needed, tax pr ogr ams ar e pr ef er able because the tax per unit of emissions limits the cost to f irms. F or e xample, wher e the costs of achie ving a le vel of emission r e d uctions ar e uncertain, policymak ers ma y decide to se t an emissions tax r a ther than taking a chance tha t an allowance price will rise to a le vel tha t is economicall y or politicall y uns ustainable. 7

5 F or a discussion of the economic consider a tions f or choosing be tw een tax es vers us emissions tr ading, see Baumol and Oa tes, 1 9 8 8

. 6 A r ecen t stud y of envir onmen tal tax es in Eur ope show ed tha t these pr ogr ams ha ve f ailed to achie ve the e xpected le vel of emissio n r e d uctions (OECD, 2 0 0 1). 7 A thir d type of economic instrumen t is essen tiall y a h ybrid of a tax and a cap and tr ade pr ogr am. This mechanism, some times known as a “saf e t y v a l ve” or a “price cap” is a cap and tr ade pr ogr am with a maximum price per ton. If the mark e tprice per ton rises above the ma ximum price,
r egula ted sources can bu y additional tons a tthe maximum price. In s uch a situa tion, the emission cap is e x ceeded, but the pric e per ton does not rise above the maximum le vel (P izer , 1 9 9 7).

2-6 Is C ap and T r ade the R ight T o ol?

## A dministr ativ e C osts Administr a t i ve costs ar e similar f or both envir onmen tal tax es and cap and tr ade. Each appr oach r equir es sources to k eep r ecor ds of fuel cons umption or emissions and to r eport this inf orma tion to the r egula ting authority . The r egula ting authority’s administr a t i ve costs include pr ocessing this inf orma tion, r e vie wing it f or comple teness and accur acy , and r ecor ding it . The r egula ting authority could also cond uct de tailed audits of selected s ubmissions. With both instrumen ts the r egula ting authority must decide the rigor of emission meas ur emen t and r eporting r equir emen ts. F or e xample, Sw eden’s NOx tax and the U .S. SO 2 Allo wance T r ading P r ogr am r equir e the use of con tinuous emission monitors (Blackman and Harrington, 1 999). Similarl y , the r egula tor y authority’s r e vie w of d a ta can be mor e or less rigor ous depending on the le vel of r e vie w necessar y. Under the U .S. SO 2 Allo wance T r ading P r ogr am, emission d a ta r e vie w is rigor ous. Although it is highl y automa ted, mor e than 7 5 percen t of staff r esources a t the f eder al and sta te le vel ar e associa ted with the measur emen t , pr ocessing, and tr acking of emissions d a t a (see Chapter 4 f or a mor e de tailed discussion of administr a t i ve costs). Under a cap and tr ade pr ogr am, a small amoun t of additional r esources ar e necessar y to pr ocess allo wa nce tr ansf ers and r econcile emissions and allo wances a t the end of a compliance period. A tax pr ogr am will r equir e r esources to collect and mana ge tax r eceipts. Some f iscal institutions, ho w e ve r , ma y alr ead y have the r esources in place to collect and mana ge r eceipts f r om other tax schemes. 

## P olitical C onsider ations Some r egions ha ve a histor y of implemen ting envir onmen tal tax pr ogr ams. In these r egions envir onmen tal tax es ma y be easier to implemen t because the y ar e alr ead y understood and accepted and much of the inf r astructur e ma y alr ead y e x ist

. In other r egions, ther e ma y be political r easons to opt f or a cap and tr ade pr ogr am. Emission sources ma y pr ef er a s y stem in which allowances ar e alloca ted without charge r a ther than a s y stem of envir onmen tal tax es in which a source has to pa

y f or emissions. The initial alloca tion of allowances r eflects a tr ansf er to sources of an asse t tha t is scarce and ther ef or e has economic v alue. Recognizing this, sources ar e often mor e s upporti ve of this mark e t-based incen ti ve pr ogr am than the y ar e of envir onmen tal tax es. In some circumstances, policymak ers might use both policies, envir onmen tal tax es and cap and tr ade. 8 A low tax can gener a te r e venue f or the r egula ting authority while still offering emission sources the benef its of a cap and tr ade pr ogr am. Alterna ti ve l y , the r egula ting authority could gener a te r e venue with a cap and tr ade pr ogr am b ydistributing some or all allowances thr ough an auction. 

# O ther F o rms of Emission T r ading This section e xamines two additional forms of emission tr ading – pr oject-based tr ading and r a te-based tr ading – and compar es them to the cap and tr ade appr oach in terms of poten tial to limit total emissions, ability to achie ve cost minimiza tion, administr a t i ve overhead, and tr ansaction costs. 

## C ap and T r ade v s . P r ojec t-Based T r ading
Po tential to Limit T otal Emissions Pr oject-based tr ading, other wise known as cr edit tr ading or offse t tr ading, is gener all y not used as a standalone pr ogr am. It can be used to off er emission sources the fle xibility to seek lower cost emission offse ts f r om sectors outside a r egula tor y pr ogr am. Historicall yin the United Sta tes, these types of cr edits or offse ts ha ve been used to mee t r a te-based emissions limits for conve n tional pollutan ts. Mor e r ecen tl y , ther e has been consider able in terna tional in ter est in using pr oject-based tr ading as a complemen t to cap and tr ade to mee t v o lun tar y or mand a tor y gr eenhouse gas emission targe ts. Emission offse ts, or cr edits, ar e typicall y calcula ted b

y comparing actual emissions a gainst a baseline. The baseline is an estima te of wha t emissions w ould be in a h ypothe tical situa tion (e.g ., if the pr oject had not been cr ea ted). De termining the baseline is often the biggest challenge with pr oject-based tr ading

. Designing eff ecti ve pr otocols to verify offse ts is diff icult because it r equir es making a de termina tion about whe ther the emission r e d uctions f r om an offse t pr oject w ould have occurr ed anywa y. This type of test is kno wn as “additionality.” If emission r e d uctions f r om a pr oject ar e not “additional,” ther e is a risk tha t these r e d uctions could dilute an emissions goal and lead to

8 F or a discussion of in tegr a ting cap and tr ade and envir onmen tal tax es, see Ellerman, 2 0 0 2

.
2-7 Is C ap and T r ade the R ight T o ol?incr eased emissions compar ed to a case in which no offse ts ar e allo w ed. A similar concern in some situa tions is “paper cr edits.” These ar e cr ea ted when a source uses its legal allowable le vel of emissions (e.g ., its maximum potential to emit) as its baseline r a ther than wha t emissions would ha ve been in the absence of the pr oject . These paper cr edits ar e the diff er ence be tw een wha t a source is allow ed to emit and wha t a source actuall y emits. These cr edits incr ease allowable emissions without gener a ting any r eal emission r e d uctions. 9 T

w o iss ues must be addr essed f or pr oject-based tr ading–the eff ect on total emissions f r om “non-additional” offse ts and “leaka ge,” which is an incr ease in emissions or decr ease in sequestr a tion caused b y the pr oject but not accoun ted f or in the emission baseline f or tha t pr oject acti vity

. 10 The underl ying concept is tha t a particular pr oject can pr od uce offse tting eff e cts tha t full y or partiall y nega te the benef its of the pr oject . F or e xample, a pr oject tha t pr otects a f o r est tr act sla ted f or def or esta tion ma y simpl y acceler a te logging of the ne xt most s uitable loca tion. Projects tha t tempor arily sequester emissions (e.g., f o r estr y projects tha t sequester carbon dio xide) also r aise iss ues of “permanence.” If the emission r e d uctions f rom the project ar e used to offse t other emissions, and the project s ubsequen tly r eleases the sequester ed emissions, not only is the en vironmen tal benef it lost , but the cr edits ma y allow emissions to incr ease. 

### C

ost M i nimization As with cap and tr ade, pr oject-based tr ading can r e d uce the economic costs of achie ving an emission goal b y adding fle xibility f or sources to de velop appr opria te compliance str a tegies. F or e xample, a polluting f acility ma y invest in an offsite emission aba temen t pr oject to earn emission r e d uction cr edits. If appr oved, these cr edits ma y be used to offse t emissions f r om the f acility

. 

### A dministr ativ e Inv o lv ement and T r ansac tion C osts A k e

y diff er ence be tw een cap and tr ade and pr ojectbased tr ading is the wa y tha t emission r e d uctions ar e verif ied and the implica tions f o r administr a t i ve invo l vemen t . A cap and tr ade pr ogr am r equir es pr eliminar y anal y sis to establish an emission cap f o r r egula ted sources. Depending on the me thod of allowance distribution (see Chapter 3), additional work ma y be r equir ed to alloca te emission allowances to the r egula ted sources. Due to the emission cap and meas ur emen t r equir emen ts, ther e is no need f or the r egula ting authority to r e vie w each emission r e d uction acti vity or to calcula te an emission baseline f or each acti vity

. Instead, each r egula ted source meas ur es and r eports its total emissions, and the r egula ting authority f ocuses on ens uring emissions ar e meas ur ed accur a tel y and an allowance is turned in f or each unit of emissions. In con tr ast , pr oject-based tr ading often r e quir es tha t pr oject participan ts de velop a pr oject specif ic emission baseline f o r r e vie w b ythe r egula ting authority or other authorized e xperts. 11 Re vie w of s uch baselines can be con ten tious and r esource in tensi ve because it is e

xtr emel y diff icult to def ine with certain ty wha t would ha ve happened in the absence of a pr oject

. T

o r e d uce administr a t i ve and tr ansaction costs and addr ess additionality concerns, the r egula ting authority ma y establish multi-pr oject baselines. Multi-pr oject baselines use per f ormance stand ar ds or benchmarks f or a type of pr oject . If the pr oject r e s ults in emission r a tes lo w er than the stand ar d, the pr oject automa ticall y r ecei ves cr edit equal to the diff er ence be tw een the baseline and the actual emissions (Sa tha y e, e t al., 2 0 0 1). Stand ar dizing baseline me thodologies in ad v ance can signif ican tl y r e d uce administr a t i ve costs and r e d uce the s ubjecti vity inher en t in the r e vie w of a pr oject baseline. The y ma y not , ho w e ve r , al wa y s be a per f ect test f or whe ther emissions ar e belo w the le vels tha t w ould have occurr ed other wise. Also, multi-pr oject baselines ma y be diff icult to de velop f or some types of pr ojects. P r oject-based tr ading can r e d uce the costs of a ttaining an emission goal, but the administr a t i ve and tr ansaction costs per unit of emission r e d uction ar e often higher than cap and tr ade pr ogr ams; ther e is gr ea ter uncertain ty and risk associa ted with an offse t than an allo wance (e.g ., d ue to baseline, permanence, and leaka ge iss ues); and e xtensi ve invo l vemen t and oversight b y the r egula ting authority ar e r e quir ed to ens ur e envir onmen tal in tegrity. These tr ansaction

9 Paper cr edits can also aff ect r a te-based tr ading pr ogr ams. 10 Leaka ge can also occur in cap and tr ade pr ogr ams tha t do not include all sources con tributing to the envir onmen tal pr oblem. Sou rces in the pr ogr am ma y shift pr od uction to other sources not participa ting in the pr ogr am, ther eb y nega ting some of the emission r e d uctions.
11 Adequa te saf eguar ds f or using an outside e xpert f or verif ica tion include: s uff icien t dir ection and oversight f r om the r egula tin g authority; accr edita tion of compe tency; and pr otection f r om conflicts of in ter est . 2-8 Is C ap and T r ade the R ight T o ol?comple xities v a r y depending upon pr oject type. P r oject-based tr ading can be an eff ecti ve wa y to in tr od uce some sectors to mark e t-based incen ti ve pr ogr ams. In addition, it can be eff ecti ve f or sectors in which it is easier to meas ur e an emission r e d u ction (e.g ., the quan tity of gas captur ed f r om a landf ill me thane r ecove r y pr oject) than total mass emissions. 

## C ap and T r ade v s . R at e-Based T r ading Under a r a te-based tr ading appr oach, the r egula ting authority de termines a per f ormance stand ar d (e.g

. , an amoun t of emissions allo w ed per unit of output) f or a sector (e.g ., tons of a pollutan t per kWh of electricity gener a ted). Sources with emission r a tes belo w the per f ormance stand ar d can earn cr edits 12 , wher eas sources with emission r a tes above the stand ar d must obtain cr edits f or their e x cess emissions to r e main in compliance. Sources with low cost opportunities to impr ove their emissions r a te ha ve an incen ti ve to oper a te a tr a tes below the per f ormance stand ar d. The y can then sell the r e s ulting cr edits to sources tha t ha ve higher costs to a ttain the per f ormance stand ar d. Ra te-based tr ading pr ogr ams ha ve been used in the United Sta tes to phase out lead in gasoline and con tr ol mobile source emissions. One consider a tion when e v alua ting r a te-based tr ading is tha t if the acti vity le vel incr eases a t a r a te f aster than the emission r a te declines, sources can earn cr edits while total emissions incr ease. 

### Po tential to Limit T otal Emissions P

erhaps the most importan t meas ur e of a r egula tor y appr oach is whe ther it can pr od uce the desir ed envir onmen tal impr ovemen t . Emission caps se t the total emission le vel, in eff ect , constructing a pr ogr am f r om the envir onmen tal goal back to the sources. In contr ast , r a te-based tr ading a ttempts to establish an emission r a te stand ar d f or each source tha t will, in a ggr ega te, pr od uce the desir ed envir onmen tal impr ovemen t . How e ve r , under a r a te-based pr ogr am, emissions and the pollution load on the envir onmen t can incr ease if sources incr ease their utiliza tion or if ne w sources ar e built

. This situa tion r aises a distinction be tw een cap and tr ade pr ogr ams and r a te-based pr ogr ams r egar ding ind ustrial gr o wth. Both types of pr ogr ams accommod a te gr o wth. The r esponsibility f or addr essing gr o wth, ho w e ve r , f alls upon the sources in a cap and tr ade pr ogr am while it f alls on the r egula ting authority in a r a te-based pr ogr am. Mor e specif icall y , under a cap, sources must de termine ho w to oper a te ne w f acilities or incr ease utiliza tion of e xisting f acilities and still compl y with the emission cap. This appr oach encoura ges ind ustr y to innov a te and f ind lo w e r-cost appr oaches to r e d ucing emissions. In the U

. S. SO 2 Allo wance T r ading P r ogr am electricity pr od uction and economic gr o w th incr eased while SO 2 emissions decr eased signif ican tl y (see F i gur e 3). In a r a te-based pr ogr am, as with an envir onmen tal tax pr ogr am, the r egula ting authority must periodicall y impose ne w r a te stand ar ds to achie ve and main tain an emission tar ge t and pr e ven t (or corr ect f or) additional emissions tha t ma y r e s ult f r om incr eased pr od uction. This cy cle of r e

vising r egula tor y pr ogr ams can cr ea te a less certain r egula tor y envir onmen t f or sources to cond uct compliance and business planning

. 

### C

ost M i nimization As with cap and tr ade, the f act tha t sources can tr ade their cr edits under the r a te-based appr oach implies tha t the per f ormance stand ar d could be achie ved a ta lowe r economic cost . This is because sources with high marginal aba temen t costs will choose to purchase cr edits f r om f irms with lower marginal aba temen t costs. 

### A dministr ativ e Inv o lv ement and T r ansac tion C osts Under a r a te-based s y stem, the r egula ting authority converts each source’s emission r a te and acti vity le ve l to cr edits. Because the r egula ting authority must collect acti vity le vel d a ta, the d a ta r equir emen ts ma y be gr ea ter f o r r a te-based tr ading . Such d a ta ma y also include commerciall y sensiti ve d a ta tha t could be diff icult to obtain. This inf orma tion, how e ve r , may be useful f or other types of tr ading pr ogr ams as w ell. The r egula ting authority can use the inf orma tion to verify meas ur ed emissions. Lik e cap and tr ade, r a te-based appr oaches do not necessaril y r equir e tha t the r egula ting authority appr ove each tr ade (in con tr ast to the pr oject-based tr ading described earlier). Because some additional steps f o r governmen t appr ov al ma y be r equir ed, the le

vel of administr a t i ve invo l vemen t and costs could be

12 F or electric pow er sources, the cr edits earned would be equal to the diff er ence be tw een the per f ormance stand ar d and the source ’s emission r a te multiplied b ythe source’s curr en t hea t input or gener a tion.

2-9 Is C ap and T r ade the R ight T o ol?

### F igur e 3. Dec oupling E c onomic Gr o wth and En vir onmen tal P r otec tion

60 Gross Domestic Product 40

20

0

-20 U.S. SO 2 Allowance Trading Program SO 2 Emissions -40 YEAR the same or slightl y gr ea ter than those of a cap and pr oject-based pr ogr ams us uall y do not r e quir e ne t tr ade pr ogr am. emission r e d uctions, the y ar e not eff ecti ve as stand- 

## Summar y of O ther F o rms of Emission alone pr ogr ams. Ho w e ve r , a w ell designed pr oject- 

## T r ading based tr ading pr ogr am ma y complemen t a Each of the thr ee f orms of emission tr ading is appr ocommand-and-con tr ol pr ogr am tha t establishes emis­ pria te in certain situa tions. When achie ving and main- sion or concen tr a tion limits. It ma y also complemen t a taining an absolute emission goal is importan t , a cap cap and tr ade pr ogr am in sectors f or which accur a t e and tr ade pr ogr am can pr ovide mor e certain ty about emission meas ur emen t of en tities or acti vities ma y not total emissions. Administr a t i ve and tr ansaction costs be as w ell de veloped. f or cap and tr ade pr ogr ams ar e often lo w er than f o r Ra te-based tr ading can be an eff ectiv e w a y to pro- pr oject-based tr ading, which is bur dened b y higher mote eff iciency if circumstances do not r equir e an uncertain ty and risk and the need f or e xtensi ve r egu- absolute cap on emissions. The administr a t iv e and la ting authority invo l vemen t . tr ansaction costs f or r a te-based tr ading progr ams ar e P r oject-based tr ading pr ogr ams have historicall y lik ely to be the same or similar to cap and tr ade. (See

e

vol ved f r om the in tr od uction of limited fle xibility in T able 2 f or a s ummar y of the f orms of emission tr ading.)
tr aditional command-and-con tr ol pr ogr ams. BecausePERCENT CHANGES SINCE 1980



## T a b l e 2 : T h r e e F o r m s o f E m i s s i o n s T r a d i n g C o m p a r e d Limit T otal C ost A dministr a tiv e & Emissions M inimiza tion T r ansac tion C o sts C ap and T r ade H igh Y es L o w P r ojec t-based T r ading L o w t o M edium Y e s H igh R a t e-based T r ading M edium Y e s L o w t o M edium

2-10 Is C ap and T r ade the R ight T o ol?

## E a r l y E m i s s i o n s T r a d i n g i n t h e U n i t e d S t a t e s C ap and tr ade in the Unit ed Stat es ev olv ed t o impr o v e upon earlier experienc es that w e r e expensiv e , r esour c e int ensiv e and bur dened with subjec tiv e r e view pr oc edur es , which r esult ed in limit ed en vir onmental benefits

. T he U.S. EP A and stat e-lev el en vir onmental agencies ha v e used sev e r al diff er ent f o rms of emission tr ading with v a r ying degr ees of en vir onmental and ec onomic eff ec tiv eness . A lthough man y of the early achiev ements w e r e modest , the early eff or ts in emission tr ading ar e impor tant because they pr o vided a f oundation and v aluable pr ac tical experienc e f or the dev elopment of mor e eff ec tiv e emission tr ading pr ogr a ms (e .g ., the U.S. SO 2 Allo wanc e T r ading P r ogr am). 

### Offse t P r ogr am EP

A first applied the c onc ept of mark etable emission permits in the mid-1970s as a means f or new sour c es of emissions t o locat e in ar eas with poor air qualit y without causing additional air qualit y pr oblems

. N ew sour c e s and existing sour c es that want ed t o expand their facilities w e r e r equir ed t o “off set ” their emissions b yacquiring emission r educ tions fr om other sour c e s . In this pr ogr a m, off sets ar e gener at ed when a sour c e r educ es ac tual emissions belo w their permitt ed lev el and applies t o a stat e agenc y f or c e r tification of the r educ tion. F or a sour c e t o r e c eiv e an off set , the stat e must det ermine that the r educ tion is: (1) surplus in the sense of not being r equir ed b ycurr e nt r egulations; (2) enf or c eable; (3) permanent; and (4) quantifiable

. O ff sets ar e normally denominat ed b ythe quantit y of pollutant in t ons r eleased o v er 1 y ear (t ons/y ear). T he most c ommon method of gener ating off sets is closing the sour c e or r educing its output. Ho w e v e r , sour c es can also earn off sets b ymodifying pr oduc tion pr oc esses or installing pollution c o ntr ol equipment. 

### B ubble Policy T he bubble polic y is another appr oach that ser v ed as a f oundation f or lat e r tr ading policies

. E stablished in 1979, the bubble polic y allo w ed sour c es t o meet emission limits b yapplying a single aggr egat e emission limit t o multiple sour c es within a facilit y r a ther than applying individual c o ntr o l equipment or emission r a t e r equir ements at each emission sour c e . T he t e rm “bubble ” is used t o in v o k e an image of a bubble o v er a facilit y (such as a r efiner y or a st eel mill) with sev e ral emission sour c e s . A facilit y or gr oup of facilities can aggr egat e emissions and use a mix of c o ntr ols that is different fr om those mandat ed b yr egulations , as long as t otal emissions within the bubble ar e equal t o or less than the cumulativ e limit f or all sour c e s within the bubble (see F igur e 4). By design, bubbles ar e int ended t o be neutr al in t e rms of en vir onmental Emission Limit: 10 tons 3 tons 6 tons

1 ton 

### F igur e 4. Bubble P olic y

2-11 Is C ap and T r ade the R ight T o ol?impac t. Ho w e v e r , bubble pr oposals must under go individual r e view and appr o v al, which, o v er the y ears , has been str eamlined but is still r a ther bur densome

. C onsequently , the bubble pr o vision has been used in less than 100 cases in the Unit ed Stat es o v er the last 20 y ears . 

### E v alua tion of Earl y Emissions T r ading Acti vities S e v e r al fac t ors limit ed the appeal of these early tr ading appr oaches

. T he tr ading mechanisms w e r e meant t o modify or enhanc e existing air pollution c o ntr o l pr ogr ams that did not themselv es addr ess t otal emissions

. T her ef or e , the tr ading mechanisms w e r e not eff ec tiv e at c o ntr olling o v er all emission gr o wth. T o ensur e that air qualit y did not det erior at e , expensiv e air qualit y modeling was of t en r equir ed bef o r e r egulat ors acc ept ed pr oposed tr ades

. D e posits t o emission banks (cr edits gener at ed f or some lat e r , y et-t o-be-det ermined use) w e r e t ypically “tax ed ” b y the air qualit y management authorit y t o meet stat e air qualit y r equir ements or t o gener at e a surplus that the ar ea c ould use , f or instanc e , t o attr ac t new firms

. O ff set r a tios (i.e ., r equiring mor e than 1 t on of emission r educ tions t o off set 1 new t on of emissions) used t o c ount er some of the unc er tainties fr om a tr ade fur ther depr essed cr edit v alue

. F inally , the administr ativ e o v ersight t o pr ot ec t against the cr eation of “ paper cr edits ” and “ a n y wa y t ons ” turned out t o be r esour c e-int ensiv e . In a 2001 study on pr ojec t-based tr ading syst ems , the En vir onmental La w Institut e (ELI) c oncluded that such pr ogr ams in the Unit ed Stat es “ha v e gener ally failed t o gener at e c onsider able tr ades and r e tr ospec tiv e r e views ha v e t ended t o blame their shor t c omings on high tr ansac tion c osts , unc er taint yand risk in obtaining needed go vernment appr o v als , as w ell as lack of clear legal authorit y and clearly specified objec tiv es ” (ELI, 2001).

2-12 Is C ap and T r ade the R ight T o ol?

# 3 De v eloping a C a p and T r ade P r ogr a m

In tr oduc tion 

# P rior to implemen ting a cap and tr ade pr ogr am, policymak ers should e xamine v arious design options, decide which f e a tur es to emplo y

, and ens ur e tha t ther e is adequa te legal authority . Key decisions include de termining which sources to include in the pr ogr am (i.e., applicability), the le vel of the emission r e d uction or limita tion (i.e., cap), and the timing when r e d uctions will be r equir ed. In addition, policymak ers should de termine r equir emen ts f or meas uring and r eporting emissions, me thods of distributing allowances, rules governing allowance use, compliance and enf orcemen t pr ovisions, and pr ovisions f or in tegr a ting cap and tr ade with e xisting policies. Bef or e design work can pr oceed, it is critical to ha ve information on the poten tiall y aff ected sources, s uch as their emissions, utiliza tion, and con tr ol options. All of these iss ues ar e discussed in this chapter

. 

# Guiding P r inciples Se ve r al over arching principles can guide the de velopmen tof a cap and tr ade pr ogr am. Adhering to these principles—simplicity , accoun tability , tr anspar ency , pr edictability , and consistency—can pr omote envir onmen tal compliance and eff icien t mark e t s. 

# Simplicit y Simplicity is an importan t goal when designing an eff ecti ve cap and tr ade pr ogr am. Pr ogr am oper a tion f o r both emission sources and r egula ting authorities can be less costl y and time-cons uming if the rules ar e not overl y comple x or bur densome. Mark e ts function be tter when the rules ar e simple and easil y understood b y all participan ts. Mor eove r , the envir onmen t is mor e lik el y to be pr otected when rules ar e clear and easil y enf orced. In con tr ast , comple xity often r equir es mor e decisions, deba te, and inf orma tion collection. This situa tion, in turn, can cr ea te uncertain ty and unnecessar y bur den tha t ma y lead to dela y s, opportunities f o r e gone, and ultima tel y higher costs. In some coun tries, comple xity ma y also mak e it mor e lik el y tha t ther e will be litiga tion over con ten tious iss ues. Another aspect of simplicity tha t will incr ease the economic eff ectiv eness of a cap and tr ade progr am is the fungibility of allow ances (i.e., an allowance is a stand a r dized unit of tr ade tha t is in terchangeable with other allow ances). F ungibility is highly desir able to minimize tr ansaction costs in the progr am and to maximize the

3-1 D e v eloping a C ap and T r ade P r ogr a mS e t t i n g t h e m a s s - b a s e d e m i s s i o n c a p :

I m p l e m e n t a t i o n d a t e s :

S o u r c e s c o v e r e d :

D i s t r i b u t i n g t r a d a b l e a l l o w a n c e s : eff iciency of the cap and tr ade progr am to lower costs. Simplicity is enhanced b y

a

v

oiding the cr ea tion of diff e r e n t ca tegories of allow ances with diff er en t a ttributes, unless it is absolutely necessar y to main tain the environmen tal in tegrity of the s ystem. F or example, discoun ting the use of certain types of allow ances based on their geogr aphic origin or on their ability to be bank ed complica tes tr ansactions and r e d uces the cost eff ectiv e ness of allow ance tr ading and ma y not ha v

e signif ican t en vironmen tal benef its. Mor e br oadl y , the principle of simplicity can be applied to all elemen ts of the pr ogr am, including: • A pplicability thr esholds (de termining which f acilities ar e aff ected) • Alloca tion f o rmulas • T r ading rules and/or r estrictions • Meas ur emen t options and rules • Reporting r equir emen ts • Penalty assessmen t 

# A c c oun tabilit y A cap and tr ade pr ogr am must cr ea te a f r ame work of oversight and enf orcemen t tha t will hold participan ts accoun table f or their emissions and ens ur e compliance with the pr ogr am’s r equir emen ts. The basis of accoun tability is the accur a te meas ur emen t and verif ica tion of emissions and the rigor ous and consisten t enf orcemen t of penalties f o r f r aud or noncompliance. The r egula ting authority can f acilita te accoun tability thr ough clear and simple rules. 

# T r anspar enc y T

r anspar ency r e f ers to the full and open disclos ur e of r ele v a n tpublic and pri v a te decisions, s uch as establishing the rules and r egula tions f o r a tr ading pr ogr am and de termining if an emission source is in compliance. T

r anspar ency is importan t to a w ell-functioning cap and tr ade pr ogr am, both in terms of its design and its oper a tion. T r anspar ency of the design pr ocess can pr omote public acceptance and conf idence in the cap and tr ade pr ogr am. Inf orma tion tr anspar ency is also importan t to the eff ectiv e oper a tion of an emission tr ading progr am. Pro viding public access to source-le v

el emission and allow ance d a ta promotes conf idence in the progr am and pro vides an additional le v

el of scrutin y to v erify enforcemen t and encour a ge compliance. In some jurisdictions these d a ta ar e classif ied as conf iden tial and ma y r equir e legal changes to mak e them publicly a v ailable. Ad v ances in inf orma tion technology and the In terne t have made it possible to pr ovide in ter ested parties with timel y and useful inf orma tion about emissions, allo wances, and pr ogr am r e s u lts. 

# P r edic tabilit y and C onsistenc y Pr edictability and consistency in the design and application of progr am rules ar e importan t principles f or an eff ectiv e cap and tr ade progr am. The y help cr ea te the right circumstances to encour a ge inno v a tion and lowe r costs. With a cap and tr ade progr am, emission sources ha

v

e an incen tiv e to f ind be tter and lower-cost opportunities to r e d uce emissions. This incen tiv e depends upon long-term, pr edictable, and consisten t rules tha t aff ect the economic v alue of emission r e d uctions. This arr angemen t does not mean, howe v

e r , tha t rules cannot change in r esponse to ne w inf orma tion. Ra ther , it means tha t the f r ame work must include the possibility f o r change and a clear e xplana tion of the process for changing the rules. 

# Establishing L egal A uthorit y As discussed earlier , ther e must be legal authority to establish a cap and tr ade pr ogr am. Although policymak ers can include many componen ts in authorizing legisla tion, the basic componen ts ar e listed below . Se ve r al of these componen ts ar e discussed in mor e de tail in this chapter and Chapter 4. • S e t t i n g t h e m a s s - b a s e d e m i s s i o n c a p : If the cap is not se t dir ectl y b y policymak ers, the r egula ting authority must have authority to limit the total quan tity of pollution f r om the r ele v a n t sector(s) b

y establishing a cap on emissions. • I m p l e m e n t a t i o n d a t e s : Sources must compl y with the emission caps starting in a particular compliance period. • S o u r c e s c o v e r e d : A comple te con tr ol pr ogr am must def ine which sectors ar e s ubject to pr ogr am r equir emen ts and, within each sector , which emission sources ar e aff ected. F or e xample, the scope of an electric gener a ting sector cap and tr ade pr ogr am could include all electric gener a t
ing units or onl y electric gener a ting units above a certain gener a tion capacity

. • D i s t r i b u t i n g t r a d a b l e a l l o w a n c e s : T r aditional air quality permits authorize a certain amoun t of

3-2 D e v eloping a C ap and T r ade P r ogr a mB a n k i n g :

T r a d i n g p r o c e d u r e s :

E m i s s i o n m o n i t o r i n g a n d r e p o r t i n g :

C o m p l i a n c e :

E s t a b l i s h i n g a n d e n f o r c i n g p e n a l t i e s f o r n o n c o m p l i a n c e : P r o g r a m a p p l i c a b i l i t y :

A l l o w a n c e a l l o c a t i o n s :

A g g r e g a t e c a p : emissions and ar e non-tr ansf er able. Policymak ers establishing a cap and tr ade pr ogr am must pr ovide f or tr ad able permits, specif icall y tha t appr opria te incr emen ts (e.g ., allo wances) ar e tr ad able among participan ts in the pr ogr am. The r egula ting authority can alloca te these authoriza tions, or allo wances, to emit in a v arie ty of wa y s, or auction them to the highest bidders. Policymak ers should also e xplicitl y sta te which r egula ting authority is r esponsible f or iss uing and distributing the allo wances. • B a n k i n g : Policymak ers might allo w sources to use allo wances iss ued in one period for compliance in s ubsequen t periods. This arr angemen t is called banking

. • T r a d i n g p r o c e d u r e s : A cap and tr ade pr ogr am needs consisten t rules f or cond ucting allo wance tr ansf ers, as w ell as a s y stem f or tr acking allo wances. Policymak ers should e xplicitl y sta te which r egula ting authority is r esponsible f o r de veloping and enf orcing tr ading pr oced ur es. • E m i s s i o n m o n i t o r i n g a n d r e p o r t i n g : Accur a te, compr ehensi ve emission d a ta ar e a cornerstone of a cr edible and eff ecti ve cap and tr ade pr ogr am. The r egula ting authority must have the authority to r equir e stand ar dized me thodologies f or emission meas ur emen t , collect emissions d a ta to de termine compliance, and publicize emission and allo wance d a ta to pr ovide tr anspar ency and pr omote conf idence in the pr ogr am. • C o m p l i a n c e : Each aff ected emission source is r equir ed to hold a t least one allo wance in their accoun t f or each unit of emissions d uring the compliance period. Cap and tr ade pr ogr ams must include pr ovisions tha t authorize the r egula ting authority to r econcile the emissions of each source with the number of allo wances the y hold to de termine compliance. • E s t a b l i s h i n g a n d e n f o r c i n g p e n a l t i e s f o r n o n c o m p l i a n c e : The r egula ting authority must have the authority to impose and enf orce s uff icien t penalties on emission sources tha t do not compl y with the rules of the pr ogr am. Legisla tion to pr ovide legal authority can r ange f r om a f e

w br oad sen tences to many de tailed pa ges. The legisla tion ma y pr ovide onl y gener al langua ge authorizing the use of emission tr ading or it ma y e

xplicitl y sta te the rules and guidelines f or a cap and tr ade pr ogr am. In addition to establishing this ne w authority , a cap and tr ade pr ogr am ma y r equir e appr opria te amendmen ts to a coun tr y’s e xisting legisla tion. F or e xample, fund amen tal legal iss ues (e.g ., e xisting technology stand ar ds or tax es) ma y hinder the de velopmen t of a cap and tr ade pr ogr am if not pr operl y addr essed. Most coun tries will alr ead y have some r egula tions tha t ar e r e la ted to envir onmen tal per f ormance. If e xisting r egula tions (or economic incen ti ves) ar e simpl y in place to collect r e venues f or the governmen t (e.g ., envir onmen t al tax es se t w ell belo w the mar ginal aba temen t cost), then a cap and tr ade pr ogr am can lik el y be added. If ther e ar e technology stand ar ds, it ma y be necessar y to mak e certain adjust men ts in existing legisla tion (e.g ., r eplacing the technology stand ar ds with caps of equal or gr ea ter stringency , or allo wing f irms to opt out of them in f avor of participa ting in the cap and tr ade pr ogr am). F or further discussion on cap and tr ade and poten tial conflicts in the e xisting legal structur e, see Chapter 4. 

# Cr ea ting an Emission In v e n t or y An importan t step in the de velopmen t pr ocess f or a cap and tr ade pr ogr am is the cr ea tion of an adequa te source-le vel emission inve n tor y . The types of d a ta and appr opria te le vel of de tail f or the emission inve n tor y will depend upon the in tended use of the d a ta. The emission inve n tor y is lik el y to be useful in anal yzing and making the f ollowing design decisions: • P r o g r a m a p p l i c a b i l i t y : The r egula ting authority ma y use inve n tor y d a ta to mak e decisions about which sectors to include, wher e to appl y the obliga tion to hold allo wances (e.g ., a t the fuel distributor or the emission source), and wha t thr esholds should be se t to de termine if a source is aff ected b y or e x empted f r om the pr ogr am (e.g ., pr od uction capacity). • A l l o w a n c e a l l o c a t i o n s : The r egula ting authority ma y use inve n tor y d a ta to anal yze the eff ects of diff er en t alloca tion options on emission sources and to decide on a me thod f or distributing allo wances. • Ag g r e g a t e c a p : The r egula ting authority will need the inve n tor y d a ta f or the aff ected emission sources to anal yze the poten tial costs and benef its of diff er en t emission caps, as w ell as to

3-3 D e v eloping a C ap and T r ade P r ogr a mP r o g r a m d e s i g n c o n s i d e r a t i o n s :

C o s t o f d a t a c o l l e c t i o n a n d a v a i l a b i l i t y o f d a t a : C o m p l e t e n e s s :

M e a s u r e m e n t M e t h o d : assess the per f ormance of the pr ogr am once implemen ted. In some cases, the emission inve n tor y is used to pr oject futur e emissions, either using a sophistica ted computer model or using simple ass umptions about pr ojected emission gr o wth. Minimum d a ta r equir emen ts f or the emission inve ntor y include: (1) indi vid ual emission source char acteristics (e.g ., size, loca tion, name-pla te capacity , pr ocess type, boiler type, fuel type); and (2) emission le vels f o r indi vid ual sources based on output , fuel use, and/or emission d a ta. These d a ta r equir emen ts will v a r y depending upon: (a) the types of sources to be r egula ted under the cap and tr ade pr ogr am; (b) the pollutan t; (c) the choice of allowance distribution me thod; and (d) the me thod f or se tting the over all cap. 

# In v e n t or y L e v e l of Detail F

or cap and tr ade pr ogr ams tha tr equir e emission sources to hold allowances, sources can be inve n toried a tf i ve diff er en t le vels of de tail: (1) the company le ve l 13 ; (2) the plan t le vel, which denotes a plan t or f acility tha t could con tain se ve r al emitting acti vities; (3) the poin t/stack le vel, wher e emissions e xit to the ambien t air f r om stacks, ve n ts, or other poin ts; (4) the pr ocess/segmen t le vel, r epr esen ting the unit oper a tions of specif ic source ca tegories (e.g ., a single boiler tha t burns both coal and gas would coun t as two segmen ts); and (5) the unit le vel (e.g ., each indi vid ual boiler) 14

. Although a full comparison of the diff er en t options is be y ond the scope of this guidebook, the most signif ican t f actors in making this decision ar e: • P r o g r a m d e s i g n c o n s i d e r a t i o n s : The le vel of de tail needed f or the emission inve n tor y is often de termined b y pr ogr am design consider a tions. F

or e xample, if the pr ogr am applicability thr eshold is based on the size of a combustion unit , then an inve n tor y cr ea ted a t the plan t le vel will not pr ovide s uff icien t de tail; additional information a t the unit le vel will be necessar y. Similarl y , allo wance alloca tion f ormulas ma y r equir e a certain le vel of inve n tor y d a ta. • C o s t o f d a t a c o l l e c t i o n a n d a v a i l a b i l i t y o f d a t a : Some options ma y make it easier to collect necessar y d a ta. F or e xample, fuel purchase r ecor ds ma y be k ept onl y a t the plan t le vel r a ther than f or each indi vid ual unit . Although d a ta can be apportioned when necessar y , it ma y be mor e cost eff ecti ve to collect d a ta a t mor e a ggr ega ted le vels of de tail, s uch as the plan t le vel. • C o m p l e t e n e s s : Inve n tor ying emissions a t the unit le vel avoids many of the complica tions tha t ma y arise with other inve n tor y le vels (e.g ., comple x conf igur a tions of pr od uction units and stacks) and pr ovides the most de tailed information about the emission sources. Ho w e ve r , this arr angemen t r equir es mor e d a ta tha t ma y be mor e diff icult to compile. • M e a s u r e m e n t M e t h o d : It is importan t to consider whe ther the d a ta ga ther ed f or the pr ogr am de velopmen t sta ge will need to ma tch the le ve l used to assess compliance once the pr ogr am is in place. If so, the r egula ting authority should e v alua te iss ues r e la ted to emission meas ur emen t f o r the v arious le vels of de tail. F or example, if instack meas ur emen t s uch as con tinuous emission monitors (CEMs) is used f or compliance with the pr ogr am, a stack-le vel inve n tor y w ould be an ad v a n t a ge because it w ould include all of the emissions f r om each stack. Ho w e ve r , for alternati ve meas ur emen t me thods (e.g ., fuel-based mass balance appr oaches), using stack le vel d a ta f o r compliance might complica te emission meas ur emen t , particularl y if se ve r al units shar e fuel s u pplies but e xhaust thr ough diff er en t stacks. 

# P r ogr am Design Elemen t s In de veloping a cap and tr ade pr ogr am, the r egula tingauthority should consider a number of design elemen ts. Each design decision aff ects other aspects of the pr ogr am. Although these elemen ts ar e discussed in a specif ic or der , the in terr ela tionships be tw een all the design elemen ts should be consider ed toge ther when making pr ogr am decisions.

13 Meas uring emissions a tthe company le vel is ve r ycomplica ted and is not r ecommended f or cap and tr ade pr ogr ams. Iss ues s uch as partial ownership, mergers, and sales all eff ect the ability to accur a tel y a ttribute emissions to a specif ic company . 14 In many cases, unit le vel ma y corr espond to poin t/stack le vel, but it is possible f or a unit to e xhaust to multiple stacks or f or multiple units to shar e a single stack.

3-4 D e v eloping a C ap and T r ade P r ogr a mC o n t r i b u t i o n t o e m i s s i o n s :

Av a i l a b i l i ty o f c o s t
- e f f e c t i v e c o n t r o l o p t i o n s :

A b i l i t y t o m e a s u r e e m i s s i o n s : 

# A pplicabilit y After deciding tha t cap and tr ade is the pr ef err ed appr oach to r e d ucing the emissions of a particular pollutan t , policymak ers must de termine which emission sources to include in the cap and tr ade pr ogr am. Ideall y , all sources, sectors, and emissions w ould be included f or full cove r a ge and maximum envir onmental eff ecti veness and economic eff iciency. Ho w e ve r , meas ur emen t capabilities and costs, av ailable con tr ol options, administr a t i ve bur dens, political consider ations, and other constr ain ts ma y limit participa tion to a s ubse t of emission sources. When determining the applicability of a cap and tr ade progr am, there are se v

e r a l importan t consider a tions: • C o n t r i b u t i o n t o e m i s s i o n s : Included sources should r epr esen t a s u bstan tial portion of emissions in or der to appr opria tel y addr ess the envir onmen tal iss ue of concern. T o de termine whe ther to include sources or sectors in a pr ogr am, the r egula ting authority should per f orm an anal y sis using the e xisting emission inve n tor y (as discussed in the pr e vious section), as w ell as an anal y sis of how futur e gr owth will change the e

xisting emission pa tterns. In this anal y sis, it is importan t f or the r egula ting authority to acknowl

### F igur e 5. L eak age ed ge and, if necessar y , addr ess emission sources tha t the y cannot f easibl y include, but tha t could r ecei ve shifts in pr od uction f r om emission sources constr ained b ythe cap. Such shifts of pr od uction f r om aff ected sources to other non-aff ected sources (“leaka ge”) could undermine the envir onmen tal benef its of the cap (See Fi gur e 5). Maximizing the cove r a ge of emissions in a cap and tr ade pr ogr am can optimize both the envir onmen tal eff ecti veness and the economic eff iciency of the pr ogr am. Conversel y , the envir onmen tal eff ecti veness of a cap and tr ade pr ogr am is diminished if a lar ge percen ta ge of emissions ar e outside the cap. Although the r egula ting authority can implemen t other policies f or emissions outside the cap, the le vel of these emissions is not guar an teed. Also, because sources outside the cap do not benef it f r om the economic eff iciency of the tr ading pr ogr am, the policies to con tr ol their emissions ma y be r e lati ve l y mor e costl y. • A v a i l a b i l i t y o f c o s t - e f f e c t i v e c o n tro l o p t i o n s : Some sources included in the pr ogr am should ha

ve a r ange of cost-eff ective aba temen t options to ens ur e the ability to achie ve the r e d uction goal. V

aria tion in aba temen t costs pr omotes compe tition among con tr ol options, stimula tes innov a tive techC apped sour c e s Uncapped sour c e s Elec tricit y Plants within capped ar ea r educ e pollution b ydecr easing pr oduc tion, but impor t po w e r fr om c e outside of the cap

. T his sour c e incr eases its pr oduc tion and pollution and sends elec tricit y int o the capped ar ea, so ther e is no benefit t o the en vir onment. T his is k n o wn as "leak age". a sour nologies, and helps lower compliance costs. • Ab i l i t y t o m e a s u r e e m i s s i o n s : As discussed further in this chapter , sources tha t participa te in a cap and tr ade pr ogr am must have the ability to accoun t f or their emissions accur a tel y and consisten tl y. Alterna t i vel y , a r egula ting authority ma y invo l ve independen t parties to meas ur e

3-5 D e v eloping a C ap and T r ade P r ogr a mN u m b e r a n d s i z e o f s o u r c e s :

S i m p l i c i t y :

E q u i t y : P o i n t o f e m i s s i o n s ( D i r e c t e m i t t e r s ) 1 5 :

U p s t r e a m ( P o t e n t i a l e m i t t e r s ) :

H y b r i d : and r eport emissions. If independen t parties ar e invo l ved, the r egula ting authority should have oversight , certif ica tion, and r e vie w pr oced ur es in place to pr omote accoun tability. Because each allo wance has economic v alue, it is importan t to ens ur e tha t emissions (and thus allo wances used) ar e quan tif ied accur a tel y and consisten tl y. • N u m b e r a n d s i z e o f s o u r c e s : The number and size of sources participa ting in the cap and tr ade pr ogr am ma y aff ect the r egula ting authority’s ability to mana ge the pr ogr am. The r egula ting authority must balance the desir e to maximize the cove r a ge of the pr ogr am to incr ease the envir onmen tal eff ecti veness and eff iciency a gainst the ability to oper a te the pr ogr am and enf orce compliance. If sources r esponsible f or a signif ican t portion of the total emissions ar e not included in the pr ogr am, the pr ogr am ma y be less envir onmen tall y eff ecti ve and less economicall y eff icien t . In addition, e x cluding some signif ican t sources within an ind ustrial sector can cause sources to shift acti vity to those sources outside the cap, ther eb y r e d ucing the envir onmen tal eff ecti veness of the pr ogr am. It might not , howe

ver , be necessar y to include all small sources. Ex cluding some small sources ma y help k eep the total number of sources to a le vel tha t is mana geable f or the administr a tion of the pr ogr am. • S i m p l i c i t y : It is importan t to avoid overl y comple x applicability criteria. Comple x criteria mak e it mor e diff icult and costl y f or sources and f o r the r egula ting authority to de termine which sources the pr ogr am covers. Comple x criteria also incr ease the lik elihood of loopholes tha t allo w signif ican t sources in the same ind ustrial sector to avoid inclusion in the pr ogr am. T o this end, the thr eshold(s) f or de termining source applicability should be based on source char acteristics tha t r emain constan t , s uch as capacity or potential to emit , r a ther than char acteristics tha t could v a r y f r om y ear to y ear , s uch as mass emissions or fuel use. This will ease administr a tion of the pr ogr am, pr ovide gr ea ter certain ty to sources, and avoid f r equen t changes in an indi vid ual source’s applicability sta tus. • E q u i t y : The r egula ting authority should gi ve car eful consider a tion to the economic compe titi veness of businesses and the eff ect on mark e t s tha t could r e s ult f r om including or e x cluding certain ind u stries f r om a tr ading s y stem. F airness r e la ti ve to emission r e d uction poten tial is another consider a tion f or the r egula ting authority

. 

## P oint of Obligation Closel y r e la ted to the questions of which sources and sectors ar e cove r ed in a cap and tr ade pr ogr am is the question of wher e ther e is an obliga tion to hold allowances (See Fi gur e 6). Ther e is a gr owing liter a tur e discussing how this would appl y to emissions tha t can be capped a tse ve r al diff er en t poin ts in an economy , including: • P o i n t o f e m i s s i o n s ( D i r e c t e m i t t e r s ) 1 5 : A poin t of emission pr ogr am f ocuses on dir ect emission sources (e.g ., electricity gener a tors and lar ge ind ustrial sources) wher e the pollutan t(s) ar e r eleased to the a t mospher e. This appr oach w orks w ell if the pr od uction or combustion pr ocess aff ects emissions (e.g ., NOx f r om ind ustrial boilers) or ther e ar e av ailable end-of-pipe con tr ols (e.g ., SO 2 f r om electricity gener a tors). The U .S. cap and tr ade pr ogr ams obliga te emission sources to hold allo wances equal to their total mass emissions. • U p s t r e a m ( P o t e n t i a l e m i t t e r s ) : An upstr eam pr ogr am f ocuses on any poin t prior to the emission source (e.g ., fuel pr od ucers and pr ocessors s uch as coal mines or oil r e f ineries). An upstr eam pr ogr am does not have a dir ect cap on emissions. Ra ther , the cap is se t on the emission poten tial inher en t in the fuel. The r estriction a t the fuels le

vel r estr ains s uppl y and can cause fuel prices to incr ease r e la ti ve to alterna ti ves. This “price signal” encour a ges fuel cons umers to r e d uce demand f or the fuel, either b y f inding mor e cost-eff ecti ve alterna ti ves or cr ea ting new technologies tha t use the fuel mor e eff icien tl y. In this wa y

, it oper a tes much lik e a pollution tax, but has the benef it of a cap on total emission poten tial (CC AP , 1

9 9 8; Kopp, e t al, 1 9 99). • H y b r i d : A h ybrid appr oach could be used to cap some en tities upstr eam and some en tities a t the poin t of emissions. F or e xample, lar ge emitters s uch as electricity gener a tors might be capped a t the poin t of emissions, while emissions f r om tr ansporta tion might be capped upstr eam (CC AP , 2 000, ELI, 1 9 9 7).

15 In U .S. liter a tur e, this is often r e f err ed to as “downstr eam,” while obliga tions a tany poin t after the emission source (e.g ., commercial electricity
cons umers) ar e r e f err ed to as “indir ect .” 3-6 D e v eloping a C ap and T r ade P r ogr a m

### F igur e 6. P oin t of Obliga tion

UPSTREAM (F uel P r oduc ers)

F uel Ex tr ac tion

DO WNSTREAM (Indir ec t Emitt ers) F uel P r oc essing

M ajor Emitting S e c t ors All Dir e c t Emission Sour c e s P oin t of Emissions (F uel C onsumers)

All Indir ec t Emission Sour c e s

Anal y sts often compar e upstr eam and poin t of 1 999). F or e xample, under an upstr eam s y stem, emission appr oaches on se ve r al k e

y pr ogr am par ame- an electricity gener a tor w ould f ace higher fuel ters: prices if fuel pr od ucers w e r e r e quir ed to hold • In most coun tries, an upstr eam s y stem could allo wances. These higher fuel prices w ould captur e the highest percen ta ge of poten tial emis- encour a ge the gener a tor to impr ove eff iciency or sions. Upstr eam can be particularl y eff ecti ve s witch to lo w er-emitting fuels in the same manwhen emissions ar e closel y r e la ted to the fuel ner tha t the gener a tor w ould be moti v a ted to char acteristics or end-of-pipe con tr ols ar e not r e d uce emissions if it was r equir ed to hold r eadil y av ailable. In addition, an upstr eam allo wances. Ho w e ve r , a f e

w anal y sts have ar gued appr oach ma y be tter addr ess sectors in which tha t a poin t of emission appr oach pr ovides a ther e ar e numer ous small ener gy users with mor e dir ect signal to r e d uce emissions, because dir ect emissions. Ad voca tes of the upstr eam the tar ge t is the emission source. Accor ding to appr oach also ar gue tha t it is economicall y eff i- this vie w

, an upstr eam s y stem, which r elies solecien t because it w ould spr ead the eff iciencies of l y on price signals, ma y not pr ovide s uff icien t cap and tr ade acr oss a lar ger segmen t of the incen ti ve to f ind ne w technologies tha t r e d uce economy. emissions per unit of fuel or sequester emis­ • Most economists ar gue tha t upstr eam and poin t sions. In particular , an upstr eam s y stem pr ovides of emission appr oaches cr ea te iden tical incen- little incen ti ve f or emission sources to de velop ti ves f or r e d ucing emissions f r om aff ected and emplo y post-combustion con tr ol technolosources’ ener gy use because ener gy cons umers gies since this behavior w ould not be dir ectl y f ace higher costs f r om using fuels with gr ea ter r e wa r ded (CC A P , 1

9 9 8). On the other hand, emission poten tial in both cases (Kopp, e t al., although it cr ea tes additional comple xity, policy3-7 D e v eloping a C ap and T r ade P r ogr a mmak ers can cr ea te incen ti ves f or post-combustion con tr ols b y awar ding cr edits to do wnstr eam emission sources tha t r e d uce or sequester emissions. • An upstr eam s y stem ma y include f e

w er sources, which w ould gener all y lo w er the administr a t i ve bur den of a pr ogr am. Although this is an importan t consider a tion, r ecen t ad v ances in the use of inf orma tion technologies to mana ge cap and tr ade pr ogr ams have allo w ed r egula ting authorities to handle gr ea ter numbers of emission sources without being overbur dened (Kruger , e t al., 2 000). Some anal y sts argue tha t a h ybrid s y stem ma y be an acceptable compr omise. These anal y sts con tend tha t s uch a design would be desir able because it would pr ovide similar cove r a ge of emissions to an upstr eam s y stem, while allowing the pr ogr am design to f ocus on the types of emission sources tha t ha ve been s uccessfull y included in past cap and tr ade pr ogr ams (Mazur ek, 2 0 0 2). P oten tial downsides to s uch an appr oach include a larger number of sources than an upstr eam pr ogr am and added comple xity f r om the need to a v

oid double coun ting emissions a tboth upstr eam and poin t of emissions sources. F or e xample, policymak ers ma y include na tur al gas-f ir ed electric gener a tors (poin t of emissions) and na tur al gas distributors (upstr eam) in a h ybrid cap and tr ade pr ogr am. The r egula ting authority would ha

ve to ded uct fuel used b ythe included electric gener a tors f r om the amoun t of na tur al gas distributed b y upstr eam sources to ens ur e tha t emissions ar e not coun ted b yboth sectors. 

## Opt-ins Some sectors ma y not mee t the above criteria for inclusion in the cap and tr ade pr ogr am but ha ve indi vid ual sources tha t can mee t the criteria. In s uch cases, it ma y be desir able to allow these sources to volun taril y “optin” to (participa te in) the pr ogr am. These sources r ecei ve an allowance alloca tion and ar e s ubject to the same r equir emen ts as sources under the cap. Theor e ticall y , these sources will ha ve cost-eff ecti ve emission r e d uction opportunities tha t warr an t the e

xpense of mee ting the monitoring and other r equir emen ts associa ted with the cap and tr ade pr ogr am. If policymak ers allow opt-ins, sources tha t choose to optin should be s ubject to all the terms of the pr ogr am. It is imper a t i ve tha t any sources opting in emplo y a meas ur emen t pr otocol tha t is equi v alen t in consistency and accur acy to the me thods used b ythe aff ected sources. This ens ur es tha t the r e d uctions achie ved ar e r eal, verif iable, and compar abl y v alued. Although volun tar y opt-in pr ovisions ma y r e d uce costs to aff ected sources, the y r aise some of the same iss ues associa ted with pr oject-based cr edits discussed in Chapter 2. Sources ma y decide to opt-in and tak e ad v a n t a ge of allo wance alloca tions tha t ar e above wha t their emissions w ould have been if the y w e r e not participa ting in the cap and tr ade pr ogr am. In some cases, the y ma y opt-in and then tak e meas ur es to r e d uce emissions tha t w ould have occurr ed anywa y

, r egar dless of participa tion in the pr ogr am. Unless the r egula ting authority can mak e an allo wance alloca tion a t a le vel tha t equals “business as us ual,” e xtr a allo wances will be in tr od uced in to the s y stem and will undermine the envir onmen tal eff ecti veness of the cap and tr ade pr ogr am. Research on the U .S. SO 2 Allo wance T r ading P r ogr am has sho wn tha t many of the sources tha t volun taril y joined the pr ogr am under opt-in pr ovisions 16 w e r e spurr ed b y overl y gener ous allo wance alloca tion f ormulas. Opt-ins using these pr ovisions achie ved ve r y f e

w additional emission r e d uctions (Ellerman, e t al., 2 000). 

# S etting the L e v el of the C a p Se tting the le vel of the emission cap is one of the most importan t decisions f or policymak ers and the r egula ting authority . In theor y , the most economicall y eff icien t le vel f or the emission cap is wher e marginal aba temen t costs ar e equal to marginal benef its f r om the r e d uced emissions (see Appendix A for further discussion). How e ve r , this le vel is often diff icult to de termine d ue to uncertain inf orma tion. Mor e gener all y , the cap should be se t a ta le vel tha t is e xpected to addr ess the envir onmen tal and health pr oblems of concern a t an acceptable cost

. As with other types of policies to r e d uce emissions, it is desir able to use a t mospheric and ecological or health eff ects models to assess the impacts of diff er en t le

vels of emission r e d uctions. Models r ange f r om those tha t describe links be tw een one r eceptor ar ea and one source, to others tha t describe comple x r egional-scale r e la tionships. Models also can pr oject a wide v arie ty of

16 Ther e w e r e thr ee pr ovisions in the SO 2 tr ading pr ogr am tha t encour a ged volun tar y en tr y in to the pr ogr am. The Substitution and Compensa ting Gener a tion pr ovisions w e r e used to bring Phase II units in to the pr ogr am d uring Phase I. The Ind ustrial Opt-in pr ovision was us ed to bring ind ustrial boilers and small gener a ting units in to the pr ogr am.

3-8 D e v eloping a C ap and T r ade P r ogr a mimpacts thr oughout the r egion. Some models addr ess changes over short time periods, s u ch 

### F igur e 7. Knee of Mar ginal Aba t emen t C ost C u r v e as episodes, while others f ocus on longer time periods, and some a ttempt to do both. Us uall y , models f ocus on one part of the over- all assessmen t and should be link ed to pr o­ d uce a trul y in tegr a ted assessmen t . Emission models de velop emission d a ta f or input in to air quality models. The output of the air qual­ ity models is then tr ansla ted in to impacts using a v arie ty of models char acterizing human health and ecological w elf ar e and other eff ects. Ultima tel y , selection of the best model f r ame work or best se t of models M a r g inal Abat ement C o st t o Emission Sour c e s

P ossible point of r egulation balancing needed emission r educ tion and c ost

0 100COST OF REDUCTIONS

depends on the question being ask ed. (USEP A, 2 0 0 1 ) In pr actice, policymak ers will de termine the cap b y considering a combina tion of science, economics, and political f easibility. One appr oach tha t policymak ers some times use to de termine the a ggr ega te emission cap is f inding the “knee in the cost cur ve” (i.e., the poin t bef or e costs per unit of emission r e d uction begins to rise r apidl y (see F i gur e 7)). Policymak ers ma y also wa n t to ens ur e tha t costs ar e within an acceptable r ange. T o estima te costs and benef its, policymak ers ma y use economic modeling to depict optimal con tr ol decisions. The decision of when to implemen t the cap is in tegr al to the decision on the le vel of the cap. Policymak ers ma y need to w eigh the pr os and cons of opting f or a tighter cap with a la ter implemen ta tion d a te ve rs us a less a ggr essi ve cap with an earlier implemen tation d a te. F or e xample, it ma y not be f easible to se t the cap a tthe optimal le vel f or the initial sta ge of implemen ta tion. How e ve r , r a ther than delay implemen t a tion un til a la ter d a te when the optimal le ve l ma y be mor e achie v able, it ma y be ad v a n t a geous to begin the pr ogr am as soon as possible to encour a g e ad v ances in con tr ol technology and influence inve stmen tdecisions. Under s uch a scenario, policymak ers ma y establish a cap tha t declines over time to ultima t el yachie ve the envir onmen tal goal. This is one of the ad v a n t a ges of allowing emission sources to bank e x cess allowances. It encour a ges earl y r e d uctions, ad v ances con tr ol technologies, and r e d uces the economic eff ect of the declining cap. F or pr edictability , it is importan t tha t policymak ers or the r egula ting authority def ine the decline in allowances in ad v ance to pr ovide sources s uff icien t time to adjust to ne w cap le vels. EMISSION REDUCTION (PERCENT )
The le vel of the cap will also depend on applicability decisions about which sources and sectors to include in the pr ogr am. In the case wher e policymakers establish a na tional emission goal and de velop a cap and tr ade pr ogr am in conjunction with other r egula tor y tools, the y must de termine wha t portion of the goal should come f r om sources in the cap and tr ade pr ogr am (the cap) and wha t portion f r om other sectors and sources. Ideall y , a cap and tr ade pr ogr am should include as many sectors as possible to maximize the cost savings f r om tr ading be tw een sources with differen t mar ginal aba temen t costs. If it is not possible to include certain sectors under the cap and tr ade pr ogr am, then alterna ti ve policy instrumen ts ma y be used to r e d uce emissions in sectors outside the cap. Wher e possible, ho w e ve r , these instrumen ts should be used to r e d uce emissions to le vels wher e mar ginal aba temen t costs in the uncapped sector(s) ar e r oughl y equi v alen t to the mar ginal aba temen t costs in the sector(s) participa ting in the cap and tr ade pr ogr am. 

# L ength of C omplianc e P e riod The length of the compliance period should be link ed to the envir onmen tal pr oblem and r eflect oper a tional consider a tions. If the envir onmen tal pr oblem is con tinuous and long-term, as in the case of acid r ain or clima te change, the compliance periods should be con tinuous, covering all mon ths of the y ear . If the pr oblem is seasonal, as is the case with gr ound-le ve l ozone in the Eastern United Sta tes, then the compliance period ma y be seasonal, s uch as the f i ve-mon th compliance period each y ear used in the Ozone

3-9 D e v eloping a C ap and T r ade P r ogr a mC o n s i s t e n c y :

A c c u r a c y : T

r ansport Region (the District of Columbia and 1 2 sta tes in the Northeastern United Sta tes). The decision of whe ther to assess compliance quarterly , annually , or less f r equen t lyshould also tak e in to accoun t the administr a t iv e bur den imposed. A short compliance period puts a larger administr a t iv e bur den on both the r egula ting authority and emission sources but allow s f or s wifter action to corr ect a case of noncompliance. A longer compliance period allow s mor e flexibility f or the sources to achie v

e compliance and r e d uces the administr a t iv e bur den f or the r egula ting authority

. B ylengthening the period be tween compliance assessmen ts, howe v

e r , cases of noncompliance can persist f o r longer periods of time, possibly incr easing the diff iculty of corr ecting those problems. Most cap and tr ade progr ams de termine compliance on an annual basis. 

# Quan tifying Emissions fr om Sour c es in the P r ogr a m One of the most importan t f e a tur es of a cap and tr ade pr ogr am is tha t sources meas ur e total mass emissions (as opposed to emission r a te or concen tr a tion) as accur a tel y and consisten tl y as possible. Because the emis
## T a b l e 3 : E m i s s i o n s M o n i t o r i n g P r i o r i t i e s P u rpose P r iorities C ap and T r ade • C omplet e and c onsist ent acc ounting of t otal mass emissions • A ccur at e and c onsist ent measur ement among sour c e s • C onser v a tiv e emission estimat e s

(not under estimat e d) C ommand-and­ • A c c ounting of emission r a t e or C o ntr o l t echnology installation P r ojec t-based • Reasonably accur at e estimat e of T r ading baseline (what emissions w ould ha v e occurr ed in the absenc e of the pr ojec t) • A ccur at e acc ounting of emission

r a t e and ac tivit y lev e l Resear ch • Best a v ailable emission data, In v e nt or y r egar dless of c onsist enc y among sour c es or sec t ors • C onsist ent emission measur ement methodologies o v er time sion meas ur emen ts ar e the “gold stand ar d” underl ying the tr aded allowances, it is importan t tha t a ton of emissions a tone source is equal to a ton of emissions a tany other source. This cr ea tes a le vel pla ying f ield f o r participan ts in the pr ogr am and a str ong f ound a tion upon which a mark e tcan oper a te. The emissions monitoring priorities f or a cap and tr ade pr ogr am diff er f r om other types of envir onmental r egula tions (see T able 3 f or emission monitoring priorities of diff er en t types of pr ogr ams). In considering poten tial emission meas ur emen t r egimes f or a cap and tr ade pr ogr am, the f ollo wing monitoring objecti ves ma y be useful as a guide: • C o n s i s t e n c y : The r egula ting authority should cr ea te clear and consisten t pr otocols f or sources to de termine emissions. This means emplo ymen t of stand ar d pr oced ur es and the use of sound engineering pr actices. This arr angemen t can be particularl y challenging if the cap and tr ade pr ogr am includes sources f r om a v arie ty of ind ustrial sectors. • Ac c u r a cy : F or a cap and tr ade pr ogr am, accur a t e meas ur emen t is mor e importan t than consistency over time. Policymak ers should consider enhancemen ts to meas ur emen t me thods or using diff er en t me thods if be tter appr oaches ar e av ailable and pr actical. The monitoring pr ogr am can also be designed to include per formance stand a r ds tha t r e wa r d sources tha t achie ve be tter accur acy than r equir ed. F or e xample, f or less accur a te appr oaches, sources should use mor e conser v a ti ve estima tion me thods tha t ar e not biased to wa r d under estima ting emissions. Ultima tel y , it is most importan t to avoid s y stema tic under estima tion of emissions. 

## C onsider ations in Choosing a M easur ement Appr oach
Pollutant The pollutan t to be meas ur ed, the conditions under which it is cr ea ted, and the mode in which the emissions en ter the a t mospher e will aff ect the types of emission meas ur emen t techniques a v ailable. F or example, meas ur emen t iss ues r e la ted to emissions of SO 2 , NOx , and CO 2 f r om sta tionar y source combustion will v a r ybecause emissions of SO 2 and CO 2 ar e dir ectl y link ed to the combusted fuel, while emissions of NOx also depend on the combustion conditions. Ther ef or e,

3-10 D e v eloping a C ap and T r ade P r ogr a m

## T y p i c a l E m i s s i o n s M e a s u r e m e n t U n d e r t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m In most cases , emission sour c es must c o ntinuously measur e and r e c o r d hourly emission c onc entr ations of SO 2 , NOx , and C O 2 , as w ell as flo w of exhaust gases with a c o ntinuous emission monit oring syst em (CEMS) (see F igur e 8). EP A has established pr o visions f or initial equipment c e r tification pr oc edur es , p eriodic qualit y assur anc e and qualit y c o ntr o l pr oc edur es , r ec or d k eeping and r e por ting , and pr oc edur es f or filling in missing data periods

. Wher e possible , inc entiv es ar e pr o vided t o impr o v e and maintain the qualit y of the monit oring

. F or example , units must periodically under tak e r elativ e accur ac y t ests on their CEMS (which in v o lv es c omparing the monit or ed emissions fr om the CEMS t o monit or ed emissions fr om an independent or r e f e r enc e measur e of emissions); if the CEMS r e c eiv es a superior accur ac y r esult , the fr equenc y of futur e t esting is r educ ed and the firm sa v es money. F or a full discussion of monit oring per f ormanc e standar ds and inc e ntiv es f or impr o ving accur ac y thr ough qualit y assur anc e r equir ements , s ee Saile , 1995.

Fl o w M o nit or Ga s Sampling P r obe

Ga s C ylinders F l o w C o ntr ol P anel Data A c quisition and Handling S y st em

Analyz ers P ump Chiller 

### F igur e 8. A C o n t inuous Emission Monitoring (CEM) S y stem

3-11 D e v eloping a C ap and T r ade P r ogr a man appr opria te meas ur emen t me thod f or CO 2 , s uch as mass balance based on carbon con ten t in the fuel will not be appr opria te f or NOx . Instead, accur a te measur emen ts of NOx emissions f r om sta tionar y source combustion must be tak en f r om e xhaust gases. 

### Ho w Emissions Enter the Atmosphere How emissions en ter the a t mospher e can limit the choice of me thodology . F or e xample, con tinuousl y meas uring actual emissions is an option onl y if emissions ar e ve n t ed thr ough a stack or other con tained ar ea wher e meas ur emen t equipmen t can be loca ted. In con tr ast , meas uring fugiti ve emissions (i.e., emissions tha t escape dir ectl y in to the a t mospher e in a diffuse manner) ma y depend on estima tion techniques based on inputs and def aults. 

### Emissions Abatement Options The aba temen t options a v ailable f or sources to r e d uce their emissions ar e also a factor in the choice of measur emen t me thod. It is importan t tha t the meas ur emen t me thod be able to accur a tel y captur e the r e d uctions made. F or e xample, meas ur emen t me thodologies based on fuel inputs (e.g ., mass balance) ma y be appr opria te f or sources tha t r e d uce emissions b y s witching or conser ving fuels, but it would be much less appr opria te f or sources tha t use r e d uction technologies s uch as combustion modif ica tion or post-combustion con tr ol. In choosing a stand ar d meas ur emen t appr oach, it is importan t to allow sources full fle xibility of compliance/mitiga tion options. It is also importan t to consider poten tial technological innov a tions in mitiga tion appr oaches. Thus, it is useful to choose a me thod tha t can meas ur e the r e d uctions achie ve d thr ough v arious r e d u ction str a tegies or to specify multiple meas ur emen t options, some of which ma y be allow ed onl y f or certain mitiga tion options. 

### Point of O bligation The poin t of obliga tion will influence wher e and how emissions, or their pr o x y , ar e meas ur ed. Similarl y , meas ur emen t constr ain ts will influence wher e and how the emissions ar e r egula ted. If the r egula tion is dir ected a tupstr eam sources, s uch as fuel s uppliers, it is not appr opria te to meas ur e combustion emissions using an in-stack monitor a tthe pow er plan t wher e the fuel is burned. Instead, the fuel s upplier’s compliance with the cap and tr ade pr ogr am should be jud ged based on the amoun t and char acteristic of each type of fuel sold, and the monitoring me thod would f ocus on de termining the total amoun t of each type of fuel sold. 

### F

requenc y of Measurement Although a cap and tr ade pr ogr am r equir es a comple te accoun ting of each unit of emissions, the minimum f r equency of meas uring emissions or the par ame ters used in calcula ting the quan tity tha t is emitted will need to be de termined (e.g ., con tinuous emissionmonitoring, periodic monitoring, or the use of emission f actors). The na tur e of the pr oblem to be sol ved, the poten tial v ariability of the meas ur ed par ame ters, and the length of the compliance period will influence the appr opria te f r equency . F or a cap and tr ade pr ogr am aimed a tsol ving a pr oblem caused b ya total accumulation of emissions in the a t mospher e, s uch as acid r ain, the f r equency will be dicta ted b ythe ability to captur e v aria tions in emissions and con tribute to an accur a t e estima te of total emissions. F or an episodic pr oblem, s uch as gr ound-le vel ozone, mor e importance will be placed on the f r equency of meas ur emen t because a ggr ega tion of emission meas ur emen ts must be a tf r equen t enough in ter v als to investiga te indi vid ual episodes. F urthermor e, gr ea ter f r equency of meas ur emen tis warr an ted when emissions, or the par ame ters used to calcula te emissions, ha ve the poten tial f or high v ariability (e.g ., f or units tha t use fuels with v a r ying char acteristics or f or units in which emissions can be aff ected b ythe wa y the unit or con tr ol de vices on the unit ar e oper a ted). Both the U

. S. SO 2 Allowance T

r ading Pr ogr am and the O T C Regional NOx T r ading Pr ogr am in the Northeastern United Sta tes (which is aimed a taddr essing episodic gr ound-le vel ozone) r equir e r eporting of hourl y emissions which ar e the a ver a ge of a tleast f our meas ur emen ts tak en each hour

. 

### F

requenc y of Repor ting In addition to deciding upon the f r equency of measur emen t , the r egula ting authority should consider how often to r ecei ve the d a ta. The RECL AIM emission tr ading pr ogr am in Calif ornia uses computers to ge t the source meas ur emen t d a ta r eported to the r egula ting authority in r eal time. The U

. S. SO 2 Allowance T

r ading Pr ogr am, which r equir es sources to r ecor d hourl y d a ta, r equir es sources to compile and send emission r eports to EP A on a quarterl y basis e ven though compliance is de termined on an annual basis. F

actors to consider when se tting the f r equency of r eporting include: allowing enough staff time to r e vie w the d a ta (e.g ., not waiting un til the end of the y ear to

3-12 D e v eloping a C ap and T r ade P r ogr a m

## M e a s u r i n g S m a l l , C l e a n U n i t s i n t h e U

. S
. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m T he U.S. SO 2 Allo wanc e T r ading P r ogr am allo ws sour c es that oper at e v e r yinfr equently or ar e v e r y small t o use c onser v a tiv e estimations of emissions r a ther than install mor e expensiv e CEMS. T he pr ogr am pr o vides limit ed alt ernativ es for smaller emission sour c e s , at which the c ost of mor e accur at e measur ement is high r elativ e t o the emissions

. T hese alt ernativ es ar e designed t o ensur e that emissions ar e nev er under estimat e d

. T he pr ogr am also allo ws lar ge units that burn pipeline-qualit y natur al gas t o use fuel met ering and default emissions r a t es t o measur e SO 2 emissions because the char ac t e ristics of pipeline-qualit y natur al gas ar e v e r yc onsist ent and the r esulting SO 2 emissions ar e v e r ylo w .

r e

vie w all d a ta a tonce); gi ving time to sources to corr ect any err ors f ound d uring r e vie w; and pr oviding timel y , r e vie w ed d a ta s ummaries to the public. 

### C

ost and F easibilit y Within a cap and tr ade pr ogr am, ther e ma y be sources tha t emit small quan tities of emissions because the y ar e small, clean, or oper a ted inf r equen tl y . Alterna tive and less costl y me thodologies ma y be appr opria te f o r s uch sources d ue to the high cost of the stand ar d me thodology . It is importan t to the in tegrity of the tr ading s y stem to ens ur e tha t less accur a te me thodologies ar e conser v a tive in na tur e (i.e., the me thods over estima t e r a ther than under estima te emissions), as well as to k eep the number of sources tr ea ted in this f ashion r e la tive l ysmall. It is also importan t to k eep in mind tha t the cost of accur a te emission monitoring should be consider ed in light of the cost sa vings aff or ded b ythe cap and tr ade appr oach over tr aditional appr oaches to en vir onmen tal pr otection. The added cost of accur a t e meas ur emen t ma y be a small percen ta ge of the sa vings achie ved b yimplemen ting a cap and tr ade pr ogr am ve rs us another f orm of r egula tion, and the r e s ulting accur acy and conf idence in the emission d a ta ma y be we ll worth the e xpense (Ellerman, e tal., 2 000). 

## Qualit y A ssur anc e and Qualit y C o ntr o l (Q A/QC) Simpl y r equiring the most accur a te emission meas ur emen tme thodology will not ens ur e an eff ecti ve tr ading s y stem. Eff ecti ve implemen ta tion is critical. It is essen tial tha t the meas ur emen t techniques ar e stand a r dized, commonl y applied to pr ogr am participan ts, implemen ted pr operl y , and v alid a ted f or indi vid ual applica tions. In addition, r egar dless of wha t meas ur emen ts y stems ar e used to quan tify emissions, it is imper a t i ve tha t any s y stem be s ubject to a w elldef ined and con tinuous quality ass ur ance and quality con tr ol (QA/QC) pr ogr am. These QA/QC pr ogr ams should be based on na tional or in terna tional stand ar ds (e.g ., In terna tional Stand ar ds Organiza tion) and must be documen ted with r ecor ds tha t can be audited. 

## M issing Data Substitution It is essen tial to accoun t f or each unit of emissions f r om a source because cap and tr ade pr ogr ams assess compliance b ycomparing the total emissions and the total number of allowances held. In r eal-lif e situa tions, how e ve r , monitor ed d a ta ma y be una v ailable because monitoring equipmen t occasionall y functions impr operl y or is being tested or main tained. Ther ef or e, ther e is a need f or rules to pr ovide a stand ar d me thodology f or s ubstituting f or missing d a ta periods. This stand ar d me thodology should pr ovide incenti ves f or r egula ted sources to k eep r ecor ds in good or der , to k eep meas ur emen t equipmen t w ell maintained, and to have pr oced ur es tha t ens ur e tha t f aulty 

## Q u a l i t y A s s u r a n c e U n d e r t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m T he U.S. SO 2 Allo wanc e T r ading P r ogr am r equir es sour c es t o t est each c o ntinuous emissions monit or (CEM) syst em in its installed location. T he CEM is t est ed at least annually against an independent r efer enc e method prior t o c e r tifying the CEM f or use . T he independent r e f e r enc e method c onsists of inser ting a calibr at ed pr obe int o the exhaust stack and running a sample of exhaust gas thr ough a calibr at ed analyz er t o c ompar e the r eading with the installed CEM. A bias t est det ermines if ther e is an y syst ematic bias in the CEM r eadings r elativ e t o the r e f e r enc e method

. I f the CEM syst ematically underestimat e s emissions , the oper at or ma y either fix the monit or and r e t est it or calculat e a bias adjustment fac t or (based on diff er enc es betw een the CEM r eading and the r e f e r enc e method) that is applied t o all r e por t ed data.

3-13 D e v eloping a C ap and T r ade P r ogr a mD a t a f o u n d a t i o n : 

## M i s s i n g D a t a S u b s t i t u t i o n f o r t h e U

. S
. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m Under the U.S. SO 2 Allo wanc e T r ading P r ogr a m, if a measur ement devic e (e .g ., c o ntinuous emission monit oring syst em or fuel flo w met er) is not oper ating pr operly or if fuel sample analysis is not a v ailable f or a par ticular hour , then the rules r equir e that a substitut e v alue be calculat ed b ythe sour c e . T he rules dic tat e the use of a substitut e data algorithm

— specified in the r egulations

— which r epr esents a gr aduat ed r esponse . W hether the substitut e v alue is calculat ed as an a v er age v alue or a c onserv a tiv e v alue depends on the per c e ntage of time that the monit oring syst em has been able t o pr oduc e and r e por t a qualit y-assur ed v alue , as w ell as on the length of time that the data is missing

. T he substitut e data calculation v a ries fr om a) the a v er age of the hour bef o r e and the hour af t er the missing data period

— f or missing data periods of shor t dur ation; t o b) a v e r yc onser v a tiv e maximum pot e ntial v alue f or long or fr equent missing data periods

. equipmen t will be r eplaced or r epair ed in a timel y f ashion. T o accomplish this most simpl y , the rules could r equir e a ve r y conser v a ti ve s ubstitute v alue (e.g ., a v alue tha t w ould r e s ult in the maximum potential emissions) to be used f or any hours of missing d a ta. Another option, which is mor e comple x, w ould be to consider the f r equency and length of the missing d a ta periods in de termining a s ubstitute v alue. This wa y

, an aver a ge or slightl y conser v a ti ve v alue is used f or short and inf r equen t periods of missing d a t a and a ve r y conser v a ti ve v alue is used f or long or f r equen t missing d a ta periods. 

# A llo w anc e Distribution The distribution of allo wances ma y be one of the most diff icult iss ues f or policymak ers when de veloping a cap and tr ade pr ogr am. Distribution decisions have economic, equity , and political r amif ica tions. 17 Cap and tr ade pr ogr ams cr ea te a v aluable asse t f o r those who o wn or con tr ol the authoriza tions to emit

. If emission sources r ecei ve allo wances thr ough a nocost alloca tion, the y captur e the gains f r om these v aluable asse ts. Under an auction, the governmen t captur es the v alue of these asse ts in the f orm of incr eased r e

venues. Some anal y sts have ar gued tha t the r e venues f r om allo wance auctions can have economy-wide eff iciency or equity benef its if the y ar e distributed in certain wa y s (e.g ., used to r e d uce distortionar y tax es or distributed in lump s ums to households or other gr oups.) 18 Diff er en t types of alloca tion f ormulas can cr ea te “winners” and “losers” among sources participa ting in a cap and tr ade pr ogr am. It is importan t to note, ho we

ver , tha t the me thod f or distributing allo wances will not aff ect the envir onmen tal in tegrity of the pr ogr am if the pr ogr am is pr operl y enf orced. The f irst ma jor step in the allo wance distribution pr ocess is to decide whe ther the allo wances will be alloca ted a t no cost to the emission sources (us uall y based on some f orm of oper a ting d a ta), sold b y the r egula ting authority thr ough an auction or a dir ect sale, or distributed b y some combina tion of these s y stems. T o d a te, e xisting cap and tr ade pr ogr ams have alloca ted allo wances a t no cost to sources. Wha te ver allo wance distribution me thod is selected, policymak ers can include se t-asides or pools of allo wances f r om within the cap. Existing cap and tr ade pr ogr ams utilize se t-asides to pr ovide allo wances f or ne w sources or to pr ovide an incen ti ve or compensa tion f or certain types of behavior (e.g ., earl y r e d u ctions, ener gy eff iciency meas ur es, or r ene wable ener gy gener a tion). This section explains the incenti ves and decisions associa ted with alloca tions, auctions, and dir ect sales. 

## Allocations If policymak ers decide tha t allowances will be alloca ted f r ee of charge, many diff er en t me thods can be used to distribute the allowances. The r egula ting authority will need to consider the f ollowing iss ues: • D a t a f o u n d a t i o n : In gener al terms, ther e ar e thr ee diff er en t aspects of a unit’s oper a tion tha t ma y be meas ur ed and used (indi vid uall y or in combina tion with per f ormance stand ar ds) as a basis f or alloca ting allo wances: mass emissions, fuel (or hea t) input , and pr od uction output (e.g .,

17 F or a mor e de tailed discussion of the equity , economic, and political r amif ica tions of diff er en t distribution schemes, see B urt r aw , e tal., 2 0 0 1 and Ellerman, e tal., 2 000. 18 F or a mor e de tailed discussion of the equity , economic, and political r amif ica tions of diff er en t allowance distribution schemes , see B urtr aw , e tal., 2 0 0 1; Ellerman, e tal., 2 000; and Dinan and Rogers, 2 0 0 2

.
3-14 D e v eloping a C ap and T r ade P r ogr a mR e f e r e n c e p e r i o d :

A l l o c a t i o n p e r i o d : 

## T h e U

. S

. E x p e r i e n c e w i t h A l l o c a t i o n s T he U.S. SO 2 Allo wanc e T r ading P r ogr am uses a c o mbination of hist oric lev el of ac tivit y (heat input inmillion British thermal units (mmBtu) and an emissions standar d , 1.2 pounds of SO 2 /mmBtu), as the primar y basis of a permanent allocation. T his ensur es that the plants with the highest emission r a t es will be enc our aged t o r educ e the most , while plants that alr eady r educ ed emissions will need t o do less (or nothing). T he RECLAIM pr ogr am also uses a c ombination of past ac tivit ylev els and an emission standar d f or initial allocations

. In both pr ogr ams , t otal allocations ar e r a t chet ed do wn t o mat ch the pr ogr a m cap . F u r ther , in both pr ogr ams , new units must pur chase allo wanc es f or c omplianc e . In the case of the U.S. SO 2 Allo wanc e T r ading P r ogr a m, units ma y pur chase these allo wanc es in the mark e tplac e or dir ec tly fr om the go v e rnment in the go vernment-oper at ed auc tion. Regional NOx tr ading pr ogr ams in the Nor theast ern Unit ed Stat es utiliz e an updating inputor output-based allocation scheme (the methodology v a ries fr om stat e t o stat e). T he tr eatment of new sour c es in the OTC Regional NOx T r ading P r ogr a m will also v a r y b ystat e , but stat es gener ally include a set-aside acc ount t o pr o vide allo wanc es for the addition of new sour c es (M cL ean, 2002).

quan tity of electricity pr od uced). The meas ur es of input and output will v a r y b y sector , but any of these pr ocesses could be used as a basis f o r the alloca tion of allo wances. Policymak ers should consider the char acter and quality of e xisting d a ta (e.g ., it ma y be diff icult to base alloca tions on historic output if multiple sectors with differen t pr od ucts ar e included in the cap and tr ade pr ogr am) and the behavior the y wa n t to r e wa r d (e.g ., alloca tions based on historic emissions benef it the lar gest and least-eff icien t emitters, wher eas alloca tions based on historic input or output benef it those tha t used the most fuel or pr od uced the most pr od uct). Additionall y , allocations could be based on the above inf orma tion in conjunction with a per f ormance stand ar d, con tr ol meas ur es, or e xisting con tr ol technology r equir emen ts, a gain depending upon the r esources av ailable and the desir ed eff ect . • R e f e r e n c e p e r i o d : The r e f e r ence period for alloca tions could be historic, curr en t , or e ven pr ojected. Though an importan t decision in any alloca tion scheme, the r e la ti ve importance of the r e f e r ence period decision incr eases with the length of the alloca tion, as further e xplained belo w . Alloca tions using historic r e f e r ence periods ar e a ttr acti ve to f irms tha t typicall y havebeen big emitters, or in the case of input or output appr oaches, near their maximum capacity in the past (whe ther the y have s ubsequen tl y r e d uced these acti vities or not) because the y ar e guar a n teed a r e la ti ve l y lar ge alloca tion under the ne w cap and tr ade r egime. Using the aver a ge of se

ve r al y ears’ d a ta can smooth out possible irr egularities (e.g ., e xtr eme w e a ther conditions, plan t shutdo wns f or main tenance). An importan t iss ue to consider when de termining the r e f e r ence period is ho w the choice will aff ect sources tha t implemen ted emission r e d uction meas ur es prior to the start of the cap and tr ade pr ogr am. F or e xample, if the allo wances ar e alloca ted based on historic emission le vels, choosing a r ecen t y ear f or the r e f e rence period will penalize those sources tha t volun taril y r e d uced emissions earl y. If emission sources pr edict tha t s uch a choice ma y be made in the design of the pr ogr am, it could pr ovide a disincen ti ve f or sources to tak e earl y actions benef icial to the envir onmen t and human health. One wa y to avoid this pr oblem is to choose an earlier y ear as the r e f e r ence period. Ho w e ve r , this ma y have a nega ti ve impact on the av ailability or quality of the d a ta used. Another option is to choose an alloca tion me thod tha t is not based on historic emissions, but one tha t ma y still be based on some historic inf orma tion. In the U

. S. SO 2 Allo wance T r ading P r ogr am the alloca tion me thod uses a per f ormance stand ar d applied to historic utiliza tion (i.e., hea t input). This hea t input d a ta was r eadil y av ailable and did not r e

wa r d plan ts with high emission r a tes. • A l l o c a t i o n p e r i o d : Policymak ers must decide whe ther alloca tions will be permanen t or upd a t
ed periodicall y. Because upd a ting s y stems change allo wance alloca tions a t periodic in terv als, en tities ma y have an incen ti ve to do mor e of the acti vity tha t will earn them mor e allo wances. Ther e f o r e , upd a ting alloca tions can influence

3-15 D e v eloping a C ap and T r ade P r ogr a mL e n g t h o f a l l o c a t i o n :

P r e s e r v i n g t h e c a p :

I n c o r p o r a t i n g n e w s o u r c e s : futur e behavior . The time period of the in ter v a l will aff ect the le vel of influence upd a ting has on futur e behavior . F or e xample, if upd a ting is done annuall y based on output , it could pr ovide a str ong incen ti ve to incr ease output in or der to r ecei ve additional allo wances. If, ho w e ve r , the time period is longer (e.g ., 1 0 y ears) the eff ect will be consider abl y less. Permanen t alloca tions, on the other hand, pr ov ide no s uch incen ti ve because changes in behavior will not aff ect futur e alloca tions. 19 • L e n g t h o f a l l o c a t i o n : The r egula ting authority ma y decide to alloca te allowances to emission sources in ad v ance of the allowance vin ta ge period (i.e., the period in which the allowance can be used f or compliance). Ha ving allowances alloca ted in ad v ance can add liquidity to the mark e t because sources and other mark e tparticipan ts can tr ade futur e allowances. This also helps emission sources de velop and implemen t compliance str a tegies in ad v ance of the compliance period (e.g ., a source tha t installs an emission con tr ol de vice can sell futur e e x cess allowances to genera t e r e venue to help offse t the cost of the con tr ol). • P r e s e r v i n g t h e c a p : Once policymak ers de termine the me thod f or distributing allo wances and calcula te the sources’ alloca tions, policymak ers should compar e the r e s ulting total alloca tions and the size of the cap. If too many or too f e

w allo wances w e r e cr ea ted while calcula ting sources’ alloca tions, policymak ers can emplo y a r a tche t (i.e., a f o rmula tha t adjusts each source’s alloca tion pr oportiona tel y). The r e s ulting total alloca tion will then ma tch the number of allo wances in the cap. This ens ur es tha t the cap is not infla ted thr ough the alloca tion pr ocess. 20 • I n c o r p o r a t i n g n e w s o u r c e s : Policymak ers must decide ho w ne w en tr an ts in to the pr ogr am will obtain the allo wances needed to oper a te. In some s y stems with upd a ting alloca tions, ne w emission sources ma y r ecei ve some allo wances. In the case of permanen t alloca tions, ne w units ma y obtain needed allo wances f r om the mark e t . In a permanen t alloca tion s y stem, f acilities tha t ar e shutdo wn con tinue to r ecei ve allo wances indef initel y. These allo wances ma y then be used b y the o wners of the shutdo wn f acility to cove r emissions a t ne w or other e xisting f a cilities tha t the y o wn, or the y can sell the allo wances in the mark e t . This s y stem w orks w ell when ther e ar e many f acility and allo wance o wners and no monopol y e xists on curr en t allo wance holdings. Alterna t i vel y , an alloca tion se t-aside could be cr ea ted f or ne w en tr an ts. The se t-aside could hold a specif ic percen ta ge of the over all cap to cover gr o wth in ne w sources. F inall y , some anal y sts have noted tha t both economic theor y and empirical e xperience s uggest tha t ther e is not a compe titi ve barrier to ne w en tr an ts tha t do not r ecei ve no-cost allo wance alloca tions in cap and tr ade pr ogr ams. These anal y sts ar gue tha t emission sources tha t r ecei ve no-cost allo wances alloca tions have the same mar ginal “opportunity cost” f or e ver y ton emitted as the mar ginal cost paid b y the ne w en tr an t . In s upport of this ar gumen t , ther e is no e v idence of en tr y pr oblems f or ne w electric po w er plan ts under the U .S. SO 2 pr ogr am, which r equir es ne w po w er plan ts to purchase allo wances f r om the mark e t . Ther e has been signif ican t en tr y b y ne w units, e ven coal-f ir ed units tha t do not r ecei ve a no-cost allo wance alloca tion (Ellerman, 2 0 0 3).


## A u c tions Auctions ar e an alterna ti ve appr oach to distributing allowances. Under this appr oach, sources ar e r equir ed to bid f or the number of allowances the y would lik e to purchase (i.e., as opposed to r ecei ving an initial amoun t of allowances f r ee of charge via alloca tions). Ther e is consider able r esearch in economic liter a tur e tha t s upports the vie w tha t auctions ar e mor e economicall y eff icien t than alloca tions. Supporters of auctions argue tha t auctions: • C r e a te a source of r e v

enue tha t can be used to offse t administr a t iv e e xpenses or distributed to aff ected groups. If the r e v

enue is used to r eplace e

xisting distortionar y taxes (e.g., labor taxes) it can cr ea te additional economic benef its (Cr ampton and K err , 1 9 9 8). Distributing auction r e v

enues, howe v

e r , ma y be politically con ten tious and ther e

19 F or further inf orma tion on alterna ti ve alloca tion me thods, see ICF , 1

999, and Harrison and Radov , 2 0 0 2

. 20 In de veloping the U .S. SO 2 Allowance T r ading Pr ogr am, the U .S. Congr ess initiall y alloca ted about 1 0 percen t mor e allowances than it established b ythe cap. How e ve r , it also r equir ed EP A to pr oportionall y r a tche t alloca tions back down to the cap le vel.

3-16 D e v eloping a C ap and T r ade P r ogr a mF r e q u e n c y o f a u c t i o n :

“ S p o t ” a n d “ A d v a n c e ” a u c t i o n s :

B i d d i n g p r o c e d u r e s : is no guar an tee tha t r e v

enues will be used for economically benef icial purposes. • Collect “windf all” pr of its tha t might other wise accrue to emission sources if allo wances ar e alloca ted a t no char ge. • A void politicall y con ten tious iss ues r egar ding alloca tion me thodology and lead to an eff icien t distribution of allo wances. • P r ovide an immedia te price signal in the allo wance mark e t . • C r e a te an equal opportunity f or ne w en tr an ts in to the allo wance mark e t . In establishing the design of an auction, the r egula ting authority will need to consider the f ollowing iss ues: • F r e q u e n cy o f a u c t i o n : The f ollo wing ar e f actors to consider when de termining the f r equency of cond ucting auctions (e.g . annuall y , semi-annuall y

, quarterl y , biannuall y): (a) the lif e time of an allo wance and the length of the compliance period; (b) the administr a t i ve bur den of cond ucting auctions; and (c) other me thods of distributing allo wances. If the auction is used in conjunction with other allo wance distribution me thods and is in tended as a means to pr ovide an earl y price signal to the allo wance mark e t it may not be necessar y to cond uct auctions as f r equen tl y. • “ S p o t ” a n d “ A d v a n c e ” a u c t i o n s : Spot auctions r e f er to allo wances tha t ar e sold f o r curr e n t use. Ad v ance auctions r e f er to allo wances f or a futur e compliance period tha t ar e auctioned in the curr e n t y ear , e ven though the y cannot be used f o r compliance un til the futur e compliance period. Earl y auctions can f acilita te de velopmen t of an acti ve futur e and options mark e t , thus impr oving risk alloca tion. • B i d d i n g p ro c e d u re s : Ther e ar e man y approaches to cond ucting auctions. The auction can be designed so tha t all s uccessful bidders pa y the same price or the price the y bid. Bidding options f or cond ucting the auctions can be ca tegorized as either sealed bid, ascending bid, or declining price auctions. Ascending bid auctions ma y tak e the f orm of “ascending-clock,” or English auctions. 21 Gener all y , with sealed bid auctions, poten tial bu y ers s ubmit bids f or a specif ic quan tity of allo wances. The auctioneer r anks the bids b y price and, starting with the highest bids, tallies the r equested allo wances un til it is equal to or gr ea ter than the number of av ailable allo wances. The price of the last winning bid is called the clearing price. Those who bid a t least as much as the clearing price r ecei ve allo wances a t tha t price (i.e., unif orm pricing me thodology) or the price the y bid (i.e., “pa y-y our-bid” me thodology.) With ascending bid auctions, poten tial bu y e rs have the opportunity to incr ease their bids, changing losing bids in to winning bids. When ther e ar e no mor e bids, the allo wances ar e distributed to the highest bidders. Descending price actions, also called Dutch auctions, ar e the r e

verse of ascending bid. Gener all y , the auctioneer starts with a high price f or each allo wance. Poten tial bu y ers can accept the price for a specific number of allo wances. The auctioneer decr eases the price un til all allo wances ar e sold. The diff er en t auction appr oaches have differen t eff ects on bidding behavior , which can thus influence the eff iciency of the allo wance distribution. 22 With “pa y-y our-bid” pricing, poten tial bu y ers tr y to bid slightl y above the estima ted clearing price. Ascending bid auctions r e veal gr ea ter inf orma tion about wha t a poten tial bu y e r is willing to pa y f or allo wances. This impr oves a bidder’s v alue estima tes and, as a r e s ult , the eff iciency of the f inal allo wance distribution (F ischer , e t al., 1 9 9 8).


## U

. S

. E x p e r i e n c e w i t h a D i r e c t S a l e S e t A s i d e In the U.S. SO 2 Allo wanc e T r ading P r ogr a m, a small dir ec t sale set aside pr o vision was included f or the first sev e r al y ears of the pr ogr am t o pr o vide assuranc es t o new sour c es that allo wanc es w ould be a v ailable f or pur chase

. T he dir ec t sale off er ed a small per c e ntage of allo wanc es at a fix ed pric e of $1,500 each (adjust ed f or inflation), which was about tw o t o thr ee times the pr ojec t ed allo wanc e pric e (mar ginal c ost) at the star t of the pr ogr a m. T he dir ec t sale was eliminat ed in 1997 because allo wanc e pric es w e r e much lo w er than expec t ed , and the allo wanc e mark et was highly liquid

.

21 F or mor e inf orma tion about f orms of auctions, see Cr ampton and Kerr , 1 9 9 8

. 22 F or mor e inf orma tion about the eff ects of bidding beha vior with diff er en t f orms of auctions, see Cr ampton and Kerr , 1 9 9 8

.
3-17 D e v eloping a C ap and T r ade P r ogr a m

## T h e U

. S

. C o n s e r v a t i o n a n d R e n e w a b l e E n e r g y R e s e r v e P r o g r a m o f t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m T he U.S. SO 2 Allo wanc e T r ading P r ogr am f e atur ed a special set-aside of allo wanc es as an added inc e ntiv e for electric po w er c ompanies t o under tak e demand-side ener gy efficienc y and r enewable ener gy gener ation pr ogr ams . Under the pr ogr a m, k n o wn as the C onser v a tion and Renewable Ener gy Reser v e , E P A can a w ar d allo wanc es t o sour c es f or ac tions tak en bef o r e a sour c e was r equir ed t o c omply with emissions limits under the U.S. SO 2 Allo wanc e T r ading P r ogr a m. Allo wanc es f or the set-aside w e r e tak en fr om the cap and w e r e limit ed t o a maximum of 300,000 allo wanc es . Under the pr ogr a m, elec tricit y gener at ors applied f or these ex tr a allo wanc es b ysubmitting inf ormation t o EP A on specific ener gy efficienc y pr ogr ams or r enewable ener gy pr ojec ts
. S our c es w e r e r equir ed t o submit inf ormation on ener gy sa vings or r enewable ener gy gener ation, and EP A a w ar ded allo wanc es at a pr e-det ermined r a t e one allo wanc e per 500 mega watt hours of ener gy sa v ed or r enewable ener gy gener at ed

. A s the first pr ogr am t o pr o v ide ac tual emission cr edits or allo wanc es f or efficienc y and r enewable ener gy pr ojec ts , the pr ogr am pr o v ides man y v aluable lessons

. On the positiv e side , the pr ogr a m f e atur ed sev e r a l elements that r educ ed tr ansac tion c osts including a standar d a w ar d f o rmula, a pr e-appr o v ed list of eligible measur es , and standar diz ed measur ement pr ot oc ols that allo w ed c ompanies t o use c onser v a tiv e default v alues f or ener gy sa vings as a wa y t o r educ e measur ement c osts
. On the negativ e side , it is unlik ely that the pr ogr am spurr e d ac tions that w ouldn ’ t ha v e happened in the absenc e of the pr ogr a m. T his is lar gely because the a w ar d f o rmula was t o o c onser v a tiv e and allo wanc es pric es w e r e t o o lo w t o pr o vide an adequat e inc entiv e f or additional ac tivities

. Auctions ma y also be used to distribute onl y a portion of allo wances with the r emainder distributed b y an alloca tion me thod. Some anal y sts have pr oposed beginning with an alloca tion s y stem and tr ansitioning to an auction-based s y stem over time (Kopp, e t al., 1 999). This w ould incr ease economic eff iciency over time and decr ease political opposition f r om emission sources w orried about the cost of allo wances. 

## S et-asides Another tool tha t can be used in allo wance distribution is an allo wance se t-aside. Under a se t-aside, the r egula ting authority withholds a certain number of allo wances f r om within the cap f or a specif ic purpose. The se t-aside can be a f i x ed number of allo wances or a percen ta ge of the total amoun t of allo wances. The r egula ting authority can distribute the se taside allo wances f or purposes s uch as an incen ti ve f o r certain technologies, as a wa y to addr ess equity iss ues, or as a r eser ve f or ne w units as e xplained in the earlier section. Policymak ers can cr ea te se t-asides tha t last f o r a f i x ed period, s uch as f i ve y ears, after which the se taside e xpir es, or it can last in perpe tuity

. Policymak ers or the r egula ting authority should also addr ess ho w e x cess allo wances f r om the se t-aside will be mana ged if the y ar e not distributed. Options f o r mana ging e x cess se t-aside allo wances include canceling the allo wances, saving them f or futur e use, and distributing them to sources thr ough an alloca tion or auction. Canceling decr eases the quan tity of allo wable emissions (i.e., the cap) and ma y ther ef or e incr ease compliance costs f or sources. Saving e x cess allo wances f or the futur e can pr ovide fle xibility in the futur e f o r unf or eseen circumstances (e.g ., many ne w emission sources in the cap and tr ade pr ogr am) but it r e d uces the number of av ailable allo wances in curr en t y e ars and can lead to incr eased compliance cost f o r curr e n t emission sources. Distributing e x cess allo wances thr ough an alloca tion or auction is perhaps the most common appr oach f or e xisting cap and tr ade pr ogr ams, but policymak ers must addr ess the same iss ues discussed earlier in the sections f or allo wance alloca tion and auction. The most importan t aspect of se t-asides is tha t the allo wances come f r om within the cap so tha t ne w allo wances do not infla te the cap and undermine the ability to achie ve the envir onmen tal goal. If a se taside will be used, policymak ers will need to decide the basis f or awar ding allo wances f r om the se t-aside and the size of the se t-aside allo wance pool tha t will be awar ded.

3-18 D e v eloping a C ap and T r ade P r ogr a m

# A llo w anc e U s e P

olicymak ers or the r egula ting authority must cr ea te rules governing the use and tr ading of allowances. These rules should be neutr al (i.e., f a voring no particular indi vid uals or gr oups of mark e tparticipan ts) and pr ovide f or low-cost e x change among participan ts. Accoun ting f or allo wances w orks lik e a banking s y stem. Each aff ected emission source should have an allo wance accoun t f or holding their allo wances. T

r ansf ers of allo wances be tw een these accoun ts should be made as simple as possible, with f e

w limits or r estrictions to impede the mark e t . Ther e ar e, ho we

ver , tw o possible ca tegories of r estrictions on allo wa nce tr ades tha t ma y be consider ed — tempor al and spa tial. 

## T

empor al C onsider ations Allowances ar e typicall y alloca ted f or use in a specif ic compliance period. P olicymak ers might consider whe ther curr en t allowances can also be used for compliance in futur e periods, r e f err ed to as “banking” (see Fi gur e 9). Allowing banking in a cap and tr ade pr ogr am cr ea tes additional fle xibility for sources, encoura ges earl y emission r e d uctions, can r e d uce compliance costs, and, partl y f or these r easons, can incr ease economic and political s upport f or the pr ogr am. Although the ability to bank allowances in a cap and tr ade pr ogr am can pr ovide signif ican t r e d uctions earl y in the pr ogr am, policymak ers must r ecognize tha t banking can also dela y the achie vemen t of the emission targe t if bank ed allowances ar e used. Because


### F igur e 9. Bank ing Emissions

YEAR Allocat ed Allo wanc esEMISSIONS Banked A llo w anc es

U se of banked allo w anc es A c tual Emissions

banking does not dela y achie vemen t of cumula ti ve r e d uctions, this tr adeoff does not r epr esen t an envir onmen tal concern f or pr oblems s uch as acid deposition and clima te change, wher e the envir onmen tal pr oblem is caused b ytotal accumula tion of a pollutan t in the a t mospher e. How e ve r , f or pr oblems s uch as gr oundle

vel ozone, wher e the envir onmen tal pr oblem is caused b yshort-term episodes of high emissions, anal y sis should be undertak en to w eigh the poten tial eff ects of banking . Ne vertheless, the U .S. e xperience with limits on banking has shown tha t s uch limits complica ted or hinder ed the oper a tion of cap and tr ade pr ogr ams and f ailed to pr ovide appar en t benef its. “Borr o wing” is another f orm of tempor al fle xibility

. With borr o wing, allo wances f r om a futur e compliance period ar e br ought f o r war d to mee t a compliance obliga tion in an earlier period. As with banking, borr o w ing pr ovides compliance fle xibility and can be helpful in smoothing out spik es in allo wance prices (Ellerman, 2 0 0 2 ). F or e xample, if prices r each a certain le vel, sources might be allo w ed to bu y allo wances f r om the governmen t tha t w ould be ded ucted f r om allo wances av ailable in futur e compliance periods. The poten tial do wnsides of borr o wing ar e tha t emission r e d uctions ar e dela y ed and ther e is a gr ea ter risk of futur e noncompliance if an emission source cannot “r epa y” the borr o w ed allo wances. In addition, borr o wing can cr ea te an incen ti ve f or emission sources to act to disrupt the cap and tr ade pr ogr am’s per f ormance and longevity in or der to avoid “r epa ymen t” of allo wances. F

urthermor e, the health and envir onmen tal benef its of emission r e d uctions tod a y ar e dela y ed un til the futur e. All else being equal, benef its in the near term ar e be tter than benef its in the futur e. Ther e is little experience with borr o wing, so policymak ers should car efull y assess the poten tial envir onmen tal and pr ogr amma tic eff ect of dela ying some emission r e d uctions and w eigh these eff ects a gainst the poten tial fle xibility and cost savings of borr o wing . In addition, policymak ers should appl y a discoun t , or in ter est , r a te on borr o w ed allo wances tha t is a t least as high as the discoun t r a te applied to the capital the source save s b y not undertaking the aba temen t or purchasing

3-19 D e v eloping a C ap and T r ade P r ogr a m

## L i m i t s o n B a n k i n g i n t h e U n i t e d S t a t e s : R E C L A I M a n d t h e O T C R e g i o n a l N O x T r a d i n g P r o g r a m In the Southern C alif ornia RECLAIM pr ogr a m, emission sour c es ar e gr ouped int o tw o cat egories with o v erlapping c omplianc e periods (i.e ., some sour c e s ’ c omplianc e is based on Januar y t o D e c ember emissions and others ar e based on July t o June emissions). T he RECLAIM pr ogr am permits sour c es t o use allo wanc es t o c o v er emissions within the period f o r which they ar e issued , so an y allo wanc es not used within that period eff ec tiv ely expir e . H o w ev er , sour c es in one c omplianc e period can tr ade allo wanc es with sour c es in the other c omplianc e period ther eb y enabling limit ed bank ing and borr o wing

. One r eason pr ogr am designers chose t o limit bank ing was that the localit y fac ed a sev e r e air qualit y pr oblem and polic ymak ers w e r e c onc erned that bank ing w ould cause pot e ntial emission spik es . P olic ymak ers initially allocat ed allo wanc es in ex c ess of ac tual emissions b ya significant amount t o pr ovide sour c es with flexibilit y. C ombining these high allocations with bank ing c ould ha v e inflat ed the cap in futur e y ears , dela ying the achiev ement of en vir onmental goals

. I n pr ac tic e , the absenc e of bank ing pr o visions ma y ha v e disc our aged sour c es fr om under tak ing early r educ tions and ma y ha v e c o ntribut ed t o v o latilit y in the mark et that r equir ed major pr ogr am r e visions t o addr ess . In the OTC Regional NOx T r ading P r ogr am in the Nor theast ern Unit ed Stat es , the bank ing of allo wanc es f o r futur e use is permitt ed

. H o w ev er , ther e ar e aut omatic limits imposed on the use of bank ed allo wanc es whenev er the bank r eaches a c e r tain lev el of allo wanc es . T hese limits r equir e that sour c es using mor e than a per c e ntage of their bank ed allo wanc es f or c omplianc e must surr ender allo wanc es at the r a t e of tw o allo wanc es f or ev er y t on of emissions

. T he limits ar e imposed in or der t o guar d against the ex c essiv e use of bank ed allo wanc es in an y single c omplianc e period , while still att empting t o maintain the inc entiv es associated with bank ing

. What has r esult ed is a segment e d allo wanc e mark et and a str atified pric e struc tur e which v alues bank ed allo wanc es significantly less than pr esent y ear allo wanc es (F arr e ll, et al., 1999). allo wances. In lieu of this discoun t r a te, sources will f ind it less e xpensi ve to dela y aba temen t , invest the capital saved, and borr o w allo wances. 

## Spatial C onsider ations Because a cap and tr ade pr ogr am allow s f or the fle xible use of allowances acr oss the geogr aphic scope of the tr ading pr ogr am, a common concern f or a cap and tr ade pr ogr am aimed a tr e d ucing emissions with localized impacts (e.g ., SO 2 and NOx ) is tha t hotspots ma y occur . 23 Ass uming tha t a f irm’s objecti ve is to maximize pr of its, those with lo w mar ginal aba temen t costs will off er to sell their allo wances to f irms with higher marginal aba temen t costs. If sources with high mar ginal aba temen t costs (i.e., ne t bu y ers of allo wances) ar e congr ega ted in specif ic ar eas, those ar eas ar e lik el y to e

xperience less envir onmen tal impr ovemen ts than others (depending also on me teor ology and wind pa tterns). F urthermor e, s uch ar eas could e xperience incr eased emissions and harmful local envir onmen tal or human health eff ects, e ven as the lar ger goal of a ggr ega te emission r e d uctions is achie ved. F

or pollutan ts with localized impacts, an e v alua tion of poten tial tr ading pa tterns ma y be useful. Poten tial tr ading pa tterns can be assessed with economic models or with less r esource-in tensi ve me thods s uch as spr eadshee t anal y sis. If the r e s u lts indica te tha t geogr aphic tr ading pa tterns will arise, it ma y be necessar y to assess wher e the lar gest emission r e d uctions ar e lik el y to tak e place compar ed to wher e the most sensiti ve envir onmen tal ar eas ar e, and whe ther the pr ogr am will adequa tel y addr ess the envir onmen tal pr oblem (see F i gur e 1 0) or be less eff ecti ve than dir ect con tr ols on sources. This invo l ves an anal y sis of the sourcer eceptor r e la tionship and includes pr edicting changes in concen tr a tions or deposition r e s u lting f r om changes in pr ecursor emissions, the influence of emission sources in one r egion on concen tr a tions or deposition in other geogr aphic r egions, and the le vels of concentr a tions or deposition in certain sensiti ve r eceptor r egions. If spa tial iss ues ar e lik el y to arise, then the cap and tr ade pr ogr am will need to be designed accor dingl y.

23 This iss ue is not r ele v a n tf or gr eenhouse gas emissions since these emissions do not ha ve local air quality impacts, and tr ading pa tterns will not ha ve localized envir onmen tal eff ects. How e ve r , ancillar y r e d uctions of criteria pollutan ts ma y ha ve local benef its.

3-20 D e v eloping a C ap and T r ade P r ogr a m

### F igur e 10. Spa tial C onsider a tions

P r e v ailing wind dir ec tion 

### Wher e ar e emission r educ tions most lik ely t o occur?

20 tp y

100 tp y 40 tp y S e nsitiv e Eco s ys t e m S e nsitiv e E c osy stem



## H o w U

. S

. T r a d i n g P r o g r a m s A d d r e s s S p a t i a l I s s u e s While en vir onmentalists initially f ear ed the pot e ntial cr eation of hotspots fr om the U.S. SO 2 Allo wanc e T r ading P r ogr a m, no such local impac ts ha v e been obser v ed and o v er all air qualit y has impr o v ed (S wif t , 2000). T her e ar e sev e r al r easons wh y the tr ading pr o visions ha v e not led t o hotspots

. F irst and f o r emost , o ther r egulat o r ystandar ds (e .g ., ambient air qualit y standar ds , t echnology and per f ormanc e r equir ements) pr ot ec t the local air qualit y fr om ex c ess pollution. T he Unit ed Stat es emplo ys c o n v entional pollution r egulations (e .g ., mandat ed emissions limits or air pollution c o ntr ol equipment) that ar e designed t o achiev e healthbased air qualit y standar ds (Schr eif els , 2000). T he U.S. SO 2 Allo wanc e T r ading P r ogr am r e pr esents an additional lev e l of pollution c o ntr ol that is designed t o r educ e t otal loading of sulfur int o the atmospher e . Henc e , all utilities r egulated under the U.S. SO 2 Allo wanc e T r ading P r ogr am ar e also r equir ed t o c omply with all other r equir ements of the Clean Air A c t

— in par ticular , t he r equir ement t o meet the health-based National Ambient Air Qualit y Standar ds , N ew Sour c e P e r f ormanc e Standar ds , and P r ev ention of Significant D e t e rior ation pr o visions

. T hese r equir ements ar e independent of the tr ading pr ogr am and cannot be cir cum v e nt ed thr ough pur chase of allo wanc es . S e c ond , the significanc e of the r educ tions r equir e d under the U.S. SO 2 Allo wanc e Tr ading P r ogr a m — 50 per c e nt belo w 1980 lev els

— ensur ed that the majorit y of high-emitting facilities w ould ha v e t o r educ e emissions significantly , ev en with the flexibilit y pr o vided b y emission tr ading

. T hir d , the most c ost-eff ec tiv e emission r educ tions ar e of t en at the lar gest , h ighest-emitting plants and ar eas with such facilities ha v e r educ ed emissions mor e than a v er age . A s a r esult , ther e ha v e been significant benefits t o human health and the en vir onment (Bur tr a wand M ansur , 1 999). T he RECLAIM pr ogr am emplo ys tw o tr ading z ones . T r ading is r estric t ed so sour c es in the do wnwind z one ma y not sell or tr ade allo wanc es t o sour c es in the upwind z one . T he O T

C Regional NOx Tr ading P r ogr am in the Nor theast ern Unit ed Stat es chose a diff er ent tac tic

. T he O T

C is c o mposed of thr ee z ones with v a r ying lev els of o z one pr oblems , and thus v a r ying lev els of emission r educ tion r equir ements in acc or danc e with the sev e rit y of each z one ’ s air qualit y pr oblem. In the pr ogr a m dev elopment phase , the O T

C c onduc t ed an analysis t o det ermine whether tr ading r estric tions w e r e needed betw een z ones t o ensur e r educ tions w e r e achiev ed

. W hen analysis failed t o pr o v ide affirmativ e pr oof that a tr ading r a tio w ould influenc e air qualit y , the O T

C opt ed t o minimiz e pr ogr a m c omplexit y and allo w unr estric t ed tr ading betw een z ones — with the ca v e at that the issue ma y be r e visit ed in futur e y ears as new inf o rmation bec omes a v ailable fr om implementation of the pr ogr am.

3-21 D e v eloping a C ap and T r ade P r ogr a m

### NONA

T T A INMENT AREA FREE TR ADE 

### F igur e 11. T r ading Z ones appr oach can be effecti ve if the cap and tr ade pr ogr am includes sources with diff er en t char acteristics tha t influence the local eff ect of the sources’ emissions (e.g ., stack height). F or e xample, the r egula ting authority ma y r estrict a tall-stack source f r om tr ading allo wances to a shortstack source because the shorter stack will lik el y have a gr ea ter impact on local air quality

. The thir d appr oach is to adopt a “tiering” of envir onmen tal policies, r equiring sources to compl y with local
Gener all y , ther e ar e thr ee appr oaches f or addr essing this iss ue. The f irst is the possibility of in tr od ucing spa tial r estrictions on tr ading . F or example, if unacceptable concen tr a tions or deposition ar e e xpected to arise in a particular ar ea, tr ading r estrictions could be imposed b y in tr od ucing “zones” wher e ne t flo w s of allo wances in to the sensiti ve ar ea ar e pr ohibited or discoun ted b y an appr opria te amoun t (see F i gur e 1 1). A dr awback of tr ading r estrictions is the effect on fungibility of allo wances and mark e t eff iciency. Spa tial r estrictions on the use of allo wances mean tha t an allo wance is not a stand ar d commodity tha t is full y in terchangeable with all other allo wances. This lack of full fungibility can diminish the economic eff iciency of the cap and tr ade pr ogr am and can complica te the allo wance mark e t (e.g ., lead to price str a tif ica tion be tw een allo wances of diff er en t zones). A simpler w a y of achie ving the same effect as discoun ting without aff ecting fungibility is to ha ve a higher r e tir emen t r a te (e.g., 1.5 allow ances per ton of emissions) in the zone of concern. This does not pr ohibit tr ading or diff er en tia te among types of allow ances; it simpl y mak es it mor e e xpensive in s uch zones. The second appr oach is to r estrict tr ading be tw een diff er en t ca tegories of emission sources. This envir onmen tal quality pr ovisions as w ell as those imposed b y the cap and tr ade pr ogr am. In its simplest f orm, this allo w s the appr opria te r egula tor y authority to limit emissions of the sources iden tif ied as con tributing to the local air quality pr oblem, while not tampering with the allo wance pr ogr am. This thir d appr oach is the one emplo y ed b y the U .S. SO 2 Allo wance T r ading P r ogr am. 

## Allo wanc e A c c ounting Each source tha t is r esponsible f or compliance should ha

ve an allowance accoun t . These accoun ts ar e the off icial r ecor ds f or allowance alloca tions, holdings, and tr ansf ers and can be used to tr ack compliance. Initial alloca tions (or initial winning bids in an auction) pr ovide the beginning balance f or the allowance accoun ts. Policymak ers might also consider whe ther the pr ogr am will allo w other in ter ested parties to have allo wance accoun ts and hold allo wances. These nonsource accoun ts pr ovide the vehicle thr ough which or ganiza tions, s uch as br ok ers or envir onmen tal gr oups, can hold and tr ade allo wances. Br ok ers, investors, and other mark e t mak ers ma y pla y a crucial r ole in f acilita ting allo wa nce tr ades. Because the allo wance br ok ering and pooling functions ar e in tend3-22 D e v eloping a C ap and T r ade P r ogr a mE n t i t l e m e n t s :

T a k i n g s : ed to f acilita te sources’ eff orts to maximize the cost savings of their compliance str a tegies, these nonsource accoun ts should be in tegr a ted with the accoun t s y stem f or emission sources. 

## Allo wanc e S e rialization Allowances can be serialized to f acilita te tr acking the allowance f r om cr ea tion to use f or compliance. Ther e ar e a number of benef its to iden tifying allowances b y serial number . Although tr acking serial numbers incr eases the administr a t i ve bur den to both r egula tors and ind ustr y , it pr ovides additional tr anspar ency and pr otection a gainst accoun ting discr epancies. The use of serial numbers could also f acilita te r ecor d k eeping so allowance holders can tr ack the diff er en t costs incurr ed in acquiring allowances. This may be necessar y f or tax purposes. Finall y , the inclusion of serial numbers in the allowance tr acking s y stem pr ovides the opportunity to anal yze tr ading pa tterns and the move men tof allowances over time. This ma y be useful f o r assessing the impacts of the tr ading pr ogr am. 24 At a minimum, allowances should be iden tif ied b yvin t a g e (i.e., the compliance period f or which the y ar e iss ued) to iden tify when the allowances ar e authorized f o r compliance use. 

## P r oper t yR ights The progr am rules must clearly def ine the legal rights and r esponsibilities of emission sources and the na tur e of allow ances. Because allow ances can be tr aded, the rights and r esponsibilities of ownership must be established so tha t these rights and r esponsibilities can be tr ansf err ed f rom one participan t to another (A G O , 1 999). When addr essing allo wance use, the r egula ting authority might wa n t to consider certain pr operty rights iss ues, namel y en titlemen ts and takings. Both can be addr essed in the implemen ting legisla tion or pr ogr am rules. The type of legal s y stem in place will also aff ect whe ther or not allo wances ar e percei ved as pr operty rights. • E n ti tl e m e n t s : Sources tha t ha v

e historically polluted with limited or no r estrictions might argue tha t the y ha v

e an implied right to allow ances based on their historical emissions le v

els (A G O , 1 999). • T a k i n g s : If the implemen ting institution r e d uces the number of allo wances a t a la ter d a te, participan ts might ar gue tha t the y ar e en titled to com

## H o w t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m D e a l t W i t h P r o p e r t y R i g h t s In the SO 2 Allo wanc e T r ading P r ogr a m, the legislation specifies that allo wanc es ar e not pr oper t y rights

. T his pr o vision was inser t ed t o ob viat e a challenge of an unc onstitutional “ tak ing ” should the go vernment decide t o alt er the emissions cap (i.e ., t o r educ e the number of a v ailable allo wanc es). F unc tionally , h o w ev er , the o wnership rights and r esponsibilities of allo wanc es ar e similar t o pr oper t y rights (Ellerman, 1999).

pensa tion f r om the r egula ting authority based on the v alue of the lost allo wances. 

# C omplianc e Determina tion The compliance de termina tion pr ocess f or a cap and tr ade pr ogr am should be simple and str aightf or wa r d

. Prior to implemen ta tion, the rules should clearl y specify the deadlines f o r r eporting and f or holding s uff icien t allowances to cover emissions. At the end of the compliance period, the emission sources should be gi ven enough time to verify emission d a ta for the period and to s u bmit them f or compliance. This verif ication period should not be so short as to cause the emission sources to s ubmit d a ta tha t has not been pr operl y quality ass ur ed, but not so long as to unr easonabl y dela y compliance assessmen t . It should also allow enough time f or the r egula ting authority , once it r ecei ves the d a ta, to f inish cond ucting the compliance de termina tion w ell bef or e the end of the s ubsequen t compliance period, when the pr ocess will begin a gain. At the end of each compliance period and d uring the time when sources ar e ass uring the quality of their emission d a ta, the rules should pr ovide f or a short gr ace period (e.g ., 60 d a y s) so tha t sources can mak e f inal allowance tr ades. This will allow sources to ass ur e tha t their accoun t has allowances equal to or gr ea ter than their emissions. The r egula ting authority should specify an allowance tr ansf er deadline—the f inal d a te f or sources to tr ade allowances for use in the compliance y ear—in ad v ance. It ma y be ad visable to f r eeze allo wance tr ansf ers in to or out of accoun ts after the tr ansf er deadline un til

24 F or e xample, EP A has cond ucted anal y sis showing no ad verse envir onmen tal impacts f r om tr ading under the U .S. SO2 Allowance T r ad ing Pr ogr am (Kr amer , 1 999).

3-23 D e v eloping a C ap and T r ade P r ogr a mthe r egula ting authority comple tes the compliance de termina tion and ded ucts allo wances f or compliance. 

# Enfo r c emen t P enalties f or Nonc omplianc e Stringen t penalties f or noncompliance ar e an in tegr al f e a tur e of a w ell-functioning cap and tr ade pr ogr am. These should be applied automa ticall y in cases wher e a source does not ha ve s uff icien t allowances to cove r mass emissions d uring the compliance period. In cases wher e ther e is noncompliance with r equir emen ts of the cap and tr ade pr ogr am (e.g ., meas uring emissions, r eporting, and other r equir emen ts), the penalties should be de termined based on the na tur e and se ve rity of the viola tion. The penalties should be s uff icien tl y high to pr ovide the appr opria te incen ti ves for compliance and can tak e the f orm of allowance, f i nancial, and/or criminal penalties. 

### Ex

c ess Emission O f fsets In cases wher e a source does not have s uff icien t allo wances to cover its emissions, an allo wance r estor ation r a te of a t least one-to-one should be applied to main tain the envir onmen tal in tegrity of the pr ogr am. Under a one-to-one r a te, one allo wance f r om the ne xt compliance period w ould be r e tir ed f or e ver y unit of e

x cess emissions in the curr en t compliance period. Alterna t i vel y , the shorta ge of allo wances can be purchased f r om the allo wance mark e t . Aside f r om the one-to-one allowance r estor a tion r a te to main tain envir onmen tal in tegrity , the r egula ting authority should appl y f inancial penalties for noncompliance if the goal is to de ter s uch beha vior . The existence of a one-to-one r estor a tion r a te without other accompanying puniti ve meas ur es f or noncompliance implies tha t sources can, in eff ect , use allowances f r om futur e compliance periods to a ttain their emissions r e d uction targe t . This can r e s ult in a scenario in which the emission cap is ne ver a ttained. Hence, it is ve r y importan t tha t the incen ti ves de ter noncompliance. 

### F

i nancial Pe nalties De terring noncompliance can either tak e the f orm of allow ance or f inancial penalties. With allowance penalties (i.e., wher e a source would ha v

e to turn in a multiple of its allow ance shortf all a t a r a tio gr ea ter than one-to-one) the a ggr ega te cap of emissions in the ne xt compliance period is r e d u ced. The en vironmen tal bene

## P e n a l t i e s t o D e t e r N o n c o m p l i a n c e i n U

. S

. T r a d i n g P r o g r a m s Under the U.S. SO 2 Allo wanc e T r ading pr ogr a m, the penalt y c onsists of a one-t o-one allo wanc e r est or ation r a t e and a financial penalt y applied at a lev el of US$2,000 (1990 dollars), adjust ed annually for inflation, f or each t on of ex c ess emissions abo v e allo wanc es held

. In 1990, this lev el of financial penalt ywas thought t o be appr o ximat ely thr ee times the expec t ed mark et pric e of an allo wanc e . Based on the inflation adjust ed penalt y amount and ac tual mark et pric e of allo wanc es , this is ac tually on the or der of 20 times the mark et pric e of allo wanc es , and c ould , in r etr ospec t , b e t o o stringent. F or example , when non-c omplianc e r esults fr om imper f e c t or lat e data or miscalculations , these penalties ma y be view ed as inappr opriat ely punitiv e . In c o ntr ast , the penalt y f or non-c omplianc e in the OTC Regional NOx T r ading P r ogr am is an allo wanc e penalt y at a r a tio of thr ee-t o-one . In other w o r d s , f o r each t on of ex c e ss emissions , a sour c e must submit thr ee allo wanc es t o the r egulating authorit y. A dditionally , stat es within the OTC ha v e the option of imposing financial penalties

. T his penalt y , ho w e ver

, m a ynot be sufficiently high. F or example , during 1 y ear , the pric e of a NOx allo wanc e fluc tuat e d betw een US$500 and 3,000. Some sour c es might ha v e sold allo wanc es f or US$3,000 and pur chased f or US$500 at the end of the y ear. f its of the progr am incr ease d ue to the allow ances tha t ar e ded ucted as a penalty , but this could lead to further noncompliance because the necessar y r e d uctions ar e gr ea ter in the f ollowing compliance period. Alterna tiv e ly , mark e t

v

ola tility ma y tempt some to specula te and in ten tionallybe in noncompliance if the y belie v

e the mark e t

price f or allow ances will drop in the futur e. F u rthermor e, taking allowances out of the mark

e t r e d uces the s upply and r aises the price of allow ances f or all participan ts, not just those tha t ar e out of compliance. Howe v

e r , this should not be a signif ican t f actor unless ther e is large-scale noncompliance. F or these r e asons, a f inancial penalty (in addition to the one-to-one offse t) ma y be pr ef er able to de ter noncompliance. P

olicymak ers or the r egula ting authority should se t the le

v

el of the f inancial penalties signif ican tly higher than the e xpected marginal aba temen t cost—the e xpected

3-24 D e v eloping a C ap and T r ade P r ogr a mmark e t

price of allow ances—to cr ea te an eff ectiv e de terr e n t f

or noncompliance. P olicymak ers could also cr ea te a gr ad ua ted f inancial penalty to r eflect the se v

erity of the viola tion or the length of dela y in making pa ymen t . F o r e

xample, if a source e xceeded its emission cap because of an accoun ting error , the penalty might be twice the price of allow ances, pa y

able in 3 0 d a ys. F or a mor e serious viola tion or if the penalty is not paid in 3 0 d a ys, it could growto se v

e r al times the price of an allow ance. If the penalty is in dispute, the source could put funds in to an escrowaccoun t a w

aiting adjudica tion. The allo wance price f r om which the penalty is calcula ted can be based on a pr ojection of the allo wance price (established d uring the de velopmen t of the pr ogr am) and adjusted f o r infla tion. Alterna ti ve l y , it can be based on a multiple of either the actual aver a g e price or the highest mon thl y price of allo wances f o r the pr eceding y ear in which the pr ogr am was in oper ation. Establishing the penalty based on a multiple of the pr ojected mark e t price of allo wances can be diff icult because diff er en t economic models often yield s u bstan tiall y diff er en t estima tes. Ho w e ve r , inde xing the compliance penalty to actual prices can also be diff icult without a liquid mark e t/e x change. In some cases, a periodic, governmen t-run auction can r e veal price inf orma tion tha t the r egula tor y authority can use to se t the penalty le vel.If a source is out of compliance with the monitoring, r eporting, and/or other r equir emen ts specif ied b y the r egula ting authority , f inancial penalties should also be applied. These also can be gr ad ua ted depending on the na tur e of the noncompliance (or “degr ee of f ault”), with higher penalties f or r epea t . T o main tain consistency , the penalty le vels should, to the e xten t possible, be def ined in ad v ance. F inall y , to ens ur e tha t the penalties ar e enf orced in a timel y manner , the penalty r a te might incr ease if the source does not pa y the penalty within a specif ied period of time. The r e v

enues f rom these penalties might be collected and r edistributed in se v

e r al w a ys. F or e xample, the y can be collected b ythe na tional tr eas ur y and r e distributed in the same w a y as income taxes or the y can be paid dir ectly to the r egula ting authority to offse t progr am costs. The r e v

enues ma y also be collected in a special fund to pro vide r esources f o r r esearch and de v

e lopmen t in to aba temen t technology and/or en vironmental purposes r ela ted to the pollutan t being r egula ted. Regar dless of the type and se verity of penalties, the y should be objecti ve and automa tic. Elimina ting penalty negotia tions be tw een r egula ting authority and emission source pr omotes impartiality and equity and r e d uces opportunities f or dishonest behavior . In addition, it se ts clear e xpecta tions so tha t sources kno w the consequences f or noncompliance. 

### Criminal Pe nalties The r egula ting authority might also impose criminal penalties on indi vid uals who knowingl y viola te any r equir emen ts, with maximum sen tences f or f irst-time and r epea t off enders. Criminal penalties pr ovide dir ect incen ti ves f or the legall y r esponsible indi vid uals (“designa ted r epr esen ta ti ves” or owners and oper a t ors) a t the aff ected sources to beha ve r esponsibl y . Owners, oper a tors, and designa ted r epr esen ta ti ves should be r equir ed to sign each f o rm tha tis s ubmitted to the r egula ting authority f or the source (e.g ., allowance tr ansf ers or emissions r eporting) indica ting tha t the y ar e liable f or acts and omissions within the scope of their r esponsibilities under the cap and tr ade pr ogr am. 

# O ther Design C onsider a tions In tegr a tion of C ap and T r ade with O ther P olic y A p pr oaches Ther e ar e a number of wa y s in which policymak ers can in tegr a te cap and tr ade pr ogr ams with other appr oaches f or envir onmen tal policy . Command-and-con tr ol appr oaches can be compa tible with cap and tr ade, but policymak ers should iden tify the r e la tionships be tw een the diff er en t policies and ens ur e ther e ar e no con tr adictions or d uplica tions. With command-andcon tr ol, the r egula ting authority specif ies sector-wide technology and/or per f ormance stand ar ds tha t each of the aff ected sources must mee t , wher eas cap and tr ade pr ovides sources with the fle xibility to choose the technologies tha t minimize their costs. Depending on the type of pollutan t tha t is being r egula ted b y cap and tr ade, in tegr a tion with command-and-con tr ol appr oaches can aid in the pr e vention of hotspots tha t ma y r e s ult f r om the use of allo wances. F or e xample, additional r e d uctions

3-25 D e v eloping a C ap and T r ade P r ogr a mthr ough a cap and tr ade pr ogr am could be la y e r ed on top of e xisting r equir emen ts. 25 F inall y , with r egar d to in tegr a ting alterna ti ve f orms of emission tr ading, if the r egula ting authority decides to establish mor e than one type of emission tr ading pr ogr am, each should aff ect distinct sectors. If desir ed, allo wances f r om a cap and tr ade pr ogr am could, in theor y , be full y in terchangeable with offse ts f r om pr oject-based mechanisms or cr edits f r om a r a tebased pr ogr am. Ho w e ve r , the r egula ting authority must ens ur e tha t pr oject-based mechanisms do not undermine the envir onmen tal in tegrity of the cap. Stringen t oversight , verif ica tion, and conser v a ti ve cr editing me thodologies need to be established to accoun t f or uncertain ties and to avoid the cr ea tion of “anywa y” tons, paper cr edits, leaka ge, or double coun ting (see Chapter 2). 

## T h e U n i t e d K i n g d o m ‘ G a t e w a y ’ M e c h a n i s m : T r a d i n g B e t w e e n A l l o w a n c e s a n d C r e d i t s One mechanism that has been pr oposed t o enable tr ading betw een allo wanc es and cr edits fr om r a t e based tr ading is the ‘ gat e wa y ’ in the U.K. ’ s Emissions T r ading P r ogr am f or gr eenhouse gases

. U nder this appr oach, sour c es aff ec t ed b ythe r a t e-based tr ading pr ogr am can pur chase as man y allo wanc es fr om sour c es r egulat ed under the cap and tr ade pr ogr a m as they wish. H o w ev er , sour c es r egulat ed b ycap and tr ade pr ogr am can only pur chase cr edits fr om sour c es under the r a t e-based pr ogr am if the net flo w of units in this dir ec tion is z e r o . T he U.K. Emissions T r ading P r ogr am is still in its infanc y ; henc e , it is t o o early t o ev aluat e this appr oach. I t is lik ely that the tr ansac tion c osts associat ed with under tak ing these int er-pr o gr am tr ades (v s . intr a-pr ogr a m tr ades) ar e lik ely t o be higher due t o the administr ativ e c o sts associat ed with assessing net flo ws .

25 F or mor e inf orma tion about la y ering command-and-con tr ol and mark e t-based pr ogr ams, see Schr eif els, 2 000.

3-26 D e v eloping a C ap and T r ade P r ogr a mI n c r e a s e d d a t a a c c u r a c y :

R e d u c e d t i m e a n d c o s t s : 

# 4 Ho w to Implemen t and Oper a t e a C a p and T r ade P r ogr a m

In tr oduc tion 

# T he cr edibility of the cap and tr ade pr ogr am and conf idence in the mark e tdepend on the accur acy of emission meas ur emen t and enf orcemen t b y the r egula ting authority . Because allowances, and ther ef or e emissions, ha ve an economic v alue, sources might misr epr esen t emission d a ta if ther e ar e no consequences or low pr obability of discove r y . The r egula ting authority must ens ur e tha t enough r esources ar e dedica ted to verifying emission r eports and auditing aff ected sources. The r egula ting authority must also ens ur e tha t allo wance accoun ting is undertak en with the appr opria te scrutiny and security to avoid err ors and f r aud. Computerized accoun ting s y stems f or emissions and allo wances can f acilita te the mana gemen t of these r esponsibilities. This chapter describes the functions necessar y to implemen t and oper a te a s uccessful cap and tr ade pr ogr am including tr acking inf orma tion on emissions, allow ances, and compliance; auditing and verifying emissions r eports; pr oviding technical s upport and policy guid ance to r egula ted sources; and costs and r esources necessar y to oper a te a cap and tr ade pr ogr am. 

# In tegr a t ed Informa tion S y stems P

erhaps one of the most importan t lessons learned f r om e xisting cap and tr ade pr ogr ams is the need f o r compr ehensi ve, accur a te, tr anspar en t , and timel y informa tion about emissions and allowances. The r egula ting authority tha t oper a tes the pr ogr am must collect , ve rify , main tain, and dissemina te the d a ta if the pr ogr am is to oper a te with envir onmen tal in tegrity, economic eff iciency , and public cr edibility . Computerized inf orma tion s y stems ar e the most eff ecti ve me thod a v ailable tod a yto pr ocess and dissemina te these d a ta. Using an inf orma tion s y stem to collect and mana ge lar ge amoun ts of d a ta on emissions and allo wances can pr ovide numer ous benef its, including: • I n c r e a s e d d a t a a c c u r a cy : T ools s uch as electr onic r eporting and automa ted d a ta quality checks r e d uce err ors and elimina te r e d und an t d a ta en tr y. • R e d u c e d t i m e a n d c o s t s : Electr onic r eporting and automa ted d a ta quality checks r e d uce the time and costs r equir ed to comple te, pr ocess, and r e vie w paper forms. In addition, the electr onic stor a ge of d a ta can signif ican tl y r e d uce, or

4-1 Ho w t o Implement and Oper at e a C ap and T r ade P r ogr a mE n h a n c e d a c c e s s :

I m p r o v e d c o n s i s t e n c y a n d c o m p a r a b i l i t y : e

ven elimina te, the costs associa ted with the collection, tr ansporta tion, stor a ge, and dissemination of paper f orms. • E n h a n c e d a c c e s s : Electr onic d a ta stor a ge mak es it easier and f aster to r e trie ve, anal yze, and e v alua t e r ele v a n t d a ta on demand. Impr oved access to d a ta can also pr omote conf idence in the tr ading pr ogr am b y permitting emission sources and in ter ested members of the public to r e trie ve d a ta to ascertain compliance, e v alua te a pr ogr am’s eff ecti veness, and mak e inf ormed decisions. Da ta tr anspar ency can also f acilita te eff icien t mark e ts, build public acceptance, and f oster cr edibility (Kruger , e t al., 2 000). • I m p r o v e d c o n s i s t e n cy a n d c o m p a r a b i l i t y : Electr onic r eporting and electr onic d a ta stor a g e encour a ge consistency b y r equiring all emission sources to r eport the same inf orma tion in a common r eporting f orma t . This consistency pr omotes compar ability acr oss time and among pr ogr am participan ts, leading to a full y fungible tr ad able commodity and eff icien t mark e t . In the earl y sta ges of a cap and tr ade pr ogr am, the d a t a s y stem ma y be as simple as a spr eadshee t with manual audit pr oced ur es. As an in terim meas ur e, this appr oach can be r eliable if volume is lo w , and it might pr ovide an opportunity to assess whe ther automa tion is necessar y and to wha t e xten t . As r esources become av ailable and the pr ogr am e vol ves, the inf orma tion s y stem can be modif ied, e xpanded and, if appr opria te, automa ted to addr ess the needs of the pr ogr am. A compr ehensi ve inf orma tion s y stem should include mod ules to collect , r e vie w

, and mana ge d a ta on emissions and allo wances and a mod ule to de termine compliance. 26 

# Emissions T r ack ing Module (ETM) The most d a ta-in tensiv e componen t of the inf orma tion s ystem ma y be the emissions tr acking mod ule, or ETM. The purpose of the ETM is to collect , r e vie w

, and main tain r e le v a n t emission-r ela ted d a ta f rom each source. The type and quan tity of d a ta collected will depend on the meas ur emen t r equir emen ts f or the cap and tr ade progr am. F or e xample, a progr am tha t r elies on emission f actors to calcula te emissions f rom combustion sources might r equir e participan ts to r eport d a ta on the type and amoun t of fuel cons umed, the combustion technologies installed, and the emission f actors used. A cap and tr ade progr am r equiring con tinuous emission monitoring s ystems might collect d a ta on meas ur ed pollutan t concen tr a tion and v olume tric flow of e xhaust gas. Although the f r equency of r eporting will depend upon the calcula tion me thod, the length of the compliance period, and administr a t iv e r equir emen ts, it should be f r equen t enough to s upply sources, the r egula ting authority , other mark e t

participan ts, and in ter ested parties with timely inf orma tion about emissions and facilita te compliance de termina tion. Regar dless of the me thod used to calcula te emissions, the d a ta must be consisten t , accur a te, and objecti ve if sources, mark e t participan ts, and the public ar e to have conf idence in the pr ogr am. T o f acilita te access to the d a ta, the r egula ting authority can mak e the emission d a ta f r om the ETM av ailable to in ter ested parties thr ough a publicl y accessible in ter f ace (e.g ., the In terne t). The d a ta ar e useful to mark e t participan ts who can use them, along with allo wance d a ta, to gauge poten tial s uppl y and demand f or allo wances. The public, in ter est gr oups, and academics can use the d a ta to e v alua te the eff ecti veness of the cap and tr ade pr ogr am (e.g ., emission r e d uctions and envir onmen tal eff ects). Ho w e ve r , simpl y making d a ta av ailable ma y not be s uff icien t . T rue tr anspar ency necessita tes making the d a ta av ailable in a useful and usable f orma t (T eitenber g and Wheeler , 1 9 9 8). De termining the appr opria te f orma t will depend on the type and quan tity of d a ta collected, as w ell as their end use. Due to the poten tiall y lar ge volume of d a ta, the r egula ting authority oper a ting the pr ogr am might benef it b y r equiring all sources to s ubmit emissionr e la ted d a ta electr onicall y. Electr onic s ubmissions impr ove accur acy and r e d uce the bur den on sources and the r egula ting authority b y elimina ting the need f o r r e d und an t d a ta en tr y , f

acilita ting automa ted d a ta quality checks, and pr oviding immedia te f eedback about d a ta quality. In the e ven t tha t electr onic s u bmission is not f easible, sources might s ubmit d a ta on disk e ttes, compact discs, or paper f orms. The r egula ting authority can then tr ansf er the d a ta to the ETM. This manual pr ocess could be cumbersome f or the r egula tor y authority and pr one to d a ta en tr y err ors. After sources s ubmit emission d a ta, the ETM should check the d a ta f or omissions, ma thema tical

26 F or mor e inf orma tion about d a ta s y stems f or cap and tr ade, see Schr eif els, 2 0 0 1

.
4-2 Ho w t o Implement and Oper at e a C ap and T r ade P r ogr a merr ors, and me thodological pr oblems. If the ETM uses electr onic r eporting, it can ackno wled ge the s ubmission and r eport the r e s ults of the quality check dir ectl y to the sources. The ETM can also per f orm in-depth anal y sis and quality ass ur ance checks. F o r e

xample, the s y stem might compar e the s ubmitted d a ta to historical d a ta f r om the source and similar f acilities to search f or inconsistencies. Poten tial pr oblems tha t the ETM iden tif ies might be r eported to the r egula ting authority so an auditor can check the d a ta and, if necessar y , r equest additional inf orma tion f r om the source. In the absence of a computerized inf orma tion s y stem, the r egula ting authority should oversee these functions. Once the d a ta passes the d a ta quality check, it can be r ecor ded in the ETM and made av ailable to in terested parties. An automa ted d a ta quality check r e d uces the time and cost of d a ta r e vie w in tw o wa y s . F irst , the ETM iden tif ies minor err ors immedia tel y and r eports to the source so the y can corr ect the err ors. Second, the r egula ting authority can f ocus on pr oblems iden tif ied b y the second sta ge of the r e vie w in or der to prioritize in-depth r e vie w s. The automa ted d a ta quality check can also r e d uce pr ocessing dela y s and pr ovide in ter ested parties with f aster access to emission d a ta. 

# A llo w anc e T r ack ing Module (A TM) The Allow ance T r acking Mod ule, or A TM, is the accoun ting s ystem f or the tr ading progr am, k eeping tr ack of accoun t inf orma tion, accoun t holdings, and tr ansactions. As with other componen ts of the s ystem, public access to the d a ta is importan t . Mark e t

participan ts, including sources, brok ers, and other allow ance owners, can use the d a ta to v e rify tr ansactions and monitor holdings. The public, in ter est groups, and academics can use the d a ta to e v alua te the eff ectiv eness of the cap and tr ade progr am, iden tify barriers to cost-eff ectiv e tr ading, assess o v

er all mark e t

activity , iden tify tr ading tr ends, and analyze the emission implica tion of tr ades. The poten tiall y large volume of tr ansactions in a tr ading pr ogr am ma y necessita te electr onic s ubmission of tr ansactions. As discussed earlier in the section on s ubmissions of electr onic emissions d a ta, electr onic s ubmissions ha ve many benef its, including impr oved accur acy , r e d uced bur den on the r egula ting authority , immedia te f eedback and tr ansaction conf irma tion to participan ts. The A T M can pla y a critical r ole in all allo wance tr ansactions, including the iss uance, tr ansf er , r e tir emen t , and cancella tion of allo wances. The r egula ting authority can use the A TM to iss ue and distribute allo wances accor ding to a pr escribed me thod (e.g ., alloca tion f ormulas, auctions, sales). A computerized A

TM can also ens ur e tha t tr ades ar e v alid b y r e vie wing the d a ta to verify tha t accoun t numbers ar e corr ect , the seller o wns the allo wances being tr ansf err ed, and the allo wances ar e still v alid (i.e., the y have not been r e tir ed f or compliance or cancelled). Once the informa tion is verif ied, the A TM can ded uct the tr aded allo wances f r om the seller’s accoun t and add them to the bu y er’s accoun t . If the tr ansaction is not v alid, the A

TM should notify the bu y er and seller and, if appr opria te, r ecor d the f a iled tr ansaction as an ackno wled gemen t tha t the tr ansaction was s ubmitted. The A TM, in conjunction with the Reconcilia tion and Compliance Mod ule, can f acilita te compliance assessmen t b y r e tiring the appr opria te number of allo wances f r om each accoun t . In addition to iss uance, tr ansf ers, and r e tir emen t , the A TM can f acilita te canceling allo wances f or envir onmen tal or other r easons (e.g ., administr a t i ve penalties, purchases b y envir onmen tal gr oups). 

## P u b l i c P a r t i c i p a t i o n i n t h e U

. S

. A l l o w a n c e M a r k e t T he public can par ticipat e in emission tr ading pr ogr ams b ypur chasing allo wanc es . E n vir onmental and student gr oups ha v e tak en adv a ntage of this option, pur chasing allo wanc es with the int e ntion of r etiring them fr om the syst em. Retiring allo wanc es f or the en vir onment pr ev ents them fr om being used t o emit pollution. F or example , in the U.S. SO 2 Allo wanc e T r ading P r ogr a m, these gr oups acquir ed a t otal of 934 allo wanc es in the period of 1994 t o 1997. In RECLAIM, en vir onmental ac tivists acquir ed a t otal of 1,925 allo wanc es in the first y ear of the pr ogr am. T his r epr esent ed about 4 per c e nt of the annual allocation. D espit e the small v olume of allo wanc es , these tr ansac tions ar e symbolic of the openness of the syst em and the abilit y of the public t o tak e dir ec t ac tion on behalf of their en vir onment.

4-3 Ho w t o Implement and Oper at e a C ap and T r ade P r ogr a m

# Rec oncilia tion and C omplianc e Module (RCM) The Reconcilia tion and Compliance Mod ule (RCM) is the vital link be tw een the ETM and A TM to de termine compliance. At the end of each compliance period, the RCM compar es a source’s allowance holdings a gainst the total emissions f r om the period. If the source’s emissions ar e equal to or less than their allowance holdings, the source is in compliance (see Fi gur e 1 2). Conversel y , if emissions ar e gr ea ter than the allowance holdings, the source is not in compliance and is s ubject to any noncompliance consequences and penalties. The RCM, in conjunction with the A TM, should ded uct the appr opria te number of allo wances f r om each source’s accoun t . The ded uctions might be made on a pr escribed basis (e.g ., f irst in, f irst out) or b

y specif ic instructions as to which allo wances ar e to be ded ucted. The la tter appr oach ma y be desir able f o r a v arie ty of r easons (e.g ., tax consequences, f o r war d tr ade con tr acts). If the source is not in compliance, the RC M should: • Instruct the A TM to ded uct all allo wances f r om the source’s accoun t and withhold futur e allo wances equal to the over a ge penalties. • Report the noncompliance and emissions overa ge to the r egula ting authority f or enf orcemen t .



### F igur e 12. Rec oncilia tion 

# A uditing and V e rifica tion Auditing and verif ica tion of emission d a ta can tak e se

ve r al f orms. If d a ta s ubmitted b ysources ar e r equir ed in a stand ar d electr onic f orma t , r egula ting authorities can use softwar e to audit the d a ta and iden tify potential discr epancies or iss ues to investiga te. The r egula ting authority can use these electr onic “desk” audits to targe t mor e in-depth audits. If sources s ubmit emission d a ta using paper f orms, the audit and verif ica tion will be mor e r esource in tensi ve. F or this r eason, r e quiring sources to s ubmit emission d a ta in stand ar d electr onic f orma t is str ongl y r ecommended. When sources use meas ur emen t de vices, either to meas ur e actual emissions or to meas ur e some other par ame ter invo l ved in calcula ting emissions, s uch as fuel flo w , the r egula ting authority should r e vie w d a ta collected f r om meas ur emen t de vices f or r easonableness. In addition, the audit should r e vie w r e s ults of any quality ass ur ance and quality con tr ol tests perf ormed on the meas ur emen t equipmen t to ens ur e tha t the equipmen t is oper a ting pr operl y. If possible, the r egula ting authority should compar e s ubmitted d a ta to independen tl y obtained d a ta. V

erif ica tion of s ubmitted emission d a ta should also invo l ve f ield audits — visits to the emission sources — especiall y when sources use meas ur emen t equipmen t . Such f ield audits can include obser ving quality ass u r ance tests, r e vie wing on-site r ecor ds, inspecting meas ur emen t equipmen t , and/or comparing installed meas ur emen t equipmen t to independen t r e f e r ence me thods. Such f ield audits can be perBeginning of y ear

Net Allo wanc e (Bought and Sold)

T otal Allo wanc e Av ailable f or C o mplianc e

D educ tions f o r Emissions

Allo wanc es Remaining 15,812

-3,201

12,611

-11,867

744 

### A llo w anc es

11,867 tons Emissions f ormed on a r andom sample of all sources, and/or f ield audits can be per f ormed on sources iden tif ied with poten tial meas u r e men t or d a ta pr oblems d uring the electr onic desk audits.

(Sour c e in C o mplianc e)

4-4 Ho w t o Implement and Oper at e a C ap and T r ade P r ogr a m

## A u d i t i n g i n t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m Under the U.S. SO 2 Allo wanc e T r ading P r ogr a m, the stat e and local en vir onmental agencies , E P A r egional offic es , and U.S. EP A Headquar t e rs f o rm an auditing t eam. Wher e possible , r egulat o r yofficials (usually fr om the local agencies) obser v e Q A/QC t esting of emissions measur ement equipment that is undertak en b yr egulat ed sour c e s . T he purpose of the audit is t o v e rify that the t esting is c omplet ed acc or ding t o standar d pr oc edur es and accur at ely r epr esent e d in the r e por ts t o EP A. In addition, emissions and t est data ar e r e por t ed t o EP A in a standar d elec tr onic f o rmat , ar e scr eened f or err ors , and ar e elec tr onically audit ed t o identify pot e ntial discr epancies

. P r oblems f ound in elec tr onic audits ar e used t o tar get facilities f or field audits

. R egulat o r yofficials per f orm both r andom and tar get ed field audits during which they visit facilities t o inspec t measur ement equipment and on-sit e r e c o r ds t o v e rify that the data r e por t ed t o EP A accur at ely r eflec ts what is happening at the facilit y. In suppor t of this pr oc ess , E P A pr o vides tr aining and audit sof twar e f o r r egional, stat e and local inspec t ors . 

# T echnical Suppor t fo r Regula ted Sour c e s An importan t elemen t of implemen ting and oper a t ing a cap and tr ade pr ogr am is the ongoing technical s u pport f or sources. The pr ogr am is mor e lik el y to be s u ccessful if the r egula ting authority and emission sources k

eep open lines of communica tion on the rules and pr oced ur es of the pr ogr am. Bef or e implemen ta tion of the pr ogr am begins, sources ma y benef it f r om workshops tha t e xplain and clarify the rules of the pr ogr am. In addition, thr oughout the lif e of the pr ogr am, as ne w iss ues arise, ne w sources and ne w emplo y ees en ter the pr ogr am, and r e visions ar e incorpor a ted in to pr ogr am rules, a con tinued dialogue be tw een the r egula ting authority and the sources will f acilita te the smooth oper a tion of the pr ogr am. It is wise f or the r egula ting authority to plan w orkshops f or sources after the rules of the pr ogr am have been publicl y dissemina ted but prior to the beginning of the pr ogr am. The w orkshops can addr ess all aspects of implemen ta tion f or which the sources ar e r esponsible, and should inf orm them about the r ole of the r egula ting authority. F or e xample, the w orkshops could: • Explain the applicability criteria of the pr ogr am and addr ess questions about which sources ar e and ar e not aff ected. • Explain the alloca tion pr ocess, including when and ho w each source will kno w its alloca tion or the pr oced ur es f o r participa ting in an auction, if applicable. • Addr ess source r esponsibilities, s uch as the pr oced ur e f or iden tifying the person who will be r esponsible f or making s ubmissions and demonstr a ting compliance f or each source. • Discuss the r equir emen ts f or meas uring emissions and r eporting to the r egula ting authority

. • Outline the pr oced ur es f or r eporting allo wance tr ades to the r egula ting authority

. • Ans w er any questions r e la ted to the de termination of compliance and poten tial enf orcemen t actions. During implemen ta tion of the pr ogr am, it might be necessar y to s upplemen t the initial published rules of the pr ogr am with guid ance documen ts tha t f ocus on specif ic questions or clarif ica tions r egar ding the rules. It is lik el y tha t the initial rules of the pr ogr am will not cover all of the situa tions tha t actuall y arise. Sources ma y need in terpr e t a tions of the rules b y the r egula ting authority to help appl y the rules to the source’s unique circumstances. This may be particularl y true f or emission meas ur emen t and r eporting

. The mor e indi vid ualized the meas ur emen t me thods and the mor e options av ailable, the mor e questions ar e lik el y to arise. F or consistency in the pr ogr am, it is importan t tha t sources r ecei ve the same guid ance. One option to ens ur e consistency is f or the r egula ting authority to cr ea te a guid ance documen t tha t includes ans w ers to both commonl y ask ed questions and unique questions. The r egula ting authority can modify the documen t as ne w guid ance is cr ea ted. Such a documen t is useful as an in ternal r e f e r ence to help main tain consistency over time, as w ell as to pr ovide inf orma tion to the public and sources.

4-5 Ho w t o Implement and Oper at e a C ap and T r ade P r ogr a m

# A dministr a tiv e C osts Associa ted with C a p and T r ade Although cap and tr ade pr ogr ams can cost signif ican tl y less than mor e tr aditional policy options, the pr ogr ams r equir e r esources to oper a te eff icien tl y and eff ecti ve l y . Regula ting authorities should consider these costs when designing the pr ogr am so the y can iden tify appr opria te funding sources and bud ge ts. The smaller a cap and tr ade pr ogr am is, the mor e lik el y it can oper a te eff ecti ve l y and eff icien tl y with a simple spr eadshee t or paper-based s y stem. Ho w e ve r , as the number of participan ts or d a ta r equir emen ts incr ease, a computer-based s y stem with automa ted d a ta pr ocessing becomes necessar y. The costs of designing and de veloping 27 s uch a s y stem can be consider able, but the savings in staff time and err or r e d uctions can help offse t some of the e xpense. Additionall y , the s y stem ma y under go modif ica tions as pr ogr am rules change, automa tion is enhanced, or technologies impr ove. 

# Enfo r c emen t Oversight and enf orcemen t ass ur e tha t sources ar e accoun table f or their emissions and compliance with the pr ogr am r equir emen ts. The functions of oversight and enf orcemen t include the verif ica tion of emissions and the enf orcemen t of penalties f o r f r aud or noncompliance. 

# A dditional C osts Other costs associa ted with cap and tr ade pr ogr ams ma y include: • Gener al administr a tion. • Recor ding allo wance tr ades. • P r oviding public access to pr ogr am inf orma tion (e.g ., emission r eports, allo wance holdings and tr ades). • M onitoring pr ogr am r e s u lts. • Responding to questions f r om pr ogr am participan ts and the public. 

## O p e r a t i o n a l R e s o u r c e s f o r t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m T he U.S. SO 2 Allo wanc e T r ading P r ogr am r equir es significantly f e w er administr ativ e and oper ational r esour c es than tr aditional c ommand-and-c ontr ol pr ogr ams in the Unit ed Stat es . T his is due in par t t o aut omation and the use of inf ormation syst ems , a s w ell as the fundamentally new appr oach wher eb y administr at ors can f o cus on v e rification and c o mplianc e r a ther than r e viewing c omplianc e plans , baseline calculations , and emission r educ tion tr ansac tions

. A ppr o ximat ely 100 go v e rnment staff members nationwide pla y a r ole in the SO 2 or NO X allo wanc e tr ading pr ogr ams . • 25 t o 30 f e der al headquar t ers staff members pr o vide polic y guidanc e , dev elop and oper at e the inf ormation syst ems t o tr ack emissions and allo wanc es , c er tify monit oring equipment , v e rify r e por t ed emissions data, audit facilities , det ermine c omplianc e , and enf or c e penalties when nec essar y. T he v ast majorit y of these staff members per f orm qualit y assur anc e and v e rification of emissions measur ement data. • 15 f eder al headquar t e rs en vir onmental staff members assist with administr ation, outr each, tr aining , assessment , and oper ation of a national netw o rk of monit ors t o tr ack acid deposition and en vir onmental impac ts
. • 15 f eder al r egional en vir onmental staff members and appr o ximat ely 40 stat e and local staff members help v e rify the emission measur ements b yc onduc ting field audits at par ticipating sour c e s . All f eder al c osts f or dev elopment and oper ation of the U.S. SO 2 Allo wanc e T r ading P r ogr am amount t o less than $1 per t on of SO 2 r educ ed (M cL ean, 1997).

27 EP A has cr ea ted compr ehensi ve design documen ta tion f or an in tegr a ted emission and allowance inf orma tion s y stem. This documen ta t ion is
a v ailable to in ter ested governmen ts thr ough the Clean Air Mark e ts Di vision.

4-6 Ho w t o Implement and Oper at e a C ap and T r ade P r ogr a m

# 5 Assessmen t and C ommunica tions

In tr oduc tion 

# This chapter describes how outr each and communica tions can f acilita te a cr edible and s uccessful cap and tr ade pr ogr am and discusses some of the communica tion iss ues tha t ar e unique to emission tr ading pr ogr ams. The chapter emphasizes the importance of tr anspar ency (i.e., the full and open disclos ur e of r elev a n tpublic and priv a te decisions) f or cap and tr ade pr ogr ams. Finall y , the chapter discusses ongoing d a ta collection and assessmen t r ecommended f or cap and tr ade pr ogr ams to de termine whe ther the y ar e delive ring the desir ed en vir onmen tal and economic r e s ults and to iden tify poten tial impr ovemen ts. These include en vir onmen tal, economic, and mark e tassessmen ts. 

# C ommunica ting Sta tus and Results R

esearch has shown tha t public acceptance of a governmen tpolicy is critical to ens ur e s uccessful implemen tation; k eeping stak eholders inf ormed and in v

o lved helps build trust in both the policies themselves and in the r egula ting authority (Jasanoff and W ynne 1 9 9 8). In addition to simpl y con ve

ying inf orma tion, communication and outr each activities can help gener a te public s upport f or cap and tr ade pr ogr ams. This s upport is particularl y importan t in the case of en vir onmen tal iss ues, which f r equen tl y engender consider able public deba te be tween compe ting in ter est gr oups with diff ering v a lues and objectives. Because ther e ar e many misconceptions about cap and tr ade, r egula ting authorities implemen ting cap and tr ade pr ogr ams need to pr ovide comple te, accur a te, and balanced inf orma tion on how the pr ogr am works and how it will help achie ve envir onmen tal objectives. It is also importan t to enga ge in communica tion and outr each activities in the beginning of the policymaking pr ocess and use these activities thr oughout implemen ta tion to de velop cr edibility f or the ne w appr oach to emission con tr ol. 

# Multiple A udienc es fo r Outr each The audience f or most outr each activities is highl y v a ried, and each constituency has a unique se t of concerns. F or e xample, the gener al public and the en vir onmen tal community ma y be primaril y in ter ested

5-1 A ssessment and C ommunications“ E m i s s i o n t r a d i n g i s i m m o r a l

. ” in learning how the tr ading pr ogr am aff ects human health and ecos y stems, particularl y in and ar ound their own communities. The aff ected emission sources, on the other hand, ma y need access to accoun t information or guid ance on how to meas ur e and r eport emissions (see Chapter 4). The academic community might show a pr ef er ence f or technical inf orma tion, s uch as d a ta on long-term emission tr ends or prices. P

olicymak ers might be in ter ested in whe ther pr ogr am goals ar e being me t (e.g., whe ther emissions ar e decr easing, b yhow much, and wher e). P olicymak ers might also be in ter ested in the pr ogr am’s over all costeff ectiveness. The needs of each of these stak eholder gr oups can be me t thr ough a well-designed monitoring, assessmen t , communica tion, and outr each pr ogr am. 

# Informa tion for the Market Another importan t r ole of a communica tion pr ogr am is to pr ovide inf orma tion to the emission sources to help f acilita te mark e t oper a tion. Sources need to know wha t their r eporting r equir emen ts ar e under the s y stem, how to compl y with pr ogr am rules and r egula tions, and whom in the r egula ting authority to con tact r egar ding questions. Mor eove r , f or a cap and tr ade s y stem tha t r elies on tr ades r ecor ded in near r eal time, it is necessar y f or the r egula ting authority to pr ovide d a ta on allow ance a v ailability and individ ual accoun ts. F

o rtuna tel y , r ecen t ad v ances in inf orma tion technology ar e making it possible to pr ovide d a ta r ele v a n tto cap and tr ade pr ogr ams in r eal time and in man y highl y useful f orms (Kruger , e tal., 2 000). F or e xample, bef or e an allow ance tr ade is comple ted and mone y changes hands, the party acquiring allow ances ma y w a n tto know tha t the A T M has r ecor ded the tr ansaction. A

v ailability of this inf orma tion helps k eep the pr ogr am running smoothl y and eff icien tl y without long la g times. Ultima tel y , tr anspar ency of inf orma tion mak e s the mark e tmor e eff icien t b yle tting those who wish to bu y and sell allow ances know who is tr ading and wha t v

olume of allow ances ar e being tr aded. This information allow s participan ts to mak e tr ading and compliance decisions mor e easil y and quickl y than if critical informa tion we r e not a v ailable. 

## P u b l i c I n v o l v e m e n t i n t h e D e s i g n S t a g e o f U

. S

. T r a d i n g P r o g r a m s Both the U.S. SO 2 Allo wanc e T r ading P r ogr am and the U.S. RECLAIM pr ogr am in v o lv ed the public in their design and implementation. During the dev e lopment of the SO 2 Allo wanc e T r ading P r ogr am r e gulations , m embers of the utilit y , c oal and natur al gas industries; en vir onmental or ganizations; c onsumer int e r est gr oups; r egulat o r yc ommissions; and members of academia pr o vided input thr ough par ticipation in the A cid R ain A d visor y C o mmitt ee (ARA C). RECLAIM was also dev eloped thr ough the use of advisor y c o mmitt ees c o mprising r epr esentativ es fr om public agencies , the business c ommunit y , tr ade unions , e n vir onmental or ganizations and financial institutions

. In both instanc es , the in v o lv ement of these gr oups early in the design pr oc ess helped t o o v er c ome misc onc eptions about the use of this new instrument and t o educat e stak eholders on the pr oc ess of pr ogr a m dev elopment and implementation (Schwar z e and Zapf el, 2000). In addition, it helped facilitat e implementation because it pr oduc ed a cadr e of k n o wledgeable individuals who w e r e c o mmitt ed t o mak ing the pr ogr am w o rk. 

# C ommunica tion Issues Unique to Emission T r ading P r ogr ams Ther e ar e some unique communica tion iss ues associa ted with cap and tr ade pr ogr ams. These pr ogr ams ar e some times me t with sk epticism f r om the envir onmental community and the public. Unique concerns or misconceptions about emission tr ading ar e s ummarized below . • “ E m i s s i o n t r a d i n g i s i m m o r a l
. ” Some critics of emission tr ading start with a philosophical opposition to wha t the y call “the right to pollute.” E ven under conve n tional r egula tion, ho w e ve r ,permitting establishes the “right” to emit pollution a t a certain le vel. Some times this right is in the f orm of an emission r a te and some times it is in the f orm of the emissions tha t r e s ult f r om specif ic, mand a ted pollution con tr ol technologies. Unlik e cap and tr ade, most of these tr aditional mechanisms do not limit the total tonna ge of

5-2 A ssessment and C ommunications“ E m i s s i o n t r a d i n g i s u n f a i r . ”

“ C o m p a n i e s w i l l c h e a t . ” “ T r a d i n g d o e s n ’ t c l e a n t h e a i r . ” pollutan ts f r om each plan t (i.e., plan ts can emit mor e when the y oper a te mor e). The mark e t
based incen ti ves in cap and tr ade can also spur innov a tion and ne w technologies. • “ E m i s s i o n t r a d i n g i s u n f a i r . ” A second misperception of emission tr ading is tha t it is unf air because companies can bu y their wa y out of their r esponsibilities to r e d uce emissions. Similarl y , some have ar gued tha t emission tr ading f avo rs lar ge companies a t the e xpense of small companies. These ar gumen ts ignor e the f act tha t under a cap and tr ade s y stem, companies tha t bu y allo wances ar e essen tiall y pa ying f or emission r e d uctions a t other companies. Mor eove r , small companies often benef it the most f r om cap and tr ade because the y ma y have f e

w er in ternal options f or emission r e d uctions and the y ma y benef it f r om the fle xibility of bu ying allo wances. In addition, the lar gest and highest emitting f acilities often have the lo w est cost per ton f o r r e d ucing emissions. This was the case in the U .S. SO 2 Allo wance T r ading P r ogr am, wher e the highest emitting plan ts in the Mid w estern United Sta tes made the most significan t emission r e d uctions. • “ C o m p a n i e s w i l l c h e a t . ” Some belie ve cap and tr ade will allow companies to a void their obligations because enf orcemen t and oversight is left to “the mark e t .” In f act , if pr ogr ams ar e pr operl y designed, accoun tability can be be tter under a cap and tr ade pr ogr am than under conve n tional appr oaches. Cap and tr ade pr ogr ams r equir e the cr ea tion of compliance structur es tha t ar e useful r egar dless of whe ther any tr ading occurs. Participa ting sources must full y accoun t to the governmen t f or each ton of emissions accor ding to stringen t emission meas ur emen t pr otocols to ens ur e comple teness, accur acy , and consistency of emission d a ta. Automa tic f inancial penalties can be used tha t ar e se t a tle vels tha t discour a g e noncompliance. The r egula ting authority’s r ole in the pr ogr am is to ens ur e emissions ar e meas ur ed accur a tel y and tha t all participa ting sources ar e in compliance. Finall y , r eported inf orma tion on emissions can be made a v ailable to the public on the In terne t or thr ough other means. This tr anspar ency can help build the necessar y conf idence in the eff icacy of the cap and tr ade appr oach. • “ T r a d i n g d o e s n ’ t c l e a n t h e a i r . ” Critics of emission tr ading some times ar gue tha t tr ading does not r e d uce emissions; it mer el y shifts the location of e xisting pollution. Ho w e ve r , this ar gumen t f ails to accoun t f or the cap. Under a cap and tr ade s y stem, the over all le vel of emissions is r e d uced and capped. The envir onmen tal objecti ve is embodied in the cap and the economic objecti ve in the tr ade. Mor eove r , the lar ger the over all r e d uction r eflected in the cap, the less concern ther e is about the envir onmen tal impacts of any indi vid ual tr ade or gr oup of tr ades. This poin t is particularl y r ele v a n t in addr essing concerns about hotspots tha t ma y arise d ue to tr ading . Economic and a t mospheric modeling done in conjunction with an EP A stud y of the U

. S. SO 2 Allo wance T r ading pr ogr am sho w ed tha t in the Eastern United Sta tes, the diff er ence in acid deposition with and without tr ading was less than 5 percen t . Diff er ences in deposition of less than 1 0 percen t ar e not e

xpected to meas ur abl y change the acidif ica tion of lak es and str eams (USEP A, 1 9 95).



## P u b l i c R e a c t i o n t o t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m Although r eac tions t o some of the initial SO 2 tr ades in the Unit ed Stat es w e r e negativ e , acc eptanc e of emissions tr ading has gr o wn as the pr ogr am has achiev ed en vir onmental r esults

. S ev er al obser v e rs ha v e not ed that the k e y t o eff ec tiv ely c ommunicating the benefits of the SO 2 cap and tr ade pr ogr a m t o the public and en vir onmental gr oups has been t o mak e the point that the flexibilit y of emission tr ading was tied t o a significant en vir onmental benefit (L oeb , 1995). Essentially , the ar gument is that the c ost sa vings fr om the allo wanc e tr ading pr ogr a m w e r e used “ t o buy ” additional en vir onmental benefits and t o ther ef or e ease the c onc erns of en vir onmentalists o v er this nontr aditional f o rm of r egulation. Ultimat ely , onc e the emissions and en vir onmental r esults of the pr ogr am became a v ailable , the pr ogr am began t o r e c eiv e mor e fa v o r able media tr eatment. In addition, a br oader r ange of en vir onmental gr oups began t o embr ac e cap and tr ade (K ruger and D ean, 1997).

5-3 A ssessment and C ommunications

## C l e a n A i r M a p p i n g a n d A n a l y s i s P r o g r a m ( C

- M A P ) EP

A’

s Clean Air M a rk ets Division uses geogr aphic data t o assess the en vir onmental eff ec tiv eness of the A cid R ain P r ogr am and t o help the public bett er understand the r esults and benefits of its SO 2 tr ading pr ogr a m. One of the most sophisticat ed elec tr onic inf ormation sour c es is the Clean Air M apping and Analysis P r ogr am (C-MAP), which allo ws users t o assess national and r egional impac ts of the A cid R ain P r ogr a m. C-MAP is a Web-based G e ogr aphic Inf o rmation S y st em (GIS) assessment t o ol used t o bett er understand and char ac t e riz e the en vir onmental r esults and benefits of national and r egional pollutant emission r educ tion pr ogr ams . T he geogr aphic c o mponent of GIS allo ws f or a clear er understanding of the spatial r elationships betw een emissions r educ tions and the associat e d eff ec ts t o air qualit y , sur fac e wat er qualit y , acid deposition, f o r est health, and sensitiv e ec osyst ems . T he user can analyz e national-, r egional-, and stat e-lev el tr ends , acc or ding t o the geogr aphic and en vir onmental ar ea of int e r est. C-MAP files ar e pr o vided via the Web sit e and ar e also included in writt en r e por ts (see: www .epa.go v/airmark ets/cmap).

F or example , this map fr om C-MAP illustr at es the geogr aphic mean c e nt ers of SO 2 allo wanc e tr ading (buying ac tivit yof plants emitting mor e than their allocation in a giv en y ear , and selling ac tivit y of sour c e s) f or 1995 thr ough 1999. T he pr o ximit y of c e nt ers of tr ading each y ear indicat es that ther e was no significant shifting of emissions fr om one r egion t o another among these units

. T he tight geogr aphic c o rr elation c o rr obor at es EP A’

s obser v a tions that units t end t o acquir e additional allo wanc es fr om within their o wn c ompan y (or geogr aphic r egion). < 25 25

– 50 50

– 75 75

– 100 > 100 Plants Acquiring Additional Allowances (Thousand Allowances) < 50 50

– 100 100

– 150 150

– 200 > 200 Plants Supplying these Additional Allowances (Thousand Allowances) 1995 Acquiring Activity 1996 Acquiring Activity 1997 Acquiring Activity 1998 Acquiring Activity 1999 Acquiring Activity

1995 Supplying Activity 1996 Supplying Activity 1997 Supplying Activity 1998 Supplying Activity 1999 Supplying Activity 

### F igur e 13. A llo w anc e T r ading A c tivit y 1995 – 1999

5-4 A ssessment and C ommunicationsIndependen t anal y sis also sho w s tha t emission tr ading can lead to gr ea ter human health and envir onmen tal benef its than non-tr ading policies (B urtr aw and Mans ur , 1 999). 

# Modes of C ommunica tion B yf ar the most eff ecti ve means of communica tion and outr each is the W orld Wide W eb. Electr onic information can r each a v ast audience a tlow cost . F or example, visitors to EP A

’s Clean Air Mark e ts W eb site 28 r ead mor e than 3 00,000 f iles e ver y mon th. A w ell-designed W

eb site should be user-f riendl y , r e l yon in tuiti ve naviga tion, and, ideall y , undergo usability testing bef or e it is made a v ailable to the public. It should also be r egularl y upd a ted to r eflect the la test pr ogr am d a ta and de velopmen ts. An up-to-d a te W eb site can gr ea tl y add cr edibility to the tr ading pr ogr am and can be used to pr ovide inf orma tion tha t builds conf idence in the cap and tr ade pr ogr am (see bo x on C-MAP). Inf orma tion can also be made av ailable to the public via prin t media. Depending on av ailable bud ge t , a r egula ting authority ma y pr epar e and distribute f act shee ts, br ochur es, and topical r eports tha t can be distributed b y mail. Periodic ne w sle tters ar e another eff ecti ve means of k eeping the public inf ormed of the pr ogr am’s sta tus and r e s ults, including emission r e d uctions to d a te, auction r e s ults, and allo wance prices. Similarl y , inf orma tion can be conve y ed a t w orkshops and conf er ences. Regar dless of the mode of communica tion, it is importan t to bear in mind tha t k eeping the public inf ormed about the sta tus and r e s ults of the cap and tr ade pr ogr am can help ens ur e the pr ogr am’s s uccess b

y highlighting its envir onmen tal and economic benef its, f acilita ting mark e t oper a tion, and building public and decisionmak er s upport . T o ens ur e tha t adequa te r esources ar e av ailable to mee t public demand f o r inf orma tion thr oughout a pr ogr am’s lif e time, a communica tion function should be designed a t the pr ogr am’s outse t , r a ther than on an ad-hoc basis after r e s ults ar e av ailable. Consisten tl y av ailable, up-to-d a t e inf orma tion will help build public conf idence in the cap and tr ade pr ogr am. 

# C o n tinued Assessmen t En vir onmen tal Assessmen t A cap and tr ade progr am, b yse tting a quan tif iable emission goal and using accur a te and consisten t emission meas ur emen t , lends itself well to periodic assessmen t . R

e

vie wing emission le v

els will help de termine how eff ectiv e lythe progr am is oper a ting and whe ther the emission cap le v

el has been achie v

ed. Equally importan t to progr am s uccess is de termining how the en vironmen t is r esponding to emission r e d uctions and whe ther o v

erarching objectiv es f or en vironmen tal protection ar e being me t . P eriodic meas ur emen t of these en vironmental endpoin ts will help pro vide inf orma tion on how we ll the cap le v

el is protecting the en vironmen t . 29 The scope of the assessmen t is de termined, to a lar ge e xten t , b y the specif ic policy questions being addr essed. Con tinued assessmen ts can include e v aluation of emission d a ta, ambien t air concen tr a tions monitoring d a ta, and pollutan t deposition monitoring d a ta. Assessmen t ma y also include an e v alua tion of endpoin t par ame ters or r eceptors, s uch as changes in s u rf ace wa ter chemistr y r e s ulting in decr eases in acid deposition. Examples of envir onmen tal endpoin ts include acidic le vels of r ainwa ter and s ulf a te deposition le vels f or acid r ain, and gr ound-le ve l ozone le vels f or NOx emissions.

In or der to e v alua te the eff ecti veness of envir onmen tal policies and pr ogr ams, a str ong commit men t to long-term monitoring pr ogr ams is critical. Eff ecti ve assessmen t r equir es a full s uite of monitoring capabilities, including tr acking stack emissions, anal yzing a t mospheric concen tr a tions of pollutan ts, meas uring w e t and dr y deposition to land and wa ter s u r f aces, and e

v alua ting envir onmen tal impacts thr ough s u r f ace wa ter chemistr y and biological monitoring . These pr ogr ams not onl y help in e v alua ting envir onmen tal compliance and pr ogr ess to wa r ds pr ogr am goals (e.g ., thr ough tr acking emissions r e d uctions), the y also enable assessmen t of the eff ecti veness of emission con tr ols in addr essing human health and envir onmental concerns. Over the long term, inve st men t in s u ch pr ogr am accoun tability mechanisms will yield gr ea t benef its thr ough their con tribution to the cr edibility of the policy

.

28 The W eb site’s URL is www .epa.gov/airmark e ts. 29 F or a de tailed discussion on ecological assessmen ts and anal ytical tools in the con te xt of acid deposition in the United Sta tes , see USEP A, 2 0 0 1

.
5-5 A ssessment and C ommunications

## E n v i r o n m e n t a l A s s e s s m e n t i n t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m Sinc e its first y ear of oper ation in 1995, ther e has been ex t ensiv e assessment of the impac ts of the U.S. SO 2 Allo wanc e T r ading P r ogr a m. T his assessment has been critical in ev aluating the succ ess of the pr ogr am and in building suppor t f or the cap and tr ade appr oach. Some of these r esults ar e summariz ed belo w : Emissions: One benefit of using c o ntinuous emissions monit ors is ha ving accur at e , c omplet e , and timely emission data that can be used t o quantify the o v er all en vir onmental eff ec tiv eness of the pr ogr a m. In 2001, the sec ond y ear of Phase II, aff ec t ed emission sour c es achiev ed t otal SO 2 emission r educ tions of appr o ximat ely 39 per c e nt r elativ e t o 1980 lev e ls (33 per c e nt r elativ e t o 1990 lev els). C ompar ed t o 2000 lev e ls , these sour c es r educ ed their SO 2 emissions b y5 per c e nt or 569,000 t ons . F igur e 14 sho ws the tr end in SO 2 emissions f or all aff ec t ed sour c es sinc e 1980. A i r Qualit y : Data c ollec t ed sinc e 1988 indicat e that ambient SO 2 co n c e ntr a tions ar e declining (see F igur e 15). W

et Deposition: F ield data c o llec t ed b ythe National A tmospheric D e position P r ogr am/National T r ends Netw ork (NADP/NTN) sho w that sulfat e lev els in pr ecipitation ha v e dr opped sharply sinc e the SO 2 Emissions T r ading P r ogr am began in 1995 (see F igur e 16) (Lynch, et al., 2000). Dr y Deposition: T he Clean Air Status and T r ends Netw ork (CASTNet) measur es dr y deposition of sulfur and nitr ogen at appr o x imat ely 100 sit es . Lik e w et deposition, dr y deposition can cause acidification of sur fac e wat e rs . I t is also link ed with damage t o mat e rials

. C ASTNet data sho w that dr y deposition sulfat e c onc entr ation lev els also ha v e declined b yappr o x imat ely 30 per c e nt in the Nor theast ern Unit ed Stat es and M i d-A tlantic (Holland , e t al., 1999). Source: EPA 0 2 4 6 8 10 12 14 16 18

Phase I sour c e s Phase II sour c e s all sour c e s allo wanc es allocat ed f o r that y e ar 17.30 16.09 15.73

11.87 12.51 12.98 13.10 12.46 11.20 10.63

2001 2000 1999 1998 1997 1996 1995 1990 1985 1980Emissions (million tons)

7.90

9.40 6.79

9.30 7.03

8.70 6.57

5.30 5.44 5.47 7.07 7.51 7.81

5.29 7.52

4.94 11.20 10.63

1989

– 1991

1

5

10

15

>20 1999

– 2001

SO 2 (μg/m 3 )

USEP

A/CAMD 08/01/02 Sour c e : CASTNET USEP A/CAMD 08/01/02 Sour c e : C lean Air M a rk ets Division, EP A

Sour c e : E P A

* Regional tr ends in ambien t SO 2 concen tr a tions. P ercen ta ge is the percen t dr op in SO 2 concen tr a tion in each Region. T r ends ar e decr easing, with most pr ominen t tr ends in the Northeast and Mid-Atlan tic sta tes. 

### F igur e 14. SO 2 

### Emissions F r om A f fe c t ed Emission Sour c e s

F igur e 15. Regional T r ends in SO 2 

### C onc en tr a tion Sour c e s

5-6 A ssessment and C ommunicationsSur fac e W a ter Impac ts: A r e c e nt study examining sur fac e wat er qualit y in acid-sensitiv e r egions of the Unit ed Stat es f ound that , sinc e the beginning of the U.S. SO 2 Allo wanc e T r ading P r ogr a m, sulfat e c onc entr ations in lak es and str eams ha v e declined significantly in all monit or ed r egions of the East ern Unit ed Stat es , e x c ept V i r g inia. Nitr at e c onc entr ations ha v e decr eased significantly in the C a tsk ill and A dir ondack Mountains and V e rmont sinc e 1990. Incr easing A cid Neutr alizing C apacit y (ANC) demonstr at es that r e c o v e r yis occurring in the A dir ondacks and P ennsylv ania, spurr ed b ythe sulfat e r educ tions achiev ed b ythe pr ogr a m. (USEP A, 2003).



### 1989

– 1991

1999

– 2001 Wet SO 4 2 (kg/ha)

Wet SO 4 2 (kg/ha) Sour c e : National A t mospheric D e position P r ogr a m USEP A/CAMD 07/31/02

USEP A/CAMD 07/31/02 0 5 10 15 20 25 30 35 >40 0 5 10 15 20 25 30 35 >40

Sour c e : Lynch et. al., 2000. (Units ar e in k ilogr ams per hec tar e). 

### F igur e 16. T r ends in Wet Sulfa te D e position

5-7 A ssessment and C ommunications

## C o n t i n u e d E c o n o m i c A s s e s s m e n t i n t h e U

. S

. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m T

o ev aluat e the scientific (and ec onomic) eff ec ts of acid deposition in the Unit ed Stat es , a National A cid P r ecipitation A ssessment P r ogr am (NAP AP) was established in 1980. A f t er a decade of r esear ch on the causes and eff ec ts of acid r a in, NAP AP pr oduc ed a c o mpr ehensiv e Int egr at ed A ssessment Repor t , published in 1991. P a r t of this eff or t included an ec onomic ev aluation of en vir onmental impac ts in selec t ed aff ec t ed ar eas f or which data w e r e a v ailable and wher e the v a luation methods c ould be cr edibly applied

. T he r e por t explicitly r e c o gniz ed that ther e w e r e limitations in the assessment due t o a lack of pr oper scientific or ec onomic data and models and that the r esults did not pr esent a full pic tur e of the t otal v alue of the damages caused b ythe r egional air pollutants

. A decade lat e r , as methodologies f or the ec onomic ev aluation of en vir onmental eff ec ts impr o v ed and c o ntinued r e sear ch was under tak en, mor e c o mpr ehensiv e estimat es indicat e that the benefits of the SO 2 r educ tions achiev ed ar e v e r yhigh, par ticularly the r educ ed health risks of pr ematur e mor talit y and morbidit y. Estimat es of the annual health benefits alone in 2010 ar e in the or der of 17 t o 70 billion 1995 U.S. dollars per y ear (Ostr o , et al., 1999). An updat ed analysis c onduc t ed in 2000 pr ojec ts annual benefits of about 50 billion 1997 U.S. dollars per y ear beginning in 2010 ( Watk ins , 2001). In addition, r e c e nt estimat es of the c osts of attaining the emission r educ tion tar get ha v e been significantly lo w er than expec t ed

. In 1989, the EP A estimat ed annual c osts of the pr ogr am t o par ticipating sour c es at full implementation (2010) t o be appr o ximat ely $5.7 billion annually

. A curr e nt EPRI estimat e pr edic ts annual c osts of $1.6 billion in 2010. O ther r e c e nt annual c ost estimat es ha v e been as lo w as about $1 billion per y ear b y2010 (C arlson, et al., 2000). 

# E c onomic Assessmen t Economic assessmen ts ar e useful to e v alua te whe ther the cap and tr ade pr ogr am is deli vering the e xpected economic benef its. Assessmen ts include a comparison of the envir onmen tal and human health benef its (or d a ma ges a voided) as a r e s ult of the pr ogr am, and the total costs of compliance (N AP AP , 1

9 9 8; B urtr aw , e tal., 1 9 9 8). These types of anal y ses can be used f or a mor e compr ehensi ve cost-benef it anal y sis to e v alua te whe ther further emission r e d uctions and/or additional con tr ol pr ogr ams ar e warr an ted. 

# Market Assessmen t Mark e tassessmen t (i.e., tr acking allowance tr ading acti vity and prices) is another importan t aspect of a cap and tr ade pr ogr am. The volume of acti vity (i.e., the number of tr ansactions tha t occur) indica tes whe ther the mark e tf or allowances is liquid and whe ther it is working eff ecti ve l yto minimize the economic costs of achie ving the emission r e d u ction targ e t . Of particular importance is a meas ur e of the number of allowances tr aded in “arm’s-length ” tr ansactions, or tr ades tha t occur be tw een unaff ilia ted companies. It is these tr ades tha t ha ve mark e tsignif icance (Kruger and Dean, 1 9 9 7) and demonstr a te tha t an allowance mark e t has de ve loped. 

# P r ogr a m Refinemen t Once a cap and tr ade progr am has been implemen ted, assessmen t of the progr am is v aluable to ens ur e its eff ectiv eness. It is importan t not only to assess the environmen tal and economic eff ectiv eness of the progr am, but also to assess the implemen ta tion. P olicymak ers should consider whe ther these proced ur es could be impro v

ed or if the y could be mor e cost-eff ectiv e . After gaining some e xperience of pr ogr am implemen t a tion, policymak ers should cons ult with the emission sources, as w ell as use the e xperience f r om the sources to assess whe ther changes ar e warr an ted in the implemen ta tion rules and pr oced ur es. In addition, input should be solicited f r om other stakeholders. Based on s uch input , it can be de termined whe ther the pr ogr am w ould benef it f r om r e f inemen t and if so, a pr ocess and time table can be established. It is importan t to minimize disruption in the pr ogr am and r ealize tha t some changes, e ven if the y w ould have been a be tter choice f r om the start , ar e not w orth implemen ting because of the disruption the y w ould cause. The sources, as w ell as the r egula ting authority , have learned the rules and any changes, e ven impr ovemen ts, might r equir e mor e time on their part to learn and implemen t . On the other hand, it is ve r y possible tha t ther e will be changes wher e the benef its will outw eigh the disruption caused b y change.

5-8 A ssessment and C ommunications

## R u l e R e v i s i o n B a s e d o n I m p l e m e n t a t i o n E x p e r i e n c e i n t h e U

. S
. S O 2 

## A l l o w a n c e T r a d i n g P r o g r a m Under the U.S. SO 2 Allo wanc e T r ading P r ogr a m, EP A initiat ed a stak eholder pr oc ess af t er the first f e w y ears of implementation t o solicit input on the implementation and experienc e with the emissions measur ement r equir ements of the pr ogr a m. T he EP A offic e r esponsible for the design and implementation of the pr ogr am led the stak eholder pr oc ess . T he pr oc ess in v o lv ed the r egulat ed po w er plants that w e r e implementing the r equir ements , the stat e and local en vir onmental agencies that help EP A per f orm field audits of aff ec t ed facilities , and en vir onmental gr oups int e r est ed in the int egrit y of the pr ogr a m. Based on the input fr om the stak eholder pr oc ess , EP

A dev eloped a r e vised set of emissions measur ement rules and pr oc edur es aimed at str eamlining the pr oc ess f or both the sour c es and the r egulat ors . While maintaining or impr o ving the qualit y of the emissions data and the int egrit y of the pr ogr a m, the r e vised rules clarified sec tions that w e r e unclear or misleading , incr eased the c ost-eff ec tiv eness of the rules , and addr essed r eal-lif e situations that w e r e not en visioned when the rules w e r e first writt en. E P A r eleased the r e visions in dr af t f

o rm t o int e r est ed stak eholders and r equest ed c omments on the r e visions , which w e r e inc orpor a t e d , as appr opriat e , bef o r e finalizing the r e vised rules

. Onc e the r e vised rules w e r e finaliz ed , E P A pr o vided an additional y ear bef o r e r equiring their use

. T his ga v e sour c es time t o learn and implement the new rules

.

5-9 A ssessment and C ommunicationsA c i d d e p o s i t i o n :

A c i d r a i n :

A c i d R a i n P r o g r a m :

A d d i t i o n a l i t y : A f f e c t e d s o u r c e :

A l l o w a n c e :

A n y w a y t o n s : A r m ’ s l e n g t h t r a n s a c t i o n s :

A s c e n d i n g b i d a u c t i o n s : 

# Glossar y of T e rms

Ac i d d e p o s i t i o n : The pr ocess b ywhich acidic particles, gases, and pr ecipita tion lea ve the a t mospher e. Mor e commonl y r e f err ed to as acid r ain, acid deposition has two componen ts: w e t and dr y deposition. Ac i d r a i n : The r e s ult of s ulfur dio xide (SO 2 ) and nitr ogen o xides (NOx ) r eacting with wa ter in the a t mospher e and r e turning to earth as r ain, f og, or snow . Br oadl y used to include both w e t and dr y deposition. Ac i d R a i n P r o g r a m : The r egula tor y pr ogr am cr ea ted under the U .S. Clean Air Act to r e d uce acid r ain. It emplo y s a cap and tr ade f r ame work to r e d uce SO 2 emissions f r om electric pow er plan ts. The Acid Rain Pr ogr am is also known as the U

. S. SO 2 Allowance T

r ading Pr ogr am, the U .S. SO 2 cap and tr ade pr ogr am, and the U .S. SO 2 emission tr ading pr ogr am. The Acid Rain Pr ogr am also r equir es r e d uctions in NOx emission r a tes f r om coal-f ir ed pow er plan ts. Ad d i t i o n a l i t y : A de termina tion of whe ther emission r e d uctions f r om a pr oject would ha ve occurr ed under normal business conditions (i.e., in the absence of a cr editing pr ogr am). Af f e c t e d s o u r c e : A f acility tha tpr od uces emissions and is s ubject to the pr ovisions of an emission con tr ol r egula tion. Al l o w a n c e : An authoriza tion to emit a specif ic amoun t of a pollutan t under a cap and tr ade pr ogr am. F o r e

xample, in the U

. S. SO 2 Allowance T r ading Pr ogr am, one allowance is the authoriza tion to emit 1 ton of SO 2 . Allowances ar e used f or compliance and can be tr aded among sources participa ting in the cap and tr ade pr ogr am. Any w ay to n s : See “Additionality .” Ar m ’ s l e n g t h t r a n s a c t i o n s : Allowance tr ansactions be tw een companies tha t ar e unaff ilia ted with one another

. A s c e n d i n g b i d a u c t i o n s : An auction in which both price and allowance quan tity ar e de termined thr ough a pr ocess of open compe tition. Each bidder has full inf orma tion about the curr en t clearing price and can upd a te their bids to incr ease price or change quan tity , changing losing bids to winning bids. Those willing to pa

y the most win the allowances.

Glossar y-1 Glossar y of T e rmsB a n k i n g :

B r o k e r :

B u b b l e :

C a p :

C a p a n d t r a d e :

C l e a n A i r A c t A m e n d m e n t s ( C AAA ) o f 1 9 9 0 :

C o m m a n d

- a n d

- c o n t r o l :

C r e d i t : C r e d i t i n g p e r i o d :

D e s i g n a t e d r e p r e s e n t a t i v e :

D o w n s t r e a m :

E m i s s i o n t a r g e t :
E n v i r o n m e n t a l i n t e g r i t y :

F l u e g a s d e s u l f u r i z a t i o n ( F G D ) :

F u e l f l o w m e t e r :
F u n g i b i l i t y : B a n k i n g : A f orm of tempor al fle xibility tha t gi ve s sources the opportunity to sa ve unused allowances and/or offse ts f or use in a la ter compliance period. B ro k e r : The person who acts as an in termediar y be tw een a bu y er and a seller , us uall y charging a commission. B u b b l e : A r egula tor y term tha t applies to the situa tion when a company combines a number of its sources in or der to con tr ol pollution in a ggr ega te; under a bubble f acility oper a t ors ar e allow ed to choose which sources to con tr ol as long as the total emissions f r om the combined sources is less than or equal to the amoun t each source would ha ve emitted under the con ve n tional r equir emen t C a p : The over all emission limit tha t a gr oup of affected sources cannot e x ceed under a cap and tr ade pr ogr am. Ma y also be r e f err ed to as the a ggr ega te emission quota, le vel, targe t , or bud ge t . C a p a n d t r a d e : A mark e t-based policy tool tha t establishes an a ggr ega te emission cap on total emissions f r om a gr oup of sources and cr ea tes a f inancial incenti ve to r e d uce emissions. The emission cap is e

xpr essed as allowances distributed to indi vid ual emission sources tha t must s urr ender allowances to cove r their emissions. The pr ogr am pr ovides the fle xibility f or sources with low-cost r e d uctions to r e d uce e ven further and sell allowances to others with higher costs of con tr ol, r e s ulting in achie vemen t of the envir onmen tal goal a tlow est cost . C l e a n A i r Ac t Am e n d m e n t s ( C A A

A ) o f 1 9 9 0 : A r eauthoriza tion of the Clean Air Act passed b ythe U .S. Congr ess in 1 990. The C A A A, which included pr ov isions f or the U .S. SO 2 Allowance T r ading Pr ogr am, str engthened the ability of EP A to se t and enforce pollution con tr ol pr ogr ams aimed a tpr otecting human health and the envir onmen t . C o m m a n d

- a n d

- c o n t r o l : A policy tool in which the r egula ting authority establishes the necessar y emission r e d uction or applicable emission limit f or specif ic sources, typicall y b yse tting a source-specif ic emission r a te stand ar d or mand a ting the installa tion of specif ic emission r e d uction technology

. C r e d i t : Under a r a te-based tr ading pr ogr am, cr edits can tak e the f orm of an authoriza tion to emit a specif ic quan tity of emissions (e.g ., 1 ton) when an emission source achie ves an emission r a te below the specif ied per f ormance r a te. Under a pr oject-based tr ading pr ogr am, once certif ied b yan authorized e xpert to ens ur e the emission r e d uction is r eal, additional, and longterm, a cr edit is an authoriza tion to e x ceed a r a te or other pr e-e xisting stand ar d b ya specif ic amoun t (e.g ., 1 ton). C r e d i t i n g p e r i o d : the number of y ears d uring which an emission r e d uction pr oject is eligible to r ecei ve cr edits f or actual emission r e d uctions. D e s i g n a t e d r e p r e s e n t a t i v e : Under the U .S. SO 2 Allowance T r ading Pr ogr am, the indi vid ual who r epr esen ts the owners and oper a tors of an aff ected source and per f orms allowance tr ansf er r equests, emission r eports, and all corr espondence with EP A concerning compliance with the U

. S. SO 2 Allowance T r ading Pr ogr am. D o w n s tr e a m : A type of cap and tr ade s y stem in which aff ected sources ar e those f acilities or cons umers after the poin t in the pr od uct cy cle wher e the emissions actuall y escape to the a t mospher e. F or example, electricity cons umers ar e downstr eam f r om the emissions tha t occur a tthe electricity gener a tor . E m i s s i o n t a rg e t : The le vel of allowable emissions in a cap and tr ade pr ogr am. See also “cap.” E n v i r o n m e n t a l i n t e g r i t y : The ability of an emission con tr ol policy , s uch as an emission tr ading pr ogr am, to achie ve its envir onmen tal objecti ve (e.g ., r e d uce or limit emissions to a specif ic quan tity). F l u e g a s d e s u l f u r i z a t i o n ( F G D ) : Post combustion contr ol technologies designed to r emove SO 2 f r om flue gases. F GD technologies can be gr ouped in to two gener al ca tegories of w e t and dr y pr ocesses. In the most common type, a w e t limestone scrubber , the flue gas en ters a large r eaction vessel (spr a ytow er or absorber), wher e it is spr a y ed with wa ter slurr y con taining limestone. The calcium in the slurr y r eacts with the SO 2 to f orm calcium s ulf ite or calcium s ulf a te tha t is r emove d f r om the r eaction vessel and the wa ter is r emoved. The thick ened waste can either be disposed of or used to pr od uce a b y-pr od uct s uch as gyps um. Fu e l f l o w m e t e r : An instrumen t tha t meas ur es the vo lume or mass of fuel burned. Fu n g i b i l i t y : The in terchangeability of allowances, cr edits, and/or offse ts, ass uming tha t each r epr esen t s a

Glossar y-2 G lossar y of T e rmsG r o u n d

- l e v e l o z o n e :

H o t s p o t s :

L e a k a g e :

M a r g i n a l a b a t e m e n t c o s t ( M A C ) :

M a s s b a l a n c e a p p r o a c h :

N e t b u y e r :

N i t r o g e n O x i d e s ( N O x ) :

O f f s e t :

O z o n e T r a n s p o r t C o m m i s s i o n ( O T C ) R e g i o n a l N O x T r a d i n g P r o g r a m : P a p e r c r e d i t s :

P e r f o r m a n c e s t a n d a r d :
P e r m a n e n c e :

P o i n t o f e m i s s i o n :

P r o j e c t h o s t :

P r i c e s i g n a l :

R a t c h e t : consisten tl y meas ur ed and stand ar dized unit of emissions. Gr o u n d

- l e v e l o z o n e : The occurr ence in the tr opospher e (i.e., a tgr ound le vel) of a gas tha t consists of thr ee a toms of o x y gen (O 3 ) and is f ormed thr ough a chemical r eaction invo l ving o xides of nitr ogen (NOx ), vo la tile organic compounds (V OC), hea t , and light . At gr ound le vel, ozone is an air pollutan t tha t d a ma ges human health, vege ta tion, and many common ma terials and is a k e

y ingr edien t of urban smog

. H o t s p o t s : Geogr aphicall yand tempor all y concen tr a ted pollution le vels tha t e x ceed desir ed emission le vels or ambien t air quality stand ar ds. Under some circumstances, hotspots ma y r e s ult in conjunction with an emission tr ading pr ogr am if appr opria te saf eguar ds ar e not designed in to the pr ogr am (e.g ., a stringen t cap). L e a k a g e : Occurs when economic acti vity is shifted as a r e s ult of the emission con tr ol r egula tion and, as a r e s ult , emission aba temen t achie ved in one loca tion tha t is s ubject to emission con tr ol r egula tion is offse t b

yincr eased emissions in unr egula ted loca tions. M a r g i n a l a b a t e m e n t c o s t ( M AC ) : The amoun t of mone y a source will need to spend to r e d uce the ne xt ton of emissions of a specif ic pollutan t . M a s s b a l a n c e a p p r o a c h : An emission estima tion me thod in which inputs and outputs ar e compar ed to calcula te the emissions of the r ele v a n tpollutan t . N e t b u y e r : Under a cap and tr ade pr ogr am, an allowa nce tr ader tha t acquir es mor e allowances than the ysell. N i t r o g e n O x i d e s ( N O x ) : Gases pr od uced d uring combustion of f ossil fuels in motor vehicles, pow er plan ts, ind ustrial furnaces, and other sources. NOx is a pr ecursor to acid r ain and gr ound-le ve l ozone. O f f s e t : An emission r e d uction of a specif ic quan tity of a pollutan t (e.g ., 1 ton) verif ied thr ough a pr ojectbased tr ading pr ogr am. An offse t can be applied to r egula tor y emission limits as an authoriza tion to emit tha t specif ic quan tity of pollutan t . See also def inition of “cr edit

. ” O z o n e T r a n s p o r t C o m m i s s i o n ( O T C ) R e g i o n a l N O x T r a d i n g P r o g r a m : A NOx cap and tr ade pr ogr am adopted b yjurisdictions (sta tes and the District of Columbia) in the Northeastern United Sta tes to addr ess ozone tr ansport in tha t r egion. P a p e r c r e d i t s : Gener a ted under pr oject-based tr ading pr ogr ams if the emission baseline f or a pr oject is se t a t a le vel gr ea ter than the one a twhich the source actuall yoper a tes. If s uch a baseline is used to calcula te the quan tity of cr edits or offse ts gener a ted b ythe pr oject , the r e s u lting cr edits or offse ts do not r eflect r eal emission r e d uctions. Similarl y , paper cr edits could also occur under a r a te-based tr ading pr ogr am if the perf ormance stand ar d is se t a ta le vel above which a source actuall y oper a tes. P e r f o r m a n c e s t a n d a r d : A quan tity of emissions allow e d per unit of hea t input or pr od uct output . P e r m a n e n c e : A concept associa ted with pr oject-based tr ading tha t r e f ers to whe ther carbon stor ed in the biospher e (i.e., carbon sequestr a tion and sinks) might la ter be emitted to the a t mospher e (e.g ., b ya f o r e st f i r e). P ermanence should be addr essed so tha t offse ts awar ded f or carbon stor ed in a tr ee which la ter burns down ar e not used to allow e xtr a emissions else wher e. P o i n t o f e m i s s i o n : A type of cap and tr ade s y stem in which aff ected sources ar e those f acilities wher e the emissions actuall y escape to the a t mospher e. F o r e

xample, the U .S. SO 2 Allowance T r ading Pr ogr am is a poin t of emission pr ogr am because the aff ected sources ar e electric gener a ting units tha t combust f o ssil fuel and emit pollutan ts in to the a t mospher e. This kind of pr ogr am is often r e f err ed to as a downstr eam pr ogr am in the United Sta tes and a midstr eam pr ogr am in Eur ope. P r o j e c t h o s t : An emission source tha t hosts a pr oject to r e d uce emissions and gener a te offse ts under a pr ojectbased tr ading pr ogr am. P r i c e s i g n a l : An indica tor of wha t people or businesses ar e willing to pa y f or allowances or wha t f irms ar e willing to accept as pa ymen t f or their s urplus allowances (or cr edits). T r ansactions, whe ther auctions or sales, pr ovide a signal of the price tha t emission sources and other mark e tparticipan ts ar e willing to pa y f o r allowances. R a tc h e t : A pr oced ur e tha t adjusts each source’s allocation pr oportiona tel y , so tha t the total alloca tion ma tches the number of allow ances in the over all cap. This s y stem pr omotes en vir onmen tal in tegrity b yens uring tha t f ormulas used to de termine alloca tions do not infla te the cap.

Glossar y-3 G lossar y of T e rmsR a t e - b a s e d t r a d i n g :

S c a r c i t y v a l u e :
S c r u b b e r :

S t a t i o n a r y s o u r c e c o m b u s t i o n :

S o u r c e :
S u l f u r d i o x i d e ( S O 2 ) :

T r a d e :

T r a d e r : T r a n s a c t i o n c o s t s :

U p s t r e a m : V i n t a g e : R a t e - b a s e d t r a d i n g : A tr ading appr oach in which the r egula ting authority de termines an emission r a te perf ormance stand ar d (i.e., an amoun t of emissions allow ed per unit of hea t input or pr od uct output) f or a sector (e.g ., tons/kWh) and allow s sources tha t overand under-compl y with the stand ar d to tr ade cr edits. (The r a te diff er ence needs to be multiplied b yeach sources’ utiliza tion to establish a tr ad able mass emission based cr edit or offse t . ) S c a r c i t y v a l u e : The economic v alue of an allowance or cr edit d ue to the limited quan tity a v ailable. S c ru b b e r : A post-combustion con tr ol technology utilizing a sorben t to r emove SO 2 f r om the emission stack. See also “Flue gas des ulfuriza tion.” S t a t i o n a r y s o u r c e c o m b u s t i o n : The pr ocess of burning fuel b ya source, s uch as a boiler , tha t is in a f i x ed location (i.e., not mobile). S o u rc e : An en tity tha t r eleases airborne pollutan ts in to the envir onmen t . S u l f u r d i o x i d e ( S O 2 ) : A gaseous pollutan t tha t is primaril y r eleased in to the a t mospher e as a b y-pr od uct of f ossil fuel combustion. The largest sources of SO 2 ar e pow er plan ts tha t burn coal and oil to mak e electricity

. Tr a d e : An e x change of allowances, offse ts, or cr edits f or cash or other consider a tions under an emission tr ading pr ogr am. T r a d e r : Any one who bu y s or sells allowances. T r a n s a c t i o n c o s t s : Financial costs associa ted with a tr ansaction under an emission tr ading pr ogr am. The costs ar e us uall y r e la ted to iden tifying, verifying, and certifying emission r e d uctions. These ma y include part ner search costs, tr a vel and communica tion, negotia tion acti vities, legal and con tr acting costs, poten tial litiga tion costs, e x-post challenges, opportunity costs associa ted with dela y s and uncertain ties, and other r e la ted costs. U p s tr e a m : A f orm of cap and tr ade wher e the obligation of compliance is placed ‘upstr eam’ of the actual emission sources (e.g ., a tthe fuel pr od ucer), s uch tha t the aff ected sources under the pr ogr am ar e not the f acilities wher e emissions actuall y escape to the a t mospher e. V i n t a g e : Repr esen ts the f irst y ear , or compliance period, in which a particular allowance can be used f o r compliance in a cap and tr ade pr ogr am.

Glossar y-4 G lossar y of T e rms

# A c r o n yms

ARAC Acid Rain Ad visor y Committee A

T M Allowance T r acking Mod ule C A A A Clean Air Act Amendmen ts CEMS Con tinuous Emission Monitoring Sy stem CH 4 Me thane C-MAP Clean Air Mapping and Anal y sis Pr ogr am CO 2 Carbon Dio xide DA HS Da ta Acquisition and Handling Sy stem ELI Envir onmen tal Law Institute EP A U .S. Envir onmen tal Pr otection Agency EPBs Envir onmen tal Pr otection Boar ds ETM Emissions T r acking Mod ule F GD Flue Gas Des ulfuriza tion GHGs Gr eenhouse Gases ISO In terna tional Stand ar ds Organiza tion MAC Marginal Aba temen t Cost MMB TU P ounds per million British Thermal Units MSD Marginal Social Dama ge N

A P AP Na tional Acid Pr ecipita tion Assessmen t Pr ogr am NOx Nitr ogen Oxides O T C Ozone T r ansport Commission QA/QC Quality Ass ur ance/Quality Con tr ol RCM Reconcilia tion and Compliance Mod ule RECL AIM Regional Clean Air Incen ti ves Mark e t R F F Resources f or the F utur e SIP Sta te Implemen ta tion Plan SO 2 Sulfur Dio xide TEV T otal Economic V alue USD U .S. Dollar

A c r o n yms-1 A cr on yms

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.

# A T he Optimal L e v e l of P ollution

A ccor ding to economic theor y , e

x cessi ve le vels of pollution occur d ue to so-called “mark e tfailur es,” s uch as the public goods na tur e of envir onmen tal quality , imper f ect inf orma tion, and other f actors. Hence, accor ding to economic theor y , governmen ts should in ter vene to pr ovide the corr ect incenti ves f or pollution con tr ol. De termining the optimal le

vel of pollution con tr ol r equir es an anal y sis of the le

vel of the envir onmen tal e xternality tha t is being gener a ted as a r e s ult of an economic acti vity . An e x ternality is def ined as a cost or a benef it tha t is not being pr operl y accoun ted f or b yeither the pr od ucers or the cons umers of the acti vity . F or e xample, consider the case of a f irm loca ted upstr eam tha t is emitting pollution in to a nearb y str eam. As a r e s ult , ecos y stems downstr eam ma y be ad versel y aff ected (e.g ., f ish popula tion decline, decline in r ecr ea tional f ishing and s wimming, ad verse health eff ects f r om con tamina ted drinking wa ter). These ar e all e xamples of nega ti ve e

xternalities (i.e., costs). If these eff ects ar e not r e flected in the f irm’s pr od uction costs, and hence in the mark e tprice of the economic acti vity , the f irm will emit a le vel of pollution tha t is above the social optimum. Gener all y , two conditions need to pr e v ail f or an e

xternal cost to e xist: (1) an acti vity b yone party causes a loss of w elf ar e to another party; and (2) the loss of w elf ar e is uncompensa ted. F i gur e A-1 depicts the sociall y optimal le vel of pollution. The Mar ginal Social Benef it (MSB) cur ve sho w s tha t initial emission r e d uctions pr ovide gr ea ter benef it than s ubsequen t emission r e d uctions. Pollution aba temen t , ho w e ve r , costs less for the initial r e d uctions but each additional (or mar ginal) unit of pollution con tr ol costs mor e than the pr e vious unit

. Thus, the Mar ginal Aba temen t Cost (MAC) cur ve is steeper as the quan tity of emission r e d uctions is incr eased. The optimal le vel of pollution con tr ol occurs wher e MAC = MSB. Hence, to achie ve this le vel, the r egula ting authority w ould wa n t to limit the a ggr ega te le

vel of emission r e d uctions to the le vel Q*, which r eflects the mar ginal cost associa ted with tha t le vel of economic acti vity , P*.

A-1 T he Optimal L e v el of P ollution

### F igur e A-1. E c onomically Efficien t C o n t r o l of P ollutionCost per Unit of Pollution

M a r ginal Social Benefit 

### C A P AND TR ADE

M a r ginal Abat ement C ost P*

Q* Quantit y of P ollution Reduc ed 

# T he E c onomics of Emission T r ading Cap and tr ade pr ogr ams ar e s uperior to the mor e tr aditional command-and-con tr ol appr oaches f or envir onmen tal r egula tion because the emissions targe t—established via the cap—is achie ved a ta minimum economic cost thr ough the tr ading of the allowances. The r egula ting authority de termines the total allowable le vel of emissions and iss ues allowances f or this amoun t (ideall yQ* in Fi gur e A–1 above). The allowances ar e then alloca ted to the sources, which ar e allow ed to tr ade with other sources in the allowance mark e t . In this wa y

, f irms with low marginal aba temen t costs will opt to r e d uce emissions be y ond the number of allowances the y hold and sell the e x cess allowances to f irms with higher marginal aba temen t costs. Thus, marginal aba temen t costs acr oss all sources ar e equalized and the costs of a ttaining the en vir onmen tal targe t ar e minimized.

A-2 Ho w t o D e v elop a C ap and T r ade P r ogr a m

# B Example Assessmen t of the P o ten tial F o r C ap and T r ade

C a s e S t u d y o f S O 2 

## i n t h e U n i t e d S t a t e s : A s s e s s i n g t h e P o t e n t i a l f o r C a p a n d T r a d e Questions f or C onsider ation A C ase Study of SO 2 in the Unit ed Stat es 

### ENVIRONMENT AL SCIENCE ISSUES
What is the natur e of the Emissions of SO 2 and sulfat es damage human health, ec osyst ems , visibilit y , en vir onmental pr oblem? and mat e rials (e .g ., buildings and monuments (NAP AP

, 1991)). During the 1980s , the most pr essing c onc ern was the impac t of acid deposition on lak es and str eams . T oda y , ther e is mor e r esear ch link ing sulfat e par ticles t o human health pr oblems and mor talit y (USEP A, 1995). New studies also sho w links betw een acidic deposition and f o r est damage

. What is the geogr aphic sc ope of A cid deposition was gr eat est in the nor theast Unit ed Stat es and C anada, but pr oblem? other r egions of the Unit ed Stat es had some impac ts and emissions w e r e k n o wn t o tr a v el fr om w est t o east acr oss the c ountr y. Elec tric utilities oper at e in mor e than one stat e so national c o v e r age was impor tant t o minimiz e gener ation and emission shif ting outside of the c o ntr ol ar ea. C an emission sour c es be link ed t o A decade of r e sear ch c ollec t ed b ythe National A c id P r ecipitation A ssessment the en vir onmental pr oblem or P r ogr am (NAP AP) quantified the tr ansf ormation and long-r ange tr anspor t of health issue? sulfat e par ticles (NAP AP

, 1991). T he lar gest emission sour c es w e r e locat ed in the M i dw est and f ound t o impac t do wnwind ar eas .

B-1 Example A ssessment of the P o t e ntial F or C ap and T r ade

## C a s e S t u d y o f S O 2 

## i n t h e U n i t e d S t a t e s : A s s e s s i n g t h e P o t e n t i a l f o r C a p a n d T r a d e Questions f or C onsider ation A C ase Study of SO 2 in the Unit ed Stat es What ar e the major sour c es of In 1980, elec tric utilities w e r e r esponsible f or mor e than 70 per c e nt of t otal emissions? SO 2 emissions in the Unit ed Stat es (NAP AP

, 1991).
Ar e ther e accur at e measur ement T echnology exist ed t o accur at ely measur e emissions but was not widely methods f or the sour c es identified? applied

. T he tr ading pr ogr am r equir ed c o ntinuous emission monit ors f or all c oal-fir ed boilers in the pr ogr a m, and all sour c es w e r e r equir ed t o pr o vide a c omplet e acc ounting of emissions

. What ar e emission pr ojec tions Emission pr ojec tions sho w ed that emissions fr om the utilit y sec t or alone w ould fr om each sec t or? incr ease t o nearly 20 million t ons b y 2010 if ac tion was not tak en (NAP AP

, 1991). 

### ECONOMIC ISSUES
Ar e ther e a v ailable emission A v a riet y of c ost-eff ec tiv e t echnological, fuel swit ching , and ener gy efficienc y r educ tion options? options exist ed

. D o diff er ent sour c es fac e diff er ent Sour c es fac ed a wide r ange of c omplianc e c osts and c o ntr ol options (e .g ., c o sts? installing scrubbers , swit ching fuels , incr easing ener gy efficienc y). What do diff er ent mar ginal c osts G ener ally , the highest emitt ers had lo w est c osts t o r educ e emissions (on a imply about wher e t o expec t c o st per t on basis). In the Unit ed Stat es , most of those sour c es w e r e locat ed r educ tions? in the M i dw est and Ohio R i v er V alley

. What ar e the o v er all c osts and E c onomic models w e r e used t o estimat e the c osts of diff er ent alt e rnativ es . benefits? T he c ost of emission tr ading was estimat ed t o be significantly lo w er than tr aditional appr oaches

. T he NAP AP r e por t estimat ed significant benefits , but w e r e not initially monetiz ed

. Ar e ther e an y adv e rse Analyses w e r e under tak en t o pr edic t which sour c es ar e lik ely t o be buy ers of en vir onmental implications t o allo wanc es and which sour c es ar e lik ely t o be sellers of allo wanc es . E stimat e s using emission tr ading? of the location of emission r educ tions and tr ading ac tivit ycan then be made

. T his inf ormation can be used t o pr edic t tr ading ac tivit yand air qualit y impac ts
. T her e ar e also wa ys t o inc orpor a t e specific r equir ements t o pr ev ent pr oblems , lik e “ hotspots

. ”
Ar e ther e sufficient sour c es f or a T h e elec tric po w er sec t or c o ntained o v er 2,000 sour c es including c oal burning , fluid mark et? n a t u r a l g a s , oil and w ood-fir ed sour c es (ser ving gener at ors lar ger than 25 MW e). 

### INSTITUTION AL AND TECHNIC AL ISSUES
Is ther e sufficient enf or c ement A u t omatic penalties f or not holding enough allo wanc es w e r e established

. authorit y t o mak e a tr ading T hese penalties w e r e set at $2,000 per t on, with annual incr eases t o r eflec t pr ogr am w o rk? inflation. Allo wanc es f or the f ollo wing y ear ar e c onfiscat ed f or ev er y t o n emitt ed o v er allo wanc e lev els

. T he CAAA has additional criminal and civil penalties of up t o $25,000 a da y per violation.

B-2 Example A ssessment of the P o t e ntial F or C ap and T r ade

## C a s e S t u d y o f S O 2 

## i n t h e U n i t e d S t a t e s : A s s e s s i n g t h e P o t e n t i a l f o r C a p a n d T r a d e Questions f or C onsider ation A C ase Study of SO 2 in the Unit ed Stat es Is ther e an infr astruc tur e t o T he existing infr astruc tur e was not sufficient t o pr o vide the needed accur ac y measur e , r e por t , and manage and handle the v olume of data in a timely fashion. EP A established standar d sour c e specific emission data? measur ement and r e por ting pr ot oc ols f or aff ec t ed sour c e s . T r ack ing syst ems w e r e dev eloped f or unit specific (i.e ., boiler-lev el) emission data and f o r allo wanc e tr ansf ers . Data ar e a v ailable t o the public on the EP A Int e rnet sit e . Ar e ther e adequat e r esour c es t o Appr o ximat ely 75 per c e nt of administr ativ e r esour c es in the U.S. SO 2 manage emission data? Allo wanc e T r ading P r ogr am ar e dev o t ed t o measuring , tr ack ing and qualit y assuring emissions

. A n elec tr onic emission tr ack ing syst em was dev eloped t o r e c eiv e emission data elec tr onically dir ec tly fr om sour c e s . Is ther e a syst em and c e ntr al In the Unit ed Stat es new syst ems w e r e cr eat ed (emission and allo wanc e authorit y that can be used t o tr ack ing syst ems) t o det ermine c omplianc e . A uthorit y f or det ermining det ermine c omplianc e? c omplianc e was par t of the legislation, and EP A hist orically had been r esponsible f or a v a riet y of c omplianc e and enf or c ement ac tions

. D o es legal authorit y exist f or an New legislation was dev eloped f or the SO 2 Allo wanc e T r ading P r ogr a m — emission tr ading pr ogr a m? Title IV of the 1990 CAAA.
Ho w can an emission tr ading Title IV of the CAAA r equir ements was separ at e fr om existing r egulat o r y pr ogr am be int egr at ed with pr ogr ams and writt en t o int e r fac e smoothly with other policies

. S our c es still existing policies? ha v e t o c omply with existing ambient standar ds and permitting r equir ements f or SO 2 . What dev elopments ar e occurring Ener gy po w er r estruc turing has pr oc eeded as the U.S. pr ogr am has been in the aff ec t ed sour c e sec t or? implement e d

. C ap and tr ade is c ompatible with a c o mpetitiv e ener gy sec t o r. 

### O THER CONSIDERA TIONS
Ar e ther e an y social or ec onomic C onc erns about unemplo yment in the c oal mining industr y w e r e a fac t ors limiting fuel choic es? significant fac t or in the Unit ed Stat es . Ar e the needed emission T he pr oc ess f or assessing polic y appr oaches t o addr ess acid r ain in v o lv ed r educ tions politically acc eptable? man ygo v e rnment agencies

. A f t er the A c t was passed , ther e was an ex t ensiv e Is emission tr ading politically stak eholder pr oc ess , including an A cid R ain A d visor y C o mmitt ee , t o solicit acc eptable? input int o implementing r egulations

. Outr each is c o ntinuously needed t o help educat e the public about the en vir onmental benefits of emission tr ading

.

B-3 Example A ssessment of the P o t e ntial F or C ap and T r adeOffice of Air and Radiation Clean Air Markets Division (6204N) EP A430-B-03-002 www .epa.gov/airmarkets June 2003