Contract-Based Trading Programs in Environmental Regulation

I. INTRODUCTION Emissions trading programs have been riding a wave of ascendancy in environmental policy since the Clean Air Act Amendments of 1990 created the Acid Rain Trading Program. This program has gone a long way to vindicate economists' claims of the superior allocative efficiency and transparency of emissions trading as a policy instrument that also meets the environmental quality goals that are so important politically to the environmental community (Hahn and Stavins, 1991). Efforts to reduce sulfur dioxide, nitrogen oxides, and mercury over the next 15 years in the United States will almost certainly be based on similar architecture. (1) The centrality of emissions trading in the Kyoto Protocol, together with the British and EU efforts to institute carbon trading programs to meet greenhouse gas reduction obligations, have also helped make emissions trading more widely known and popular as a centerpiece of new or newly strengthened environmental regulatory regimes. These programs have created or anticipate creating emissions trading markets. The commodity in these markets is the right to emit a substance that would otherwise be legally prevented. This commodity is undifferentiated and homogeneous, much like traditional commodities, such as corn and soybeans. Rights can be traded across time and space without contact between buyers and sellers and with very low transactions costs. These markets are efficient and appropriate, relative to other kinds of regulatory instruments, for the problems they are designed to help solve--greenhouse gas reduction, acid rain, and urban air pollution from power plants. There are a wide variety of environmental problems where the conditions necessary for a market like this are not present. This does not mean that emissions trading is not an appropriate policy instrument. Rather, it implies that contracts, rather than markets, have advantages as a way of thinking about emissions trading in some contexts. Trading takes place with many more limits than in a traditional commodity market. These programs will be referred to as contract-based trading programs (CTPs) herein. The author begins by distinguishing contract-based trading programs from the textbook cap-and-trade programs like the acid rain trading program. The article will then discuss the advantages of these programs, in spite of their less than perfect characteristics. After briefly cataloging the most important U.S. programs of this type, the author develops an expository model of the kinds of heterogeneity that drive CTPs and how this heterogeneity can be parameterized in trading programs. Resolving information problems about environmental damages and benefits will be essential for decreasing transactions costs and allowing more efficiency-enhancing trades. Trading systems also increase the value of accurate monitoring information. The article concludes by arguing that the combination of better regulatory information and innovative trading systems can further improve the efficiency and performance of environmental regulation. II. CONTRACT-BASED TRADING PROGRAMS Contract-based trading programs can be loosely defined as programs where the terms and the allowability of a transaction depend on the individual characteristics of the buyer, the seller, and their environmentally damaging (or improving) behavior. This is in contrast to the many buyers, many sellers model of markets in general and of cap-and-trade allowance systems. There is no sharp, unambiguous divide between cap-and-trade programs and CTPs; rather, there is a continuum between programs that are very close to textbook cap-and-trade programs and those where each transaction is entirely unique and idiosyncratic. The reason for emphasizing a distinction is that recognition that some programs have elements of contracts makes it clear that institutional design must explicitly consider the factors that make a pure market impractical. …