Abatement Cost Heterogeneity in Phase I Electric Utilities

I. INTRODUCTION Title IV of the Clean Air Act Amendments of 1990 established a system of tradable emission allowances as a market-based mechanism designed to reduce sulfur dioxide (S[O.sub.2]) emissions in the U.S. electric utility industry. Economists have traditionally supported such decentralized, property rights approaches to solving the problem of environmental externalities. (1) The attractiveness of market-oriented pollution reduction policies, such as emission allowances, lies in their ability to achieve a given level of pollution reduction at the lowest cost. In addition, such programs allow plants the flexibility to choose their own emission reduction strategies, spurring competition among the previously independent abatement technology industries, which leads to additional cost savings. The changes in deposition patterns since the S[O.sub.2] trading program began and the accompanying environmental impacts have been dramatic. The first phase of the program began in 1995 and affected 110 of the largest fossil fuel burning electric plants in the eastern and midwestern United States. Emission reductions from phase I plants occurred ahead of schedule, with environmental benefits observed in the eastern and northeastern United States. The General Accounting Office (2000) reports that wet sulfate deposition in three selected environmentally sensitive areas decreased by an average of 19% since 1995. While other factors, such as the increasing availability of inexpensive, low-sulfur Western coal, certainly contributed to these reductions in acid deposition, it is encouraging that they occurred simultaneously with the adoption of the Title IV provisions. Recently, spawned by the success of the Acid Rain Program, several legislative proposals have been designed to further reduce harmful emissions such as S[O.sub.2], nitrogen oxides (N[O.sub.x]), mercury, and carbon dioxide (C[O.sub.2]) from electric utilities. (2) The specific provisions of the proposals differ in various aspects, but they all advocate marketable permit-based systems as the preferable method of emission reduction. This study evaluates the performance of the first phase of the program concentrating on plant-level economic responses to the change in the institutional framework. Under a tradable allowance system, low marginal abatement cost plants reduce emissions below their initial allowance allocation and sell the resulting excess allowances, with the difference between the market price and their marginal abatement cost captured as gains from trade. Alternatively, low marginal abatement cost plants may opt to save current allowances for future use if marginal abatement costs, or market prices, are expected to rise due to increased regulatory stringency. Conversely, high marginal abatement cost plants find it economically advantageous to increase emissions beyond their initial allocation and supplement these allowances with open market purchases. These plants also capture gains from trade by purchasing allowances for prices below what they otherwise would have paid to reduce emissions. Absent binding regulatory constraints or uncertainty over future economic conditions and allowance allocations, an efficient plant will emit up to a point where its marginal abatement cost equals the market price of the allowance. Montgomery (1972) showed that voluntary allowance exchanges, via an efficient market, guarantee that the total cost of aggregate emission reduction is minimized. Any additional heterogeneity across marginal abatement costs indicates additional cost savings that have not been realized, and therefore potential gains from trade have not been exhausted. This article has three main objectives. First, we calculate plant-specific shadow prices for S[O.sub.2] emissions for a panel of affected plants during the Acid Rain Program's phase I period (1995-1999). These shadow prices measure the opportunity cost of pollution abatement and therefore provide an indirect calculation of marginal abatement costs. …