I think it is wrong to assume that the success of market-based cap and trade pollution control programs for sulfur dioxide (SO2) and nitrogen oxides (NOx) guarantees that market-based trading variations such as cap and dividend or a carbon price will work for carbon dioxide (CO2) reductions. This post describes the reasons why I think the results from RGGI show that success is unlikely and could end badly.
I think it is important to understand where I come from on this topic. You won’t find any papers by me in the literature and I have no background in economics. However, I have been involved with cap and trade programs since the start of the EPA Acid Rain Program in the early 1990’s. At the beginning I was responsible for compliance submittals to EPA in a traditional utility but as the electric generation business transitioned to de-regulation in New York my responsibilities grew to helping to develop trading program compliance strategies for affected sources across the country in a non-regulated generating company. From that time until the present I have evaluated numerous national, regional, and state-only trading programs for SO2, NOx, and CO2. As a result, I have a niche understanding of the information necessary to critique trading programs from the seldom heard background of affected source staff complying with the rules.
Since my retirement I have turned to blogging with an emphasis on a pragmatic approach to pollution control. My posts can be very technical because that was necessary to submit substantive comments to regulatory agencies. I regularly post on the Regional Greenhouse Gas Initiative and update the status of investment proceeds and allowance holdings regularly. The opinions expressed on this blog and in this post do not reflect the position of any of my previous employers or any other company I have been associated with, these comments are mine alone.
Cap and Trade
In a standard cap and trade program i a cap is established, allowances are allocated to sources based on historical operations, and affected sources are required to submit an allowance for every ton emitted. Sources are in compliance if their allowances are less than the cap established. As long as there are sources that can over-control cost-effectively below their cap limits and trade allowances so that sources that don’t have options to meet their limits, then overall costs are cheaper to meet the cap. The Environmental Protection Agency’s Acid Rain Program (ARP) is a standard cap and trade program and has been an unconditional success in my opinion. Annual SO2 emissions are down 92% since 1990 and annual NOx emissions are down 84% since 1990 at a much lower cost than expected at the beginning of the program.
Despite the success of the ARP there are caveats that should be considered. When the ARP cap was proposed it was assumed that sources would have to install control equipment to significantly reduce SO2 emissions. However, it turned out that fuel switching was a very effective option because power companies figured out how to burn low-sulfur coal and railroad de-regulation made it cost effective to ship low sulfur coal everywhere. My point is that the primary reason that the ARP was cheaper and produced greater reductions than expected had much more to do with the fuel switching to meet the cap than trading resulting from pollution control installation providing over-control and generating tradable allowances.
On the other hand, pollution control technology advancements have played a role in the reductions in NOx cap and trade programs. I feel more comfortable arguing that cap driven technological solutions contributed to the success for those programs than fuel switching. Importantly though, I believe trading on the open market is not a widespread compliance option. Rather than depending on the vagaries of the allowance market, power plant operators implemented control programs based on system-wide compliance across their facilities. The majority of trades necessary for compliance have been within operating systems and not on the open market.
There are some misconceptions about cap and trade programs within the environmental advocacy community. For example in a description of the cons of cap and trade this author states many of the emissions credits are just given away: “Sometimes these credits are just given away, creating no trade benefit at all. This means it costs a business nothing to expand their emissions and that can harm a local economy, which receives no economic gain in return.” However, because the cap is lower than the existing emissions even if a business expands their emissions others have to reduce their emissions so the cap is met. The perception that there is a give-away colors the opinion of traditional cap and trade opponents such as the author’s comment that giving them away creates “no economic gain in return”. Actually, the allowance credits only have economic value because they are a compliance obligation. That economic value has to be earned by a facility that invests in pollution control equipment to over-control their emissions. In doing so they earn the right to sell their excess and fund their investment.
Over time, the concept that the affected sources have received a “windfall” has led to program adjustments where regulators set aside allowances for sale and a variation on cap and trade where the allowances are sold at an auction. The Regional Greenhouse Gas Initiative (RGGI) is a prime example of cap and auction program. Note that these programs are commonly branded as “cap and dividend” programs where the money earned is a dividend to the public.
Cap and Auction
It is commonly accepted that RGGI cap and auction program has been successful. As shown in the RGGI Nine-State EPA CAMD Annual CO2 Emissions table the total emissions have decreased from over 127 million tons prior to the program to just under 75 million tons in 2018, for over a 40% decrease. However, as I have shown, when you evaluate emissions by the primary fuel type burned it is obvious that emissions reductions from coal and oil generating are the primary reason why the emissions decreased. Both coal and oil emissions have dropped over 80% since the baseline. Natural gas emissions increased but because of the inherent low emission rate overall emissions declined. I believe that the fuel switch from coal and oil to natural gas occurred because natural gas was the cheaper fuel and had very little to do with RGGI because the CO2 allowance cost adder to the plant’s operating costs was relatively small.
I think that there are fundamental differences with CO2 trading programs as compared to SO2 and NOx trading programs that make CO2 trading programs inherently suspect. Most importantly, there are no cost-effective add-on pollution control systems available to reduce CO2 emissions at existing sources so they have limited options to reduce emissions to meet the cap. For example, there is no evidence that any affected source in RGGI installed add-on controls to reduce their CO2 emissions. The only other substantive option at a power plant is to become more efficient and burn less fuel. However, because fuel costs are the biggest driver for operational costs that means efficiency projects to reduce fuel use means have always been considered by these sources. In other words, if it made financial sense it was implemented long before this program. Because the cost adder of the RGGI carbon price was relatively small I do not believe that it changed the business case at any affected source to install an efficiency project as part of its RGGI compliance strategy. Therefore, because affected sources in RGGI and, arguably any other CO2 cap and auction program, do not have any viable control options, they simply treat the cost of purchasing allowances at an auction as a tax.
Cap and trade programs have proven successful for SO2 and NOx. The primary reason that those programs have reduced emissions at lower costs as opposed to simply requiring every facility to meet a specified limit is that there were technology or fuel-switching options available to the owners and operators of the affected sources that allowed some facilities to over-control and trade with facilities that did not have cost-effective control options. Note however, that to date, SO2 and NOx trading programs have not constrained allowances beyond the control option capabilities. Future cap reductions will have to push this limit so I think future cap and trade reductions will not be as cost-effective as in the past.
There are ramifications to the success of the SO2 and NOx trading programs that have not been acknowledged by the regulators or advocates for stringent CO2 cap programs. If there are no control options then affected sources provide power as long as they have allowances to cover their emissions. While in an idealized world advocates may think that a fossil-fired plant operate would invest in carbon-free generation, I think the reality is different simply because the owners background, resources, and expertise is mostly inapplicable to fossil generation. Those owners simply treat the auction cost as a tax.
In the real world, there is another problem if the cap and auction program actually constrains emissions. Because RGGI is “successful” the latest program review reduced the number of allowances available in the future so we will conduct an experiment to see what happens. Because the allowances were sold in an open auction anyone can purchase them. There is a problem associated with the allowances purchased in the past and banked for future use (see posts here and here). At this time, non-compliance entities own the majority of the surplus or banked allowances that were sold in earlier auctions. When the number of allowances available in future auctions is reduced, the inevitable result will be that entities that have compliance obligations will necessarily have to buy allowances on the market with the non-compliance entity knowing that it is a seller’s market. Obviously, the price will increase markedly to the consumer’s disadvantage.
Finally, a constraining CO2 allowance program will cause the price of allowances and the ultimate cost of energy to consumers to go up in the best case, but in a worse case, allowances are unavailable and affected sources will simply not run. However, in the worst case the reliability of the electric grid could be endangered if enough affected sources are unable to run.
 In the interest of full disclosure, I should note that I own RGGI allowances that I purchased in an auction.