-1- Regulatory Impact Analysis Protecting Stratospheric Ozone: Process for Exempting Critical Uses from the Phaseout of Methyl Bromide (SAN 4535)

U.S. Environmental Protection Agency Office of Air and Radiation Global Programs Division 1200 Pennsylvania Avenue, NW (6205J) Washington, D.C. 20460

Docket Number A-2000-24-2- Regulatory Impact Analysis Framework for the Methyl Bromide Critical Use Exemption (CUE)

Introduction Attached is the economic impact analysis (EIA) prepared for EPA on the proposed rulemaking that would create the critical use exemption (CUE) and describe the framework for how the exemption program would operate. In the proposed rule EPA seeks to balance several different goals. These goals include designing a system that is simple and minimizes the administrative burden of the regulation, ensures transparent compliance with the Montreal Protocol on Substan ces that Deplete the Ozone Layer (Protocol) and, promotes the most economic efficient distribution of methyl bromide while still maintaining fairness to those who applied for a critical use exemption. EPA believes that we have achieved a successful balance of simplicity, transparency, fairness, and efficiency in the proposal. Background EPA outlined three basic implementation options for the exemption program which were then analyzed in the EIA. EPA held six stakeholder workshops over the summer of 2003 to explain the various options being developed and to solicit input from stakeholders on these options. The three basic options are as follows: Option 1: An upstream cap and trade allowance system which would give critical use allowances to producers and importers of methyl bromide. This allowance system would enable allowance holders to trade their allowances with one-3- another. Allowances may be expended in order to produce or import critical use methyl bromide. Option 2: An upstream cap and trade system with a downstream permit trading system. This system would additionally distribute permits to end users of methyl bromide and allow those permit holders to trade permits with one another. The holder of a permit could exchange his/her permit to buy 1 kg of methyl bromide. Option 3: An upstream cap and trade system with a downstream permit trading system where the permits are initially obtained through an auction. EPA received extensive feedback from the regulated community regarding the viab ility of each of these options. As a result of feedback, EPA realized that an auction would be an impractical solution in this user community. As a result, the EIA provides a more in-depth analysis of the first two options than it does of the last. Major Findings in the EIA The EIA seeks to describe the impact of the proposed regulations which amend the existing phaseout requirements for methyl bromide production and consumption (consumption is defined as production plus imports minus exports). The existing regulations call for a complete elimination of methyl bromide production and import as of January 1, 2005, except for quarantine and preshipment (QPS) applications. Therefore, it is important to note that any change in theexisting regulations that allow for continued production and import of methyl bromide is deregulatory in nature and confers an economic compliance benefit to industry.-4- The estimated negative costs (i.e. reduced costs resulting from the de-regulatory creation of the exemption) for industry are approximately $19 million to $31 million on an annual basis and $380 million to $600 million on a Net Present Value basis depending on the particular option and discount value analyzed (EIA, p.126). These reduced costs are quite dramatic owing to the high value of methyl bromide for crop production and agriculture related activities. The approach used in the EIA to derive the negative costs, or cost savings, associated with the proposed action are as follows. First, the EIA examines the original cost projections provided with the current regulations which were developed in 2000. These original projections were developed using the phaseout model, an engineering type approach (bottom up analysis) that drew data from the literature on the costs of alternatives to methyl bromide and the comparative yields obtained. The EIA, updated the phaseout model with more recent data from newly published studies and from the critical use exemption applications. Then using the updated data points, the EIA looked at what the costs may be under the proposed exemption. The negative cost results are given in the paragraph above and in the table below.

Table I:Annualized and Net Present Value of Private Sector Compliance Costs Discount Rate Annualized Costs Net Present Value Costs Sector Specific Approach Illustrative Universal Approach Sector Specific Approach Illustrative Universal Approach 3% -$19.5 million -$21. 9 million - $616.6 million - $695.6 million 7% -$26.8 million -$31. 3 million - $382.7 million - $446.8 million

The de-regulatory benefit to industry varies depending on the discount rate used and the approach selected. There are two factors which affect the costs of compliance; they are the size of the cap (i.e. the amount of critical use methyl bromide exempted) and how the cap is-5- constrained (i.e. if there is one “universal” amount of methyl bromide made available to all approved critical users or if there is a sub-cap for each sector/commodity group). Both of these variables are likely to be determined by a consensus decision taken by the Parties to the Montreal Protocol when they authorize the critical use exemptions. In the absence of perfect knowledge, some basic assumptions are used in the EIA. The EIA assumes that the amount of critical use methyl bromide made available is 39% of U.S. baseline consumption in 2005, 37% in 2006 through 2010, and then decreases 5% per year until it reaches zero in 2018. EPA used these numbers purely for analytical purposes and does not presuppose the outcome of any decisions to be taken by the Parties to the Protocol who are the final arbiters on the amount of material to be exempt in a given year. In addition, we assume that all material produced in a given year is used in that same year (no stockpiles) and that no new acreage comes into production (no growth). The nature of the cap is a question of keen interest to regulated entities and to policy analysts. Regulated entities spent considerable time and money to prepare applications that they

submitted to EPA. These entities would like some assurance that at least a minimum amount of methyl bromide will be guaranteed to their sector and thus, they favor a sector specific approach despite the fact the total compliance costs (the de-regulatory benefits) for the industry overall would be lower under a universal approach. Policy analysts may tend to prefer a universal approach because more cost savings are achieved by allowing methyl bromide to go to the user with the highest value use across sectors. The phaseout model relies on an engineering approach and is not an economic model well-6- suited to predict the distribution of methyl bromide under a universal approach. Therefore, EPA assumed that under a universal approach, 80% of the total available amount of methyl bromide would go to the two largest groups of end users, tomatoes and strawberries. Eighty percent was used to reflect the total amount of material originally requested by these applicants, an amount which these applicants still maintain is truly critically needed. At a 7% discount rate, the total compliance costs savings are $27 million under a sector specific approach and $31 million under the illustrative universal approach, which means that end users save an additional $4 million annually under the universal approach. A paper written by Kim et al., attached to the EIA as appendix C, looks at the cost of compliance when comparing tradeable permits among end users to non-tradeable permits (command and control). According to Kim, the costs of compliance under command and control are between $55 million and $177 million depending on how the initial allocation is made. If trading is allowed, compliance costs could be reduced to as low as $55 million to $35 million depending on the type of cap in place (i.e. universal or sector specific). It is important to note that EPA is not considering a command and control approach under any of the frameworks analyzed in the EIA. The EIA addresses the question of whether or not a framework option that would create either an upstream cap and trade system (option 1) or a downstream tradeable permit system (option 2) is more economically efficient. The EIA concluded that in fact the framework has little impact on the efficiency of compliance costs per se and that such costs are impacted more by the size of the cap and constraints on the cap as identified in the preceding paragraphs. Under both options, methyl bromide is ultimately purchased by the user of methyl bromide with the highest-7- willingness to pay. The main driver of efficiency is whether or not methyl bromide goes to the highest value use within a commodity sector or if it goes to the use with the highest value across sectors. According to chapter 5 of the EIA, however, there are some factors that could affect whether or not the options produce the same result in terms of consumption of methyl bromide by end users and in control costs, namely how smoothly the market functions under either option. If one option leads to a market that is sticky, the end result will be a less than optimal distribution of methyl bromide and thus higher control costs for industry overall. Some factors that may lead to sticky markets under option one are the existence of preferential historic relationships between suppliers of methyl bromide and well organized end-users. This preferential relationship may lead to methyl bromide being sold to a user who is not necessarily the user willing to pay the most. These preferential historic relationships have been maintained since 1999 when the existing regulations began reduction steps in the production and consumption of methyl bromide. Under option two, in order to achieve a smooth market, permit prices must be known by buyers and sellers, transaction costs must be low, prices adjust to clear the market, and buyers and sellers take full advantage of opportunities to reduce compliance costs by trading (Ellerman 2000, as cited in EIA). Clearly, complications with these market characteristics may arise under option two. For example, many of the end users are smaller entities or entities who do not necessarily have full time environmental compliance managers. Therefore, they may be unable to spend the necessary time and effort to fully research factors such as permit prices and who has permits available. The size of transaction costs is not well understood and the higher the transaction costs the lower the expected participation from end users, particularly small businesses. In addition, the lack of predictability from year to year under the exemption is another-8- factor that may cause market stickiness as the number of permits available and the price of permits will change on an annual basis. Finally, to the extent that methyl bromide costs are perceived as small relative to other production inputs, some users may not find it necessary to spend the resources needed to research the information required to make profit maximizing decisions regarding the use of methyl bromide relative to substitutes. Under option 1, critical use methyl bromide may be universally available or available based on end use. In other words, if the U.S. receives an authorization for 9,000 metric tonnes (mt) to distribute universally, a tomato farmer may purchase an amount of methyl bromide and draw down the 9,000 mt supply. However, if the Parties authorize 9,000 mt for the U.S. but only allow 1,000 mt to be used on tomato production, then the farmers purchase their methyl bromide, they could draw down only the 1,000 mt supply. The tomato farmer’s decision to buy methyl bromide does not impact the remaining supply for other users such as the strawberry farmer next door under a sector specific scenario, hence the perception that such a system is more fair to the end user groups who applied to EPA for an exemption. Under option 2, the supply would function in an identical fashion. However, since users are given permits and since a permit would be required in order to buy methyl bromide, end users are actually given an item of intrinsic value. This way, the end user who doesn’t use methyl bromide is actually compensated because she can sell her permit to another entity that may need the methyl bromide more. This transfer allows end users to capture some surplus value that theoretically could be used to finance the transition to alternatives and would render moot concerns about universal vs. sector specific approaches. It is difficult to calculate the potential magnitude of these transfers, however, without having a basis to estimate the future price of a-9- permit. While option 2 is better than option one in compensating end users who give up their “rights” to methyl bromide, the drawback to option 2 is the additional complexity in both administering the system and in complying with the system. The EIA estimates that the administrative burden for the regulated community and EPA under options 1 and 2 as follows:

Table 2: Administrative Burden of Options 1 and 2 EPA Burden Industry Burden Option One $25 k (annual) $15 k (onetime) $2,200 k(annual) $86 k (onetime) Option Two $2,100 k (annual) $53 k (onetime) $6,400 k (annual) $2,000 k (o ne time) source: EIA pages 102 and 117 The burden estimated in the EIA for option one is $25,000 annually for EPA and $2.1 million annually for industry. The burden for option two is substantially higher at $2.2 million annually for EPA and $6.4 million for industry. EPA estimates that there are more than 2,000 end users of methyl bromide who have applied for an exemption. Most of the exemption requests were provided to EPA by groups of like users. In fact, no one knows exactly how many users of methyl bromide there are in the U.S. today, nor which exact entities actually applied; we only know the conditions for which an exemption was nominated and may be granted and used. In 2000, EPA met with representatives from industry about the CUE application and indicted a preference for farm level data. Other pesticide exemption programs run by EPA, notably the Section 18 emergency exemption program, only require sector or commodity level data. After extensive industry consultation, EPA ultimately decided to only require aggregate data due to the burden involved. Thus, EPA does not-10- have the basic information available to make individual entity level disbursements of permits. To collect and analyze such data for the number of entities involved would place a significant new burden on the regulated community. The extra burden of option two compared to option one is significant for the government as well. Under option two, the government would be directly regulating thousands more entities than under option one. The EPA would require additional data submissions from each of those entities and, once received, would begin the highly resource intensive, and undoubtedly controversial process of analyzing and determining a baseline for each entity. It would likely take two years to establish the baselines and resolve any appeals that would arise which would mean that end users would not have permits available to them in the first one to two years of the exemption program even if this were the proposed option. If the U.S. were to receive all of the exempted material requested under this exemption, EPA would distribute almost 10 million permits. To manage this many permits and to facilitate easy trading of these permits among end users, EPA would undoubtedly need to create a customized electronic permit tracking system, similar to the one used in the acid rain trading program. A system of this complexity would conservatively cost EPA approximately $500,000 and would require a dedicated FTE to manage. In contrast, the entire ozone protection program has one person that manages the reporting of all the chemicals we regulate, not one person for each exemption for each chemical. The Proposed Option After considering the above analysis, EPA developed a proposal that is a hybrid approach. This option maintains administrative simplicity but also allows for end users to capture some portion of the transfers.-11- EPA proposes in the accompanying rulemaking, to create a framework using option one as the basis for distributing allowances and creating reporting requirements. It is essentially an upstream system. However, it allows end users to reserve quantities of CUE methyl bromide and to sell their reservations to another approved critical user. This secondary market would allow end users to capture some of the surplus if they believed the revenues they could receive from selling their methyl bromide rights and producing their crop with an alternative ex ceeds the value of retaining the methyl bromide for production of their crop. Permits are used in environmental policy making to simulate a market. For example, permits are used in the acid rain program in order to create a value for a non-tangible waste product, sulfur dioxide. In the case of methyl bromide, however, there is already a well functioning market, making a permit system redundant so long as the regulation clearly articulates how end users could legally conduct such transactions. In relying on the market instead of on permits, the administrative burden for industry and EPA is substantially reduced because the most resource intensive activity for both the Agency and the end users, baseline determination, is

eliminated. EPA also ensures transparent compliance with Protocol obligations by proposing an upstream system. Since there are few regulated entities, it is easy to track on a quarterly basis whether or not the U.S. is under the Montreal Protocol cap. These entities are currently regulated by EPA in the same manner under the phaseout. They find this system straightforward with

minimal burden. EPA proposes to allow end users to make reservations for methyl bromide using an electronic reservation system (ERS). The ERS allows users to obtain and sell rights to critical use-12- material and allows EPA to track the use of critical use methyl bromide on a quarterly basis. The ERS is a simplified version of the permit tracking system that tracks the volume of exempted material available in the marketplace on a quarterly basis. The ERS is able to track amounts of methyl bromide used in a given commodity or end use and provides transparent information to end users about the amount of exempted material available for use in their sector. At the beginning of the year, EPA will populate the ERS with the total amount of exempted methyl bromide available for each sector. Then end users, or an entity working on their behalf such as a custom applicator, may reserve a quantity of methyl bromide in the system. The reservation will generate a self certification form which may be printed out, signed, and sent to the supplier. On a quarterly basis, the entity that entered the original reservation would have to close out the reservation by indicating if the reserved amount was used, cancelled, refunded, or available for sale on the secondary market. A similar system is already in pl ace for the management of Telone, a significant alternative to methyl bromide, in California. The proposed methyl bromide CUE system is different from the Telone tracking system because the proposed system does not require real time tracking and allows users more time to close out their reservations. Additionally, the proposed system allows end users to make reservations themselves without having to rely on a supplier to make a reservation for them, thus providing additional market power to those end users willing to accept quarterly tracking obligation. However, it allows end user to opt out of this obligation and instead rely on their supplier for such activities. One policy issue not addressed by the option proposed nor by options one and two is the issue of windfall profits or non-social cost transfers to producers and importers. A policy solution to address windfall profits would include an excise tax or an auction of permits to end users. In-13- addition, a system where permits are given to users downstream and then sold by the users to producers and importers to allow for the production or import of methyl bromide, would also impact windfall profits. The later framework option was recently suggested to EPA and EPA will seek comment on this option in the proposed rulemaking. EPA did not propose this option because of concerns raised by producers and users that the supply of methyl bromide must be created with minimal interference. Producers argue that they need a certain amount of time for their planning horizon to make production decisions. Under other parts of the phaseout program, the U.S. Treasury Department has statutory authority to implement an excise tax on specified ozone depleting substances (ODS). Such taxes prevent producers from amassing large stockpiles of ODS. They also reduce windfall profits since the price of the ODS to the end user was already high due to the tax thus minimizing a suppliers’ ability to further increase the price. The Treasury Department does not have statutory authority to tax methyl bromide. For more information on the history of taxing ozone depleting substances please see “Taxing Pollution” an article by J. Andrew Hoerner in WRI’s publication

Ozone Protection in the United States: Elements of Success

. It is unclear to EPA what the ultimate price of methyl bromide might be since we know relatively little about the demand elasticity for methyl bromide fumigation in the various end use categories. Unless a tax is set at a point that equals the difference between the baseline price and the maximum amount that users are willing to pay, the methyl bromide s uppliers would still be able to charge some incremental profit as a result of the scarcity created by the phaseout and subsequent regulations. In addition, some in the regulated community argue that the non-social cost transfer issue is not as significant as it might initially seem. They argue that EPA is eliminating their ability to derive a profit from methyl bromide in perpetuity and that temporary profits are compensation for the future loss. Further details regarding the de-regulatory benefits of the proposed critical use exemption-14- are discussions on the relative merits of the two main options are available in the attached EIA.