# **IV. (ii) Disturbance Term Structure and Alternative Specifications**

The regression model (31) is based on the assumption that units are price-takers in the allowance market. One potential concern is that the equilibrium allowance price could be endogenously determined by units that abuse market power. Emission price endogeneity may be particularly relevant in the first couple of years of the trading program when the market was not liquid enough and the price determination process might have involved significant interplay of supply and demand between only a few companies.

To test for the possibility of allowance prices endogeneity, I use the annual average natural gas wellhead price<sup>22</sup> as an instrument for the allowance price. Natural gas and coal are competing fuels for electricity generation. Fluctuations in natural gas prices have the potential to influence the market share of coal-fired generation, which is a major driving factor of allowance prices. However, since natural gas prices are generally determined by weather conditions (hot summer days, cold winter days), the prices of substituting fuel (oil and gasoline), and economic activities, may not be directly correlated with individual units’ emission rates. As robustness check, I dropped potential noisy observations for the early years (1996 and 1997) and compare the results of this reduced sample estimation with that of the full sample.

In addition to allowances price endogeneity, the endogeneity of low- and high-sulfur coal costs may arise as an issue if coal prices are determined by the demand for coal. A more likely situation is that because coal is a differentiated product in terms of both quality (sulfur content, Btu content, moisture content)<sup>23</sup> and location, coal suppliers (producers and carriers) may have great latitude in formulating prices, while electric generating units are price-takers in coal markets,. When pricing decisions are correlated with unobservable factors affecting a unit’s choice for coal and its emission performance, estimations ignoring this correlation would be biased.

Given the potential endogeneity of coal prices, following Ellerman and Montero (1998), I use the distance from a unit to the Power River Basin (PRB) in Wyoming and Montana as a proxy for the prices of the low-sulfur coal available to the units.<sup>24</sup> The rationale for using this variable is that PRB produces most of low-sulfur coal in the U.S. with the cheapest coal-mine prices, while transportation costs factor importantly into the delivered price of coal.<sup>25</sup> A unit’s location in relation to PRB coal will to some extent reflect the actual cost of low-sulfur coal or other competing coals. However, as Ellerman and Montero (1998) and Montero (1999) point out, the distance to the PRB coal does not affect low-sulfur coal price uniformly. In particular, lowsulfur coal from central Appalachia becomes more competitive for units 1000 miles away from Wyoming. To reflect this nonlinear relationship, I included a third degree polynomial to control for the distance. It is expected that low-sulfur coal price will first increase with the increase of

> 22 Wellhead price is the value at the mouth of the well. In general, the wellhead price is considered to be the sales price obtainable from a third party in an arm’s length transaction.

> 23 Some fuel contracts specify more than a dozen attributes of coal qualities.

> 24 Ideally, to control for the potential fuel price endogeneity, I would estimate hedonic price functions for fuel. However, it is not possible to identify all of the relevant fuel attributes that might be important in determining fuel prices, such as the fuel grandability, fuel size or the chemical content of the fuel.

> 25 In fact, for some western coal hauls, transportation costs account for up to 75% of delivered fuel costs. (EIA, 1995),

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