Aldyen Donnelly: Fiddling with Cap and Trade: The Acid Rain example

The conclusions outlined in this Toronto Sun article are completely wrong.

It says "The U.S. figure [17%] is derived strictly from cuts that can be achieved by capping greenhouse gases and trading emissions permits."

This is not true.

In fact, the 17% reduction derives strictly from the normal US capital stock turnover rate (40% of US power generation capacity has to be retooled or retired before 2020 on a business as usual basis) and the "additional measures"…"fuel efficiency rules for cars, renewable electricity standards and investments in "green" development in poor countries,".

In fact, the proposed US GHG quota allocation and trading rule adds no incremental reductions before 2030. In this way, the US federal cap and trade system is consistent with the California and Western Climate Initiative (WCI) cap and trade regime. EVERY US cap and trade system in history has relied ENTIRELY on the foundation of "mandatory measures" to achieve its emission reduction objectives. There is NEVER an incremental reduction associated with the quota allocation and trading rule.  

Given the mandatory measures, the quota allocation and trading rule is a mechanism that governments attempt to use to shift economic rents in a manner different from the shift that the market will reveal without intervention. The reliance of the California/WCI system on the additional or "mandatory" measures, and the limited incremental role of the quota allocation, is explained in detail in the attached analysis and decision written by California’s Public Utilities Commission and Air Resources Board.

What is not explained in this very enlightening memo is the regulators’ rational for endorsing cap and trade.

It is very, very important to note that in US history, no cap and trade regime ever generated emission reductions. Every emission quota allocation is laid on top of a foundation of regulations or "mandatory measures". Compliance with the mandatory measures achieves emission reductions. Then, the US Congress lays a GHG quota allocation on top of those measures.

Through the quota allocation, Congress attempts to redistribute economic rents according to Congress’s objectives, in effect interfering with the efficient market response to the mandatory measures and ensuring that the market operates less efficiently than it otherwise might. More importantly, Congress has never successfully achieved its agenda through the emission quota and trading rule.

In every historical example, a subset of regulated market incumbents has been able to use the quota rule to their benefit, at the expense of US consumers, new market entrants and innovators, in particular.

The US SO2 market is a case study that tells this story quite effectively.

How the US SO2 Allowance Allocation and Trading Rule Effects a Wealth Transfer Within the US

For example, under the US Acid Rain regulations, every US utility-owned SO2-emitting power generation unit was assigned at least two mandatory SO2 emission limits: (1) an intensity limit (SO2/MMBTU heat input) and (2) an absolute annual limit. The SO2 regulation obliged regulated unit operators to apply for "SO2 permits", and these two limits were incorporated in the new permits. Then there was an SO2 allowance (quota) allocation to plant owners.

No plant operator can legally exceed either of the two SO2 emission limits outlined in the unit’s SO2 permits no matter how many surplus SO2 allowances that operator might hold.

Between 1995 and 1999, the EPA issued free US SO2 allowances only to the 425 oldest (built before 1970) and highest-emitting electricity generation units in the US. Over that 4-year period, the free allocation of SO2 allowances to those 425 units exceeded those units’ maximum physical capacity to discharge SO2 (at 100% capacity utilization without scrubbing technology).

The total allowance supply set aside for these old units equated to an average of 2.5 lbs of SO2 per MM BTU of maximum heat input capacity per plant. To put that rate in context, US EPA New Source Performance Standards ensured that every power generation unit built in the US after January 1, 1970 was designed and built to discharge no more than 1.25 lbsSO2/MMBTU heat input. In 1977, the US New Source Performance Standard for power generation units was amended to 0.8lbsSO2/MMBTU heat input.  

In other words, all of these old SO2 program "Phase I" units could cut their SO2 emissions below 1.25 lbsSO2/MMBTU simply by installing 30 year-old scrubber technology.  In fact, over 70% of the "reductions" to date attributed to the SO2 allowance market arose from the installation of scrubbers—before the end of 1996—at the nine largest power generation units in the US.

Why did these old plant operators suddenly invest in scrubbers in the fist year of the US Acid Rain Program?  It is the consistent US tradition to rule that once/when a pollutant/discharge is regulated by the US EPA, affected plant owners can claim 100% depreciation, for tax purposes, on any capital expenditures related to the measurement, control or reduction of that pollutant. In US tax lingo this is called "expensing capital in the same year".

70% of the reductions that most analysts attribute to the introduction of the permit trading rule is actually industry’s practical response to the change in capital depreciation rate that is associated with any US emission regulation—whether or not it incorporates a market provision. Most of the academics and government agencies that report on the "success" of the US SO2 allowance market fail to acknowledge the capital depreciation provision or the fact that it is unrelated to the trading provisions to which they often, incorrectly, attribute 100% of SO2 reductions in the regulated pool of SO2 sources.

In 2000, the first year of Phase II of the Acid Rain Program, the EPA freely allocated SO2 allowances to all of the rest of the existing utility-owned US power generation units (over 5,000 units), where the free allocation equaled the units’ permitted emission levels.  The free SO2 allocation to all (Phase I and Phase II) units last for a 35 year term.  

Starting in 2000, the aggregate free allocation of SO2 allowances to the oldest 425 units fell to, on average, roughly 1.75 lbSO2/MMBTU heat input.  But when you add the excess allowances that were awarded to the oldest US generation units over 1995 through 1999 period to the continuing allowance allocation to those units, if those units hoard their allowances they could continue to discharge SO2 at 1996 levels through 2014.

But the regulation also says that starting in 2000, any developer of any new US power generation unit has to buy 100% of the allowances they need to cover their SO2 emissions from the marketplace. And any operator who has a free SO2 allowance allocation continues to receive their schedule allocation for 35 years, even if/after they shut down the power plant to which the allowances were first allocated.

So, even though the typical new US utility-owned power plant discharges SO2 at 10% the rate of the 425 oldest plants, its developer has to surrender SO2 allowances to the EPA covering 100% of its SO2 discharges, and the new plant operator gets no free SO2 allowance allocation. The old plant owner receives free SO2 allowances through 2035, even if he shuts down the plant.

In other words, most of the US SO2 emission cuts since 1990 derive directly from the 1-year straight-line capital depreciation rate that came into effect in the US simply because of the introduction of a (any) new SO2 regulation. The remaining SO2 reductions were driven by the two (this is important…two) SO2 limits—one intensity and one absolute—that were written into every covered source’s operating permits. No regulated source can exceed its permitted emission limits, no matter how many SO2 allowances the source owner might have banked.

The full and intended effect of the SO2 allowance allocation is that developers of new, clean power generation capacity have to compensate owners for shutting down the oldest US power generation units through their SO2 allowance purchases. The free allocation of SO2 allowances to old plant owners was guaranteed for at least 35 years (50 years in some cases), even if the plant ceases operating, to ensure that compensation for the plant shut downs is earned for terms of at least that length.

Wash-Trading Dominates Existing Emission Allowances Markets

The unintended effect of the US SO2 allowance allocation and trading rule is that there are effectively no new entrants in the US electricity market, and there has been no productivity increase in the US electricity sector for the last 20 years.

Owners of the oldest power generation units earn higher returns to their other assets by shutting down plants and hoarding allowances. These operators do "lease" allowances for terms of 1 to 3 years to select new market entrants, who cannot operate without access to allowances. The allowance "leases" are constructed with swap agreements. After leasing operating rights from market incumbents for a number of years most new market entrants find they have little choice but to sell their new assets to an incumbent allowance holder.

Between 1995 and the end of 2002, 97% of SO2 allowance "transactions" reported by the US EPA to be trades between economically unrelated parties were "swaps". The allowance prices reported by the EPA over that period were largely imputed prices.  Relatively small fees were paid on swap agreements, which fees reflect the real cost of an allowance "lease".

Over 80% of the reported "trades" in the EU CO2 allowance market to date are also swaps/allowance leases. This explains why it is ALWAYS the case that reported prices for future vintage CO2 allowances are a relatively constant increment (roughly 4% to 5%) higher than market prices for current vintage allowances, on every CO2 exchange—even when it is evident that short and long term market prices are declining.

For most transactions, the only cash changing hands is the difference between the nearest future market price and the reported spot market price (the one-year lease rate).

The US Acid Rain Program: Really a Market Success Story?

There appears to be a global consensus that the US SO2 market rule is a major environmental success story. The US Government Accounting Office (GAO) has found it an efficient regulatory strategy because: (1) regulated sources consistently under-utilize their allowance allocations and (2) the "market price" of US SO2 allowances is lower than economists had estimated it would be before the regulation was implemented.

But, as outlined above, older plant owners are highly motivated to shut down their plants and hoard SO2 allowances. The allowance trading scheme enables these market incumbents to drive up the price of US electricity while they block new market entrants.  Apparent "under-utilization" of the originally excessive allowance supply is inevitable under these circumstances.

It is true that the apparent price of SO2 allowances is less than the marginal cost of control. But most years at least 5 newer plant operators fail to comply with their allowance holding mandates, because they are unable to buy (as opposed to "lease") their full SO2 allowance requirement. The fine for an SO2 allowance shortfall is $2,000 per allowance of shortfall plus 1.30 x the shortfall in additional allowances the following year. This tells us that the real market price for allowances exceeds $2,000 per tonne, at least in the years that certain operators are unable to secure their full allowance requirements.

And while academics and the GAO interpret the apparently low market price of allowances as a market "success", actual power generation unit operators who are not among the incumbents who have secured increased market power do not express the same view. The actual marginal continuing cost (operating costs plus capital cost recovery) of cutting SO2 emissions in the US is over $500/TSO2 (with 1-year straight-line depreciation for tax-paying entities) and up to $1,200/TSO2 (for entities that are not profit-earning and cannot take advantage of the capital depreciation benefit).

The current reported (apparent) market price for SO2 allowances is essentially meaningless. If you track SO2 allowance futures and spot market trades on the NYMEX, you will see 0 volume all of this week and most weeks.

Contrary to my statements above, the price imputed to US SO2 allowance futures is lower than the price imputed to current transactions. This has been true since 2005, when the US EPA introduced a rule that effectively cut the value of all allowances in half starting in 2010 and wipes this derivative out as a compliance unit by 2020.  The EPA took this action to try to un-wrestle market control from incumbents, but so far the EPA’s intervention has failed.  It was struck down by the US Supreme Court in 2008.

In the late 1970s, all members of the OECD pledged to cut national SO2 emissions 50% from 1980 levels by 2000.  When all is said and done, how did the US rank in terms of performance relative to this SO2 reduction pledge?

Second worst among developed OECD nations. Canada ranked worst.  

How did the world come to believe that such a failure of an emission management regime is the most effective emission management tool the world has ever seen?

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