[Economic Report of the President (2000)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 7
Making Markets Work for the Environment





In 1900, one of the most common environmental problems confronting
cities was the accumulation of horse manure on streets, giving offense
to sight and smell and posing a public health hazard. Although the
automobile eventually solved this problem, it caused others. Economic
growth, structural change, and technological change over the past
century gave rise to new environmental problems but also provided
the income and know-how needed to address them. Innovative efforts
to remedy these problems through market-based incentives help
achieve environmental goals cost-effectively and provide lessons
to guide efforts to solve the world's potentially most significant
environmental challenge in the 21st century: global climate change.


Economic growth brings abundant benefits but can also unleash a wide
array of environmental problems. Some, like water pollution, air
pollution, and soil contamination, are by now long-familiar
afflictions; others, like changes in the earth's atmosphere and
climate, are of more recent onset. All must be dealt with, or else
the very foundation of growth is threatened. Fortunately the same
economic growth, structural change, and technological change that
gave rise to these problems also provide the income and the know-how
needed to address them. An economy that is healthy and thriving is
better able to combat environmental ills. The challenge in addressing
environmental problems lies in harnessing and channeling the power
of markets, so that they both deliver continued economic growth and
foster sound environmental practices.
The past century of experience in addressing environmental pollution
illustrates that environmental goals must and can be achieved cost-
effectively. Innovative efforts to address environmental problems
through market-based incentives--such as emissions permit trading and
emissions charges--can, when designed appropriately and applied in
the appropriate context, achieve these goals at lower cost than other
approaches. Poorly designed environmental markets and regulatory
schemes, on the other hand, can squander valuable resources in the
pursuit of environmental goals. Importantly, lessons learned in
one environmental initiative can often be applied to others. In
particular, the lessons already learned from addressing pollution
in its various local manifestations can guide efforts to solve the
world's potentially most significant environmental challenge in
the 21st century: global climate change. The global nature of the
problem illustrates the need to provide innovative incentives to
global markets to address the potential damages.



Environmental Problems Since 1900

The nature of environmental pollution has changed during the past
100 years, reflecting, in large part, technological change and the
changing structure of the economy. As fresh innovations allow firms
and industries to reallocate their resources to more productive uses,
the by-products of their production processes also change.



A Brief History of Environmental Problems

In 1900, one of the most common environmental problems confronting
cities was the waste associated with the primary means of
transportation, the horse. People traveling short distances usually
rode either on horseback or in horse-drawn carriages. In densely
populated cities, horse manure covered many streets, not only giving
offense to sight and smell but also posing a public health hazard.
The automobile eventually solved this problem but brought new ones
in its wake.
As the century progressed, new environmental problems caught the
public's attention. Before the introduction of filtration in 1889
and chlorination in 1908, outbreaks of typhoid fever from drinking
contaminated water were common. Investments in new treatment
technologies addressed this concern, and by 1958, 83 percent of the
U.S. population had access to filtered or disinfected drinking water.
The dust bowl phenomenon of the 1930s illustrated the potential
for agriculture to result in serious soil erosion, as the wind
carried away significant amounts of topsoil.
After World War II, faster growth and structural change led to a
variety of new environmental problems. The Donora, Pennsylvania,
``killer smog'' of 1948 that took 20 lives demonstrated the
seriousness of the public health threat posed by air pollution.
The agrochemical revolution greatly increased agricultural yields,
but the roughly threefold increase in pesticide tonnage between
1964 and 1982 also raised concerns about the effects of these
chemicals on the environment and on human and animal health. One
of these was the impact of the pesticide DDT on the bald eagle,
as detailed in Rachel Carson's 1962 book Silent Spring. A burning
river in Cleveland and air pollution so thick that cars drove with
headlights on during the day made manifest the growing water and
air quality problems of the 1960s.
Growing attention to many of these problems culminated in Earth Day
in 1970. That event helped spur the series of groundbreaking
environmental laws of the 1970s, such as the Clean Air Act, the
Clean Water Act, the Endangered Species Act, the Safe Drinking Water
Act, and the Resource Conservation and Recovery Act. In the late
1970s, incidents at Love Canal, New York, and elsewhere revealed
concerns about the use and disposal of toxic and hazardous
substances. The Environmental Protection Agency (EPA) currently
has more than 1,200 Superfund sites--areas designated as most
contaminated with hazardous wastes--on its national priority list
for cleanup and remediation. The hole in the atmosphere's ozone
layer that appears each spring over Antarctica, first detected
during the 1980s, demonstrates the destructive effect of
chlorofluorocarbons on this fragile but critical structure. In
the 1990s the scientific community concluded that the balance
of scientific evidence suggested that emissions of greenhouse
gases from human activity have a discernible influence on the
global climate.



Environmental Pollution and Development

This sampler of environmental problems in the United States over
the past 100 years mirrors the path of the Nation's economic
development. For example, early in the century as the economy
developed, emissions of sulfur dioxide (SO2) and nitrogen oxides
(NOX) increased at a faster rate than economic growth. However,
in the 1920s and 1930s, emissions relative to gross national
product (GNP) began to fall for both of these air pollutants.
In 1997 the U.S. economy was only one-third as NOX-intensive as
it had been in 1900 (that is, 1997 NOX emissions per unit of
output were one-third the level of 1900 emissions) and only
one-tenth as SO2-intensive as in 1900 (Chart 7-1). Although these
trends may have reflected significant changes in the economy and
more effective emissions control since the 1970s, current levels
of NOX and SO2 emissions still present public health risks in the
United States. Much the same has happened with carbon dioxide
(Chart 7-2). The continuing transition of the U.S. economy away
from traditional energy-intensive industries has reduced





carbon dioxide emissions per unit of GNP (Box 7-1). Advances in energy
technology and changes in primary energy sources may have contributed
to this improvement.

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Box 7-1. Structural Economic Change and Carbon Dioxide Emissions

Historically, U.S. carbon dioxide (CO2) emissions from energy use have
grown about 2/3 percent for every 1 percent increase in real gross
domestic product (GDP). In general, a variety of factors besides
growth in aggregate output can affect CO2 emissions.
Structural change. The U.S. economy continues to experience a shift
of its output composition away from traditionally energy-intensive
manufacturing sectors.
Weather. Cold winters increase the demand for heating fuels, and hot
summers increase the demand for electricity for cooling. Because
heating on a cold day is more energy-intensive than cooling on a
hot day, on balance a warmer year tends to reduce energy use.
Energy prices. Sharp energy price increases can stimulate energy
efficiency and reduce CO2 emissions, whereas energy price decreases
can result in higher energy consumption and higher CO2 emissions.
Technological change. Technological improvements can reduce the
consumption of energy necessary to generate a unit of output. Higher
energy prices can accelerate the diffusion of more energy-efficient
technologies, as can government programs aimed at promoting energy
efficiency.
In 1998, U.S. CO2 emissions from energy use grew 0.4 percent, while
output in non-high-technology industries grew just 2.3 percent--
less than the 4.3 percent increase in aggregate GDP and less than
the long-term trend rate of growth of 3.1 percent per year for this
group of industries. This slow emissions growth probably reflected
not only the long-term shift toward high technology and services in
the economy but also weakness in several energy-intensive industries,
such as chemicals and primary metals. Weather, too, played a role
in moderating energy use. The winter months of 1998 were 8 percent
warmer than the same months in the previous year. The summer of
1998 was also warmer than the previous year's, but the increase in
emissions from more summer cooling was less than the reduction in
emissions from less winter heating. Finally, electricity prices
changed little, and fossil fuel prices actually fell, between
1997 and 1998.
A statistical model of how structural change, weather conditions,
and energy prices influenced U.S. CO2 emissions over the 1962-98
period found that these emissions track non-high-technology output
very closely. After accounting for non-high-technology output,
weather,

Box 7-1.--continued
and energy prices, the level of 1998 emissions predicted by the
model was very close to (0.5 percent less than) actual 1998
emissions. This suggests that short-term technological change
independent of these factors was not an important determinant
of the 1998 emissions. As the high-technology component of the
economy continues to grow as a share of the total, CO2 emissions
growth should slow further. This would maintain the long-term trend
since the 1920s toward a less CO2-intensive economy (Chart 7-2). As
of 1996, for example, the economy was only about one-third as CO2-
intensive as the economy of 1900, possibly reflecting both increased
diversity of fuels and change in the composition of GDP. Although
it is less CO2-intensive, growth in U.S. economic output over this
century has resulted in a substantial increase in CO2 emissions.
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Many of the same problems are evident today in countries at various
earlier stages of their economic development than the United States.
The challenge for these countries is to pursue a ``cleaner''
development path. As they continue to develop and become wealthier,
they will have the opportunity to benefit from the experience of
the United States and other rich countries in addressing the
environmental risks that economic activity generates. In some cases
the United States was reactive to environmental problems in the
past, because the scientific understanding of various environmental
risks, as well as the technologies and policies to address them,
lagged the need. Further, the United States lacks a coherent
framework for accounting for environmental quality and natural
resource use in tandem with market economic activity. A recent
National Research Council report, for example, calls for a supplement
to the national income and product accounts that would include
assets and production activities associated with natural resources
and the environment. This information, combined with traditional
measures of economic welfare such as gross domestic product, can
provide a more complete picture of this Nation's economic
development (Box 7-2).
In contrast to the U.S. experience, those technologies and policies
are there to be adopted almost off the shelf, and that means
developing countries can be proactive, instituting appropriate
policies to focus their development along a path that accounts for
the costs of pollution. Appropriate policies may allow developing
countries to leapfrog the more developed ones in environmental
technology, in the way that some already have in communications
technology. Just as some countries have adopted fully digitized
wireless phone systems without first having built extensive
traditional wired systems, so developing countries can effectively
skip a generation of more pollution-intensive technologies and


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Box 7-2. Taking Account of the Environment

A National Research Council (NRC) report released in July 1999
concluded that extending the U.S. national income and product
accounts (NIPAs) to include assets and production activities
associated with natural resources and the environment is an
essential investment for the Nation. The report argues that it
would be even more valuable to develop a comprehensive set of
environmental and other nonmarket accounts, although not at the
expense of maintaining and improving the current core national
accounts.
The NIPAs were designed to measure production and income that
arise primarily from the market economy. However, much economic
activity takes place outside the market economy. Thus, by omitting
important activities such as nonmarket work, environmental services,
and investment in human capital, the NIPAs provide an incomplete
and potentially misleading picture. Recognizing this, private
scholars and governments have begun to develop methods of extending
the national accounts to measure as much economic activity as is
feasible, whether that activity takes place inside or outside
marketplace boundaries. In the United States, the Bureau of Economic
Analysis (BEA) began intensive work on environmental accounting in
1992, but it was directed by the Congress in 1994 to suspend further
work and seek an external review of environmental accounting. The
NRC report represents that review.
The NRC panel argues that environmental and natural resource
accounts would provide useful data on resource trends and help
governments, businesses, and individuals better plan their economic
activities and investments. These accounts would provide valuable
information on the interaction between the environment and the
economy; they would help in determining whether the Nation is using
its stocks of natural resources and environmental assets in a
sustainable manner; and they would provide information on the
implications of different regulations, taxes, and consumption
patterns.
The NRC panel supports developing a broad set of accounts that
would parallel each of several asset types. These include subsoil
mineral assets such as fossil fuels and metals; renewable and other
natural resources such as forests, agricultural resources, and
fisheries; and environmental assets such as clean air and water.
It is acknowledged that the last category poses considerably greater
conceptual and data challenges than the first two. To preserve the
integrity of the well-developed core income and product accounts,
the NRC panel supports the BEA's preference for developing natural
resource and environmental accounts as satellite or supplemental
accounts. Satellite accounts serve the basic purpose of the national
accounts in

Box 7-2.--continued
providing useful information. In addition, and in light of the
current state of knowledge and preliminary nature of the data and
methodologies involved, developing satellite accounts allows
experimentation and encourages the testing of a wide variety of
approaches.
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adopt less polluting technologies from the start. Because knowledge
and technology developed in one country can diffuse itself
worldwide, economic development does not have to result in the same
stream of environmental problems that the United States and other
industrial countries have suffered since 1900.



Designing Policies to Address Environmental Pollution

Private markets by themselves usually do not provide the needed
incentive for producers and consumers to take into account the costs
of the environmental pollution they impose on others. For example,
a pulp-and-paper mill will aim to minimize all the inputs it must
buy in the market, such as labor and capital, in the production of
a unit of fiber product. But if it is unregulated, the mill has no
economic incentive to minimize its water pollution, because it does
not have to pay for the damage that its pollution causes. Absent
appropriate policies that provide an incentive for producers to
account for pollution costs, economic activity produces too much
pollution. Lacking this incentive, the mill also lacks the incentive
to invest in research and development (R&D) into pollution-reducing
technologies. Well-designed policies that create such an incentive
in private markets could make society better off. Of course, an
excessively stringent policy might impose a high cost on society,
with little benefit at the margin. The costs of eliminating all
pollution, for example, could be so exorbitant that society would
suffer from having to forgo using those resources on other valuable
endeavors, such as education, health care, or product R&D. The task
that falls on policymakers, then, is twofold: they must first set
acceptable levels of pollution, and they must then select and use
policy instruments that will achieve these levels efficiently.
Economists have long argued that environmental goals should be set
so that the benefit from the last unit of pollution abatement is
equal to the cost of abating that last unit of pollution. However,
environmental goals in practice do not usually reflect such an
explicit weighting of benefits and costs. Consequently, some
environmental policies may have gone too far, imposing costs of
pollution reduction that exceeded the benefits and making society
worse off. Other policies may have not gone far enough, lowering
pollution only to a level where the benefits of more reduction
would have still exceeded the costs. In some cases, benefit-cost
analysis is legally obstructed from guiding environmental policy,
because environmental law prevents regulatory agencies from even
considering the costs of reaching the goal. The Clean Air Act of
1970, for example, mandates that air quality standards be set ``to
protect public health'' with an ``adequate margin of safety,'' and
the courts have ruled that the EPA Administrator cannot consider
the costs of achieving a clean air standard when setting that standard.



Traditional Regulatory Approaches to Address Environmental Pollution

Marked improvements in environmental quality have occurred over the
past century, and especially since 1970. These are due in large part
to technological innovations that have allowed industrial, energy,
and transportation activities to continue while significantly
reducing their impact on the environment. Although these gains are
important, the means of achieving them have often included inflexible
mandates that prescribe specific technologies and result in higher
costs than may have been necessary. As the costs of addressing
pollution (which the EPA estimated at $125 billion a year in 1990)
have increased over the past three decades, attention has come to
focus more on the means of achieving environmental goals.
Traditional regulations focused on setting technology and performance
standards for pollution sources. (Technology standards mandate
specific equipment that sources must use to control emissions.
Performance standards, in contrast, mandate a limit on emissions
allowed by each source but allow the source to choose how best to
comply with the limit.) However, since technology standards mandate
the same technologies across all sources, and performance requirements
mandate the same level of emissions reductions or emissions rates
across sources regardless of any heterogeneity in costs across
sources, traditional regulation may not necessarily result in cost-
effective attainment of the environmental standard in all areas. Only
approaches that focus on eliciting emissions abatement from those
activities with the lowest marginal cost of abatement will result
in cost-effective attainment of an environmental standard.



Incentive-Based Approaches to Address Environmental Pollution

Two incentive-based approaches to environmental regulation, tradable
permit systems and emissions charges, have the potential to save
substantial resources in achieving environmental goals, because
they promote the cost-effective attainment of emissions reductions.
Tradable permit systems apply an aggregate emissions cap or quota
to a set of emissions sources. The government then allocates among
these sources a number of emissions permits that equals the cap or
quota. Allocation may be by auction, or on the basis of the sources'
historic emissions or desired performance levels, or by some other
approach. Each source must hold enough permits to cover the level
of emissions it chooses. Sources can buy and sell permits from each
other, and in a well-functioning market an equilibrium permit price
will evolve that reflects the value of an additional permit to all
sources. Each firm managing a source then faces the same trade-off:
it can either cut back emissions by one more unit or buy one more
permit. Naturally, firms will cut back on emissions if it is cheaper
to do so. The outcome will be that each firm equates its marginal
abatement costs to the permit price. And because all sources face
the same permit price, marginal abatement costs will be equalized
across all sources. This minimizes the costs associated with achieving
a given goal. (Box 7-3 provides an illustration.)
The emissions charge approach requires that each emissions source pay
a charge based on its level of emissions. Sources will reduce their
emissions until the cost of reducing another unit of emissions is
greater than the charge. Just as in the case of tradable permits,
the marginal cost of abatement is uniform across sources.
Besides promoting cost-effective emissions reduction, tradable
permits and charges can promote technological innovation by
stimulating R&D investment in a wider range of abatement
technologies and processes. When this happens, emissions reductions
may ultimately exceed those sought under either technology or
performance standards. Under regimes using tradable permits or
charges, each firm has the incentive to develop technologies and
production processes that reduce emissions regardless of the firm's
current emissions level. If, in a tradable permit system, a firm
reduces emissions below what its permits allow, it can sell the
unused permits to other firms; similarly under a charge system, a
firm that reduces emissions pays a lower charge. Under a technology
standard, two conditions must be satisfied for a firm to have an
incentive to invest in R&D for new, cheaper abatement technologies:
it must believe that the cheaper technologies can achieve the same
level of emissions performance as existing technologies, and it must
win regulatory approval to use the cheaper technologies. Under a
performance

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Box 7-3. Emissions Trading: An Illustrative Example

Consider a hypothetical example of two neighboring power plants that
emit sulfur dioxide. Suppose that both plants emit 100 units of SO2
each year, so total emissions are 200 units, and a regulatory agency
has set an emissions target of 140 units per year for these two
sources. Under a traditional approach, the regulatory agency could
mandate a known technology (for example, an SO2 scrubber) that
would reduce both plants' emissions to 70 units each. Each plant
would need to eliminate 30 units of emissions. Assume that it will
cost Utility A $600 to reduce the 30th unit of emissions, and
$9,000 to reduce all 30 units of emissions, and that it will cost
Utility B $300 to reduce its 30th unit, and $4,500 to reduce all
30 units. The total cost for both plants of reducing emissions to
140 units per year is thus $13,500.
However, since the costs of reducing emissions vary significantly
between these two plants, a market-based approach can achieve
substantial cost savings. If these two plants can engage in emissions
trading, they may find it economic for Utility B, with lower
emissions abatement costs, to reduce its emissions level below 70
units per year, allowing Utility A to emit more than 70 units per
year. Utility B finds that it can reduce its emissions down to 60
units per year, at which point the 40th unit of abatement costs
$400, and the total cost of reducing all 40 units is $8,000. Utility
A can reduce emissions down to a level of 80 units per year, at
which point the 20th unit of abatement also costs $400, and the
total cost to reduce all 20 units of emissions is $4,000. Utility
A would save resources by purchasing tradable permits for 10 units
of emissions at $400 a unit from Utility B, because this is less
than it would pay if it had to undertake emissions reductions to
achieve the 70-unit emissions level. Utility B would earn money by
selling 10 tradable permits at $400 a unit, because this is more
than what it costs to reduce emissions. With the sale, the total
costs for Utility A are $8,000: $4,000 for emissions abatement and
$4,000 for purchasing 10 permits. Total costs for Utility B are
$4,000: $8,000 for emissions abatement minus $4,000 from the permit
sale. The compliance cost for both facilities with trading would be
$12,000, or 11 percent below the cost with the mandated technology
standard ($13,500).
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standard, a firm does have the incentive to find a lower
cost way of reducing emissions, but only up to the level of the
standard. Some performance standards are so strict that current
technologies cannot achieve them. These ``technology-forcing''
performance standards, when set several years into the future,
may induce innovation. However, innovative activity is risky:
investments in R&D may or may not pay off in new discoveries.
If they do not, compliance costs may fall by less than anticipated,
and the ambitious environmental goal may prove extremely costly
to meet.
These incentive-based approaches also provide an opportunity for
the government to raise revenue, either through the auctioning of
tradable permits or through the system of charges. Such revenue can
be used to reduce existing taxes, thereby delivering additional
economic benefits relative to a traditional regulatory approach
(Box 7-4).



Important Issues in Designing Incentive-Based Instruments

Environmental problems come in various forms, some of which may be
better addressed through emissions trading, others through charges,
and still others through other means. By tailoring policy instruments
to the characteristics of a given type of environmental pollution
and its sources, policymakers can implement policies at lower cost
than with traditional approaches.



Uncertainty About Costs and Benefits

The tradable permit approach imposes a fixed quantity restriction
on a given type of pollution in the aggregate, whereas a charge
approach imposes a specified price on pollution. In a world with
perfect information and certainty, these two instruments would have
identical effects on emissions abatement and cost. An omniscient
regulatory authority could set a charge knowing it would deliver a
certain level of emissions, or it could set the quantity of tradable
permits in the knowledge that it would deliver a certain price of
emissions abatement. In the real world, however, uncertainties
about costs and benefits can influence which approach is preferred.
For example, if there are paramount concerns about the environmental
effects of a control policy, a tradable permit approach may be
preferred. This could be the case where a small increase in the
level of emissions could result in a large decrease in benefits. On
the other hand, if the costs of achieving a given emissions level
are highly uncertain, the charge approach may be preferred. This
could be the case where estimated abatement costs for a given level
of emissions lie in a wide range. If there are concerns about both
costs and benefits, a hybrid approach could allow for sources to
engage in a tradable permit system but place a ceiling on the
permit price (for example, a price at which the government would
sell additional permits), to ensure against exorbitant compliance
costs that exceed the marginal benefits.


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Box 7-4. Should Regulators Allocate or Sell Tradable Permits?

The Administration has proposed a domestic greenhouse gas tradable
permit program for 2008-12. Implementing a tradable permit program
would require industries covered by the program to restrict their
greenhouse gas emissions to comply with the Kyoto Protocol emissions
target. Abating greenhouse gas emissions involves costs associated
with investing in new technologies, fuel switching, and other means
of reducing emissions. As the energy sector becomes more competitive
over the next decade, the costs of controlling emissions will be
reflected in consumer prices. For example, the Administration's
economic analysis of the Kyoto Protocol found that a tradable permit
price of $23 per ton of carbon equivalent would increase energy
prices to consumers by about 5 percent in 2010.
A key question in implementing a tradable permit system is the
distribution of permits. For example, the government can allocate
(give away) permits to firms, or it can sell permits to firms through
auctions. So long as the tradable permit market is efficient, the
price of energy to consumers is likely to be the same in either
case. Permits will be scarce, and the price of energy will reflect
the cost of buying a permit or taking abatement measures regardless
of how the permits were originally distributed. Producers who receive
free permits will be like owners of particularly low cost oil wells
when oil prices go up: they will sell at the market price and reap
windfall profits. In contrast, an auction allows the government to
capture the value of the permits, because competition should lead
companies to bid away almost the full value of any potential
windfall profits from owning the permits.
Allocating permits to firms would result in handing over assets
valued in the tens to hundreds of billions of dollars annually.
Because these firms can pass on most of the cost of reducing
emissions to consumers, allocating permits would provide these firms
with significant windfall profits and allow them to enjoy higher
profits under climate policy than without climate policy. On the
other hand, if the government sells permits, it will receive
revenue in the tens to hundreds of billions of dollars annually.
Although energy firms would make lower profits under an auction
system, the permit revenue could, for example, be recycled back
into the economy through tax cuts. Recent research has found that
such revenue recycling could reduce the costs to society resulting
from the use of greenhouse gas permits by up to about 80 percent.
Allocating permits to energy industries would significantly increase
the value of their equity, whereas selling permits would lower it. An
alternative is to follow a hybrid approach that combines elements of
both allocating and auctioning. Recent research has estimated that
allocating

Box 7-4.--continued
roughly 5 to 15 percent of the permits to energy firms while auctioning
the rest would be sufficient to ensure that these firms' average
equity values would be unchanged, all else equal. Furthermore, since
most of the permits would be auctioned, such an approach would still
provide significant revenue to the government.



Heterogeneity in Abatement Benefits

The environmental effects of a unit of pollution may vary across
sources. For example, rural Montana is in attainment with the national
standard for ozone, so the NOX emissions that contribute to ozone
concentrations may not have any significant human health effects.
However, Los Angeles is not in attainment with the standard, so
NOX emissions there contribute to ozone concentrations that do cause
human health problems. Further, with prevailing wind patterns, NOX
emissions from Montana are not expected to carry to Southern
California and contribute to ozone concentration in Los Angeles.
Thus a one-for-one emissions trade between a source in Montana and
a source in Los Angeles would not be appropriate, and a more complex
system that takes account of different environmental effects of
emissions in these two areas would have to be designed. The key
attribute of an environmental problem, then, that facilitates effective
trading is sufficient mixing of emissions prior to human exposure.
For example, if two sources near each other emit NOX, and their
emissions mix well in the local airshed, the environmental effects
of a unit of emissions by either source can be considered roughly
the same. The benefits of emissions abatement will then be roughly
the same regardless of which source undertakes the abatement. In
this case a simple permit trading program would be appropriate,
because it would deliver environmental outcomes comparable to those
from a traditional regulatory approach.
Variability in abatement benefits among sources could result in a
permit trading program creating ``hot spots,'' or local areas where
emissions concentrate to the detriment of public health and the
environment. As trading of emissions permits proceeds, a set of
neighboring emissions sources might purchase a substantial number of
permits and maintain high levels of emissions. Locally high
concentrations may not matter for some environmental pollutants, such
as carbon dioxide, because of the global nature of greenhouse gas
accumulation and mixing. However, some hazardous air pollutants, such
as benzene, do have local effects, and the potential for a hot spot
could arise with a tradable permit system for such emissions.



Heterogeneity in Abatement Costs

If the cost of abating emissions varies substantially across
sources, the potential for cost savings through a trading program is
great. It would be profitable for a firm with a high cost of
reducing emissions to make a trade with a firm with a low cost,
at a price somewhere between the two costs. Large discrepancies
in abatement costs--which may relate to differences in the age of
facilities, in previous investments in pollution control
technologies, in fuel inputs, or in other respects--provide the
economic incentive for a high volume of trade and can facilitate
the development of an emissions market. However, if the costs of
reducing pollution are similar across sources, a tradable permit
system might not deliver substantial cost savings. The transactions
costs of participating in trading (for example, from having to seek
out another firm with which to trade) may overwhelm the cost
savings associated with the trade if the two firms have similar
abatement costs, and this may reduce the incentive to trade. In
such a situation, a charge or other type of regulation may be more
appropriate than trading.



Scope of the Emissions Trading Market

The size of a potential emissions market can significantly affect
the volume and cost savings of a tradable permit system. A market
with a small number of emissions sources may experience low trading
volumes and inefficient, monopoly-like behavior--a robust market may
never evolve. A larger set of participants can promote a more active,
efficient market.
Several factors can influence the number of participants in a
tradable permit market. First, the monitoring of emissions sources can
significantly influence which sources participate and which do not.
If their cost of monitoring emissions exceeds the gains from trading,
small firms will have no incentive to join the trading program and
will likely prefer a traditional regulatory approach. Continued
technological development in monitoring equipment may help reduce
the costs of monitoring and allow for markets to expand to more
sources. However, inability to effectively monitor some sources may
make it more difficult to design well-functioning tradable permit
systems and emissions charges.
Second, additional scientific research on the human health effects
of various types of emissions can influence the size of a market. By
taking advantage of similarities in the effects of different
pollutants, tradable permit markets can be structured to allow for
trading across pollutants. For example, because both NOX and
volatile organic compounds contribute to the formation of ozone,
the potential is there to allow for trading across these gases.
However, some of these compounds may also be carcinogenic, so a
system of multipollutant trading should also recognize that a given
pollutant might have multiple health effects.
Third, the extent of participation in a permit market may also
depend on the technical capacity within firms to understand and
engage in the trading system. Participating in a tradable permit
market requires that a firm first evaluate its own cost of emissions
abatement, then assess its potential role as either a buyer or a
seller in the permit market, and finally identify potential trading
partners and execute the trade. This involves a different set of
managerial skills than does the traditional regulatory approach,
which tends to require primarily an engineering focus. This may
have important implications when considering the application of
such instruments in other countries, where firm managers may have
less experience both with environmental protection rules and with
efficient markets.



Restrictions on Trading

Restrictions on trading eliminate some of the benefits of this
approach, and substantial restrictions can seriously hinder the
development of an efficient market in emissions permits. Restricting
a firm's purchases of tradable permits to a specified fraction of
the firm's own abatement raises the costs of achieving a given
environmental standard without delivering additional environmental
benefits.



Liability

Approaches that result in uncertainty regarding the value of
tradable permits also may reduce participation in such markets.
For example, a government may restrict the buyer's use of emissions
permits and may even revoke them at a later date, depending on an
ex post evaluation of the seller's emissions abatement. This
increases uncertainty because it effectively institutes a system
of buyer liability. If the seller does not undertake emissions
abatement sufficient to back the permits it has sold, the sold
permits are effectively returned to the seller. Then the seller
has sufficient permits to cover its emissions, but the buyer, having
effectively surrendered its purchased permits to the seller, does
not have enough permits to cover its emissions, and will be found
out of compliance. The buyer effectively becomes liable for the
seller's efforts to abate emissions. The uncertainty that this buyer
liability creates may bias firms against interfirm trading, leading
them to focus solely on intrafirm or internal trading, where the
benefits are more limited.



Banking and Borrowing

The severity of some environmental problems is a function of the
stock of pollution as it accumulates over time, whereas for others
it is a function of the flow of pollution during a specific period
of time. An example of the first type is carbon dioxide emissions:
these accumulate in the atmosphere, where they can last for more than
100 years, and it is their total stock that influences global
warming. In contrast, ground-level ozone pollution usually threatens
human health most significantly during short episodes of perhaps
several days. In the first case, the long-term effects of pollution
over time may allow for trading to occur across time as well as
across space. With stock pollution problems, a unit of pollution in
one period may have environmental effects roughly comparable to a
unit of pollution in a subsequent period. With flow pollution
problems, emissions in one period may have significantly different
environmental effects from emissions in a later period, and this
limits intertemporal trading.
The flexibility to trade across time--to effectively bank, or save,
emissions permits for future use or to borrow permits from the future
for current use--can also result in significant economic benefits. If
environmental standards are expected to become more stringent in the
future, the costs of emissions may increase significantly over time.
Thus a firm may find it profitable to reduce emissions below the
standard early in the program and save its surplus emissions permits
for use later in the program. However, if the costs of a pollution
control program are high in the near term because developing new
technologies requires time, it may be profitable for a firm to borrow
an emissions permit from the future and use it in the current period.
In cases where total emissions over time, not the flow of emissions,
cause the environmental damage, this flexibility to trade emissions
across time can reduce the costs of achieving a desired
environmental goal. Without the opportunity to bank and borrow,
permit prices--even in a well-functioning market--could vary
significantly over time and could even spike in the presence of
new or unexpectedly stringent standards.



Tradable Permits and Charges in Practice

Economists have advocated emissions charges since the 1920s, and
tradable permit systems since the 1960s, yet both approaches received
limited application until recently. Among the first applications of
permit trading were the EPA's efforts in the 1970s to provide
additional flexibility to firms as they complied with Clean Air
Act regulations. Later applications of trading to air quality issues
have included the Regional Clean Air Incentives Market in Southern
California, the phaseout of lead additives in gasoline, and the
sulfur dioxide trading program. The charge approach has been used
to address residential solid waste generation. Although these
applications represent only a subset of incentive-based approaches
in the United States, they illustrate the importance of appropriate
policy design in achieving environmental goals at the lowest
possible cost.



Permit Trading: Emissions Trading Policy Under the Clean Air Act

The Clean Air Act of 1970 directed the EPA to develop ambient air
quality standards for common air pollutants. Accordingly, the EPA
set standards to protect public health for ozone, sulfur dioxide,
lead, particulate matter, nitrogen dioxide, and carbon monoxide.
It designated metropolitan areas that did not comply with these
standards as ``nonattainment areas'' and established a set of
technology and performance standards for a variety of emissions
sources. In the late 1970s, to provide some flexibility in
reducing emissions, the EPA implemented a trading policy consisting
of ``netting,'' ``offsets,'' ``bubbles,'' and ``banking''
mechanisms.
Netting allowed a facility that created a new source of emissions
to net its total emissions across all sources within the facility.
This effectively promoted internal ``trading'' among sources within
a facility: the new source could emit pollutants in excess of its
required level if an existing source reduced its pollution below
its required level. Offsets allowed a new source in a non-attainment
area to offset its emissions by paying to reduce emissions at
another source in that area. Bubbles created aggregate caps for
all existing sources within a facility. Instead of specific
technology standards for each smokestack, the facility has the
flexibility to reduce emissions in any manner it desires so long
as the aggregate emissions are consistent with its cap. In
addition, a facility with emissions below its bubble limit could
sell emissions credits to other firms. Banking allowed facilities
to save emissions reductions that exceeded the current standard for
use at a future date. Whereas netting only occurs with respect to
internal trading, the other three mechanisms can occur through both
internal and external trading.
The experience with these mechanisms showed benefits but also
demonstrated some design problems that limited the cost savings. A
review of these programs in the late 1980s found that netting
generated by far the greatest economic benefits, with estimates
ranging rather broadly from $500 million to $12 billion. Bubbles
generated cost savings on the order of more than $400 million, and
offsets could likewise have generated benefits on the order of
several hundred million dollars. Little banking activity occurred,
resulting in very modest benefits. Nor was there much external
trading: only about 10 percent of offsets occurred between two
firms, and fewer than 2 percent of bubbles were between two
firms. Compared with estimated Clean Air Act compliance costs
on the order of $500 billion over the 1970-90 period, these
cost savings are very modest.
Several factors may have dampened the volume of external trading
and the subsequent cost savings. First, the ability of firms to
engage in trading was restricted. Firms had to invest in abatement
technology before they were allowed to purchase permits from other
sources, and this effectively stunted the growth of the emissions
permit market. Trading ratios greater than one (for example, where
one firm sells 12 permits but the buying firm can only use 10 of
the permits that it purchases) reduced trading. Second, the review
process for trades was costly and created uncertainties about
whether the emissions credits created actual property rights;
this uncertainty further lowered their value. The uncertainty that
buyer liability creates may have biased firms in early trading
programs toward internal trades. Third, the concept of trading
was novel to many facilities managers, and the lack of appropriate
human capital has been suggested as one reason for the low volume
of external trading.
Trading under these rules in Southern California during the late
1980s incurred transactions costs as high as 30 percent of the
value of the emissions permits in the transaction. These
transactions costs reflected the costs of negotiations with
other parties, an administrative fee, a certification fee, and
costs for documenting the trade and the emissions reduction. If
a firm wanted to bank emissions permits, it had to pay a banking
fee as well. Moreover, the Southern California regulatory
authority granted only 60 percent of proposed trades, and this
increased uncertainty among potential participants. Together the
extensive fees and the review process dampened the market for
emissions permits.



Permit Trading: RECLAIM

In response to the increasing cost of air quality regulation and
the inefficiency of the then-current system of trading rules, in
1994 the Southern California Air Quality Management District began
a tradable permit system known as the Regional Clean Air Incentives
Market (RECLAIM). This program covers stationary sources that emit
4 or more tons annually of either nitrogen oxides or sulfur oxides.
Smaller facilities can join the program voluntarily as well. The
program also includes provisions that allow the retirement of older,
more-polluting automobiles to generate emissions credits to be used
by stationary sources. At its inception the program included 65
percent of all NOX and 85 percent of all SOX stationary sources
(such as electric utilities and petroleum refineries).
RECLAIM has a single major restriction on trading, designed to
prevent hot spots. Geographically, sources are divided into an
inland zone and a coastal zone. Trades can occur within a zone,
but permits can only be sold from coastal zones (upwind) to inland
zones (downwind), not vice versa. Without this restriction, a
significant set of upwind sources could emit enough NOX to result
in the ozone standard being exceeded locally downwind.
To facilitate compliance, major sources must install continuous
emissions monitors (CEMs), which provide emissions data to the
regulatory authority. For 1994 through 1997, CEMs in RECLAIM cost
approximately $13 million more per year than the monitoring
equipment that would have been required under a traditional
regulatory program. This cost was about one fifth the projected
cost savings associated with the program between 1994 and 1999
and comprised a majority of the projected compliance costs borne
by participating firms. However, monitoring provides important
benefits. By providing greater certainty about a source's emissions,
monitoring may enhance the integrity of the environmental market
and reduce the need for regulatory supervision of every trade.
RECLAIM has been largely successful in reducing emissions in a
cost-effective manner. Annual ozone standard violations in 1998
were roughly two-thirds fewer than in 1980, and half the number
in 1993 (Chart 7-3).






Permit Trading: Sulfur Dioxide Trading Program

In the atmosphere, emissions of SO2 transform into sulfates and
sulfuric acid and are transported over large distances. Because 70
percent of all U.S. SO2 emissions come from electric utilities, and
many of these are based in the eastern half of the United States,
the sulfates are usually deposited in the Northeast. Acidic
deposition, also known as acid rain, can acidify lakes, resulting
in fish kills; it can reduce the alkalinity of forest soils,
thereby harming various tree species; and it can degrade various
ecosystem functions. In addition, SO2 has been linked with several
respiratory problems.
To address the acid rain problem, the 1990 Clean Air Act Amendments
directed the EPA to design a tradable permit system for SO2. The
program required the 110 highest emitting, primarily coal-fired,
power plants (representing 263 units) in the Eastern and Midwestern
States to hold, starting in 1995 (phase I), permits sufficient to
cover all their SO2 emissions. Starting in 2000 (phase II), all
large fossil fuel-fired power plants (approximately 2,000 units)
in the eastern half of the United States will have to hold enough
SO2 permits to cover their emissions. Most allocations are based
on the product of a common emissions performance standard and
historical utilization, although a small percentage every year
(about 3 percent) are auctioned at the Chicago Board of Trade.
Utilities can freely buy and sell permits, and entities not required
to hold permits to cover emissions may also participate in the SO2
market. Utilities can also bank emissions permits for use in future
years.
The SO2 market has enjoyed very active participation and yielded
substantial cost savings. Innovations in scrubber technology as well
as the availability, due to rail deregulation, of low-cost,
low-sulfur coal from Wyoming and Montana have contributed to
compliance estimates as low as half of what had been predicted
for the program. The market has experienced high volume, in part
thanks to the role of private brokers. Compared with a traditional
regulatory alternative, the fully implemented SO2 market has
generated cost savings of up to $1 billion annually. The
heterogeneity of abatement costs for SO2 in the utility industry
has been recognized as one reason why the SO2 market has experienced
such heavy volume and substantial cost savings. The absence of
individual trade reviews by the government and a system of seller
liability have also contributed to high trading volumes. Banking
of permits has also occurred to a substantial degree: total SO2
emissions in 1995 were nearly 40 percent below the environmental
goal because of banking activity (Chart 7-4). These banked permits
will likely be used during phase II, which has tighter annual
emissions limits.





Permit Trading: Phasedown of Leaded Gasoline

Exposure to lead can cause an array of health problems, including a
reduction in children's IQ, behavioral disorders, and adult
hypertension. Exposure to lead can occur through a variety of
pathways, such as ingestion of lead-based paint flecks and lead-
contaminated dust, drinking lead-contaminated water, and inhalation
of airborne lead resulting from the combustion of lead-based
gasoline. In the 1970s, vehicle emissions were responsible for
approximately three-fourths of total U.S. lead emissions.
To address the risks of lead exposure, in 1982 the EPA implemented
an interrefinery trading program for lead credits. The EPA capped
the amount of lead allowed in all gasoline sold, and this cap
declined until the lead content was 10 percent of its previous
level. To sell gasoline containing lead, a refinery had to hold
lead credits commensurate with the lead content of the sold fuel.
Refineries could buy and sell lead credits, and the volume of trade
was quite substantial.
During 1983 and 1984, only one refinery did not participate in the
trading program. Up to 50 percent of all lead in gasoline was at one
time or another the object of a lead credit transaction between
refineries. In addition, the EPA provided a banking mechanism starting
in 1985, and many refineries took advantage of banking until the end
of the phasedown program in 1987. The inclusion of banking may have
reduced costs up to 20 percent over alternative schemes without
banking. Unlike the experience with air pollutant emissions trading
in the early 1980s, the phasedown of lead evolved into a fairly
efficient market, resulting in an extraordinary reduction in lead
emissions (Chart 7-5). Although this certainly reflects the less
intrusive government role in the lead market (individual trades did
not require government approval), the efficiency of the market may
also reflect the technical capacity within firms to participate in
trading. Firms that already have experience in trading, such as
refineries that engage in intermediate product markets within the
refinery industry, may be more inclined to trade. However, smaller
firms may have been less inclined to trade because they lacked the
technical capacity to evaluate their own costs of removing lead from
gasoline and to assess their potential role in the lead market.






Charges: Unit-Based Pricing of Residential Solid Waste

Everyday activities generate solid waste. Through direct and
indirect consumption, an average individual generates approximately
4 pounds of waste per day. The generation of waste requires the
appropriate disposal at landfills and incinerators. Its disposal
can result in numerous problems, including water pollution
(from landfills), air pollution (from incinerators), and
transportation-related problems associated with hauling waste,
including noise, odor, and traffic congestion.
To address the problems associated with waste disposal, many
communities have implemented waste management programs that
include unit-based pricing of waste collection, in which households
pay for disposal services according to the amount of waste they set
out for collection or bring to collection centers. This alternative
to traditional methods of paying for trash collection (through
general revenue or a flat annual fee) can provide explicit
information about the cost of waste generation to households.
Households can respond in a number of ways to being charged for
each unit of waste they set out for disposal. For example, they can
do more recycling, set aside yard waste for separate collection, or
buy goods with reduced packaging (what is called source reduction
behavior). Some people have worried that unit-based pricing could
also promote illegal dumping and burning, although this has not
been a serious problem in most communities, in part because of
antidumping programs. Under unit-based pricing, collection
schemes usually take one of three forms: special bags; tags or
stickers attached to waste receptacles; or subscription cans of
varying sizes. Recycling programs and public education campaigns
on viable substitutes for waste disposal often accompany the
introduction of unit-based pricing programs.
By 1998, more than 4,000 communities in 46 States had adopted
unit-based pricing schemes for their residential waste collection,
covering nearly one in seven Americans (Table 7-1). Unit-based
pricing reduces the amount of waste collected for disposal relative
to a flat-fee system. Increasing the number of types of recyclables
covered by a community's recycling program and introducing a yard
waste collection program also appear to reduce the amount of waste
collected for disposal. However, the total amount of waste





generated (waste to landfills and incinerators plus recycling plus
yard waste collection) does not appear to be significantly different
under unit-based pricing from that under a flat-fee system. In other
words, unit-based pricing may promote diversion from landfills to
recycling and yard waste collection, but it does not appear to
promote source reduction behavior.
Since the cost of reducing residential waste may not vary
significantly across households, this experience with unit-based
pricing may illustrate the merits of a charge approach. The small
gains available through a trading approach may be swamped by the
costs of acquiring information about potential buyers and sellers
and other transactions costs in such a market. Thus very few trades
would occur, resulting in little cost savings. In this case where
control costs are fairly homogeneous, the charge approach appears
to be more appropriate, and in the case of unit-based pricing of
solid waste, it has been fairly successful at reducing waste to
landfills and incinerators.



Implications of the U.S. Experience

These trading and emissions charge programs illustrate the potential
for regulatory strategies to achieve environmental goals through
approaches that provide incentives to effectively harness private
markets. Of these examples, some have demonstrated more substantial
cost savings than others, but in none did the market-oriented
approach undermine the achievement of the environmental goal. More
cost-effective attainment of environmental goals depended in large
part on the design of markets tailored to the specific characteristics
of the environmental problem at hand. In cases where emissions
sources have roughly equivalent environmental effects, where
emissions monitoring is available, and where the cost of reducing
emissions varies across sources, trading can be a powerful tool to
address pollution cost-effectively. The rules for the design of
trading can ensure that the program achieves more of its potential
cost-effectiveness. Such rules can include reasonable liability
rules, banking and borrowing, and appropriate restrictions on
trading, for example to address hot spots. In cases where the costs
of reducing pollution are similar across sources, the charge
approach may be more appropriate, and as we have seen, it has been
used in many U.S. communities to address residential waste generation.
Such incentive-based approaches have also been used in other countries
and in other policy contexts. For example, several European countries
employ charges on air and water pollution. However, many of these
programs are designed more to raise revenue and have minimal effects
on emissions because the charges are set too low to induce much
emissions abatement. In Singapore a traffic congestion pricing
system has been in use since 1975 to reduce the number of vehicles
in the central business district. In the United States, tradable
permits have also been used to address such problems as overfishing
(Box 7-5).


------------------------------------------------------------------------
Box 7-5. Individual Quotas for Fisheries Management

Most commercial fisheries are experiencing declining fish stocks
because of too much fishing. To prevent overfishing, some fisheries
have resorted to fixing the total amount of fish that may be caught
in a given year. Fishery managers set this limit, called the total
allowable catch (TAC), low enough to guarantee the sustainability
of the fishery, and they officially end the season once this limit
has been reached. Because fishers know that managers have limited
the total catch, their goal becomes to catch as large a fraction
of it as possible. The ``derbies'' that result as each fishing
crew tries to beat the rest of the fleet can waste significant
resources. Fishers respond by overinvesting in gear and purchasing
ever faster, ever larger boats, but these investments only make the
derbies more frenetic. The rapid pace has in some cases significantly
shortened the fishing season, needlessly restricting consumers'
access to some fish species during certain periods and forcing fishers
to concentrate their work effort into a shorter period.
Managers have tried to supplement the TAC with gear and access
restrictions, but a potentially more efficient approach for some
fisheries is to allocate shares of the TAC in the form of individual
quotas. Since each fisher then has a right to a specified share of
the TAC in a given year, each can catch this share in the cheapest
manner possible without having to worry about the behavior of
competitors. The incentives to concentrate production in the early
portion of the season and to overinvest in capital disappear. And
because the quotas can be traded, the market provides an incentive
for the most efficient operators to catch the most fish. Less
efficient fishers can sell their rights to more efficient fishers
for an amount greater than their expected profit on the catch.
Similarly, the more efficient fishers stand to net more than the
profit of the less efficient ones, and so the individual quotas
can be exchanged in such a way that both are better off.
Individual quotas have been used extensively around the world, with
very promising results. New Zealand first introduced such a program
in 1986, and at least seven other countries now employ individual
quotas. Currently three programs operate in the United States,
covering fishing for surf clams, ocean quahogs, wreckfish, Alaskan
halibut, and Alaskan sablefish. The Sustainable Fisheries Act of
1996 placed a moratorium on the use of individual quotas through
October 1, 2000, and requested a study of the quota approach by
the National Research Council. The NRC panel released its report
in April 1999. It recommended that the Congress lift the 1996
moratorium and allow regional fisheries to use individual quotas.
The report emphasized that the quotas are not a panacea applicable
to all fisheries. But it also concluded that past

Box 7-5.--continued
experience has repeatedly demonstrated the effectiveness of individual
quotas for ``matching harvesting and processing capacities to the
resource, slowing the race to fish, providing consumers with a better
product, and reducing wasteful and dangerous fishing.''
------------------------------------------------------------------------



Applying the Lessons Learned: Global Climate Change

Perhaps the leading environmental challenge of the 21st century
will be to address the risks associated with global climate change.
Climate change results from the long-term accumulation of greenhouse
gases in the atmosphere. The balance of scientific evidence suggests
that emissions of greenhouse gases from human activity have a
discernible influence on the global climate. Three characteristics
of the climate change challenge create great potential for emissions
trading and similar flexibility mechanisms to reduce greenhouse gas
emissions. One is that a very large number of sources emit
greenhouse gas emissions, which stay in the atmosphere for many
years, so that the climatic effect of a unit of emissions is the
same no matter where the emissions come from. A second is that the
different types of sources have significantly different abatement
costs, especially across countries. The number of potential
participants and this heterogeneity in their abatement costs provide
the basis for an active, competitive emissions trading market.
Finally, emissions of carbon dioxide, the most prevalent greenhouse
gas resulting from human activity, are relatively easy to calculate.
Emissions of greenhouse gases occur as a by-product of a variety of
activities: fossil fuel combustion, deforestation, rice cultivation,
maintenance of electricity transformers, aluminum manufacturing, and
others. The atmospheric concentration of carbon dioxide has
increased about 30 percent since the preindustrial period. Absent
new mitigation efforts, that concentration will likely rise to
double the preindustrial concentration by the middle part of the
21st century. Moreover, greenhouse gases can reside in the
atmosphere for very long periods. Carbon dioxide and nitrous oxide
may last in the atmosphere for approximately 100 years, and other
greenhouse gases, such as perfluoromethane and perfluoroethane,
can last in the atmosphere tens of thousands of years. Such an
accumulation of greenhouse gases could pose significant risks,
including rising sea levels, more frequent and severe storms,
shifts in agricultural growing conditions, increased range and
incidence of certain diseases, changes in the availability of
freshwater supplies, and damage to ecosystems and biodiversity.
A landmark international agreement to address the risks of climate
change was the Framework Convention on Climate Change, signed at the
1992 Earth Summit in Rio de Janeiro. Building on this treaty, 160
countries agreed to the Kyoto Protocol in December 1997. The Kyoto
Protocol established binding greenhouse gas emissions targets for
38 industrialized countries for the period from 2008 to 2012. The
United States agreed to a target of 7 percent below 1990 emissions
levels. To promote cost-effective attainment of these targets,
the agreement also established four flexibility mechanisms:
emissions target bubbles, international emissions trading, Joint
Implementation (JI), and the Clean Development Mechanism (CDM). The
last three of these, if designed and implemented efficiently, could
provide the foundation for a global emissions market. Since
greenhouse gas emissions have the same climatic consequences
wherever they occur, the most efficient way to address the risks
of climate change is to reduce emissions wherever such reductions
are cheapest.



Flexibility Mechanisms in the Kyoto Protocol

Emissions target bubbles effectively allow a group of countries to
aggregate their emissions targets into one megatarget and to
reallocate emissions to new targets within this group. For
example, all the countries of the European Union have Kyoto
Protocol targets set at 8 percent below their actual 1990
emissions (written herein as 1990 ï¿½8). Under the bubble, the
EU target becomes 1990 ï¿½8, and individual countries within the
group have targets that vary between 1990 ï¿½28 and 1990 +27.
Thus, those EU countries that expect to find it easier than others
to reduce emissions effectively take on bubble allocations below
their Kyoto Protocol targets, whereas those that may find the
targets more difficult to achieve get bubble allocations in
excess of these targets. The bubble concept allows for countries
to engage cooperatively in one set of ``political trades''
before the commitment period. However, once all EU countries have
ratified the Kyoto Protocol, the allocations established under
the bubble become their new targets.
International emissions trading may occur among all countries with
binding emissions targets. With these targets, each country is
allowed to emit a specified level of emissions: its so-called
emissions allowances. Trading occurs when one country agrees to
sell some of its emissions allowances to another country. It can
also occur among firms and other private sector entities that hold
emissions allowances through domestic trading programs. For
example, a U.S. firm that must hold allowances for the U.S. domestic
trading program could trade with a Canadian firm that must hold
allowances for a Canadian domestic trading program. For countries
that have opted for a traditional regulatory approach or a charge
approach to controlling emissions, it may still be possible for
international trading to occur between firms and governments.
Like international emissions trading, Joint Implementation may
occur among countries with binding targets. Unlike international
trading, however, JI is focused on projects. A firm in one
industrial country may invest in a project to reduce greenhouse
gas emissions in another. If both countries' governments approve
the project, emissions allowances from the country where the
reductions occurred are transferred to the other country in exchange
for the investment.
The Clean Development Mechanism allows industrial and developing
countries to work together to design and implement projects in
developing countries that abate greenhouse gas emissions; however,
developing countries do not need binding emissions targets to
participate in the CDM. CDM projects must be certified on the basis
of several criteria. In addition, a portion of the emissions
credits generated by the project would support an adaptation
fund for low-income countries especially vulnerable to climate
change (adaptation charges) and for administrative costs of the CDM.
Industrial countries can use CDM reductions to meet their emissions
targets. The rules for international emissions trading, JI, and CDM
are expected to be finalized at the next round of climate change
negotiations at The Hague later in 2000.
Finally, the protocol allows for emissions allowances to be banked
from one commitment period to the next. A 5-year average commitment
period provides additional flexibility by effectively allowing for
the banking and borrowing of emissions allowances within this period.
This opportunity to bank and borrow can smooth out permit prices,
which might otherwise experience large price swings due to normal
annual fluctuations in the weather or the economy.



Cost-Effectiveness of Kyoto Protocol Flexibility Mechanisms

Although international emissions trading, Joint Implementation, and
the Clean Development Mechanism can all help lower the cost of
compliance with the Kyoto Protocol targets, their cost-
effectiveness may vary. An efficient international emissions
trading system would not require case-by-case reviews of trades;
however, JI and CDM might require such review, and CDM projects
would also require independent certification. Further, the
adaptation charges and administrative costs would increase the
costs of participating in a CDM project. The reviews and charges
associated with project-based approaches could be similar to
those in the early emissions trading programs under the Clean
Air Act--netting, bubbling, and offsets--which experienced less
activity than would have been expected with less bureaucratic
oversight. In addition, the project orientation of JI and CDM would
effectively exclude some cost-saving efforts. For example, a
country pursuing a policy of cutting energy subsidies might find
it impossible to classify this policy as a project under JI or
CDM. However, the country could cut energy subsidies and sell
unneeded emissions allowances through the international
emissions trading mechanism.
An international emissions market based on trading, JI, and CDM
could allow substantial gains from trade in meeting emissions
targets because the cost of controlling greenhouse gases differs
widely from country to country. Countries that have relatively
inexpensive ways of controlling greenhouse gases have incentives
to reduce emissions by more than their targets require, because
they can then sell tradable allowances that they will not need.
By the same token, countries facing more expensive emissions
abatement measures have incentives to buy less costly allowances
from others. Modeling analyses of the Kyoto Protocol have found
that, for the United States, moving from a no-international-
trading scenario to a scenario of efficient trading among
industrial countries would cut the price of a tradable carbon
dioxide permit (a measure of marginal compliance cost) by half.



Expanding the Scope of Trading to More Countries

Modeling analyses also illustrate the significant potential for
additional cost savings by expanding emissions trading to developing
countries. Among the world's large economies, the cost to a country
to abate a given percentage of its greenhouse gases may vary by
more than a factor of 20. If developing countries adopt binding
emissions targets, they can participate in international emissions
trading and may gain substantial revenue from selling permits in
the international emissions market (Box 7-6). In an efficient
global market, low-cost opportunities to reduce greenhouse gases
in developing countries would attract foreign direct investment
in energy and industrial abatement technologies and for carbon
dioxide sequestration activities (such as planting and managing
stands of trees to absorb carbon dioxide). Developing countries
could generate billions of dollars in revenue annually through
the sale of emissions allowances to countries with higher abatement
costs. Effectively, the Kyoto Protocol provides the potential for
low-cost abating developing countries to create an export
industry whose product is emissions abatement. While providing
economic and environmental benefits to developing countries, an
efficient global trading system could reduce the tradable
permit price by up to about 90 percent in the United States.



Expanding the Scope of Trading to More Greenhouse Gases

Expanding the scope of trading could capture even more benefits.
Recent analyses have found that allowing for trading across
greenhouse gases can lower the cost of meeting emissions targets.
Greenhouse gases could be traded on the basis of global warming
potentials, which provide a measure of the effect of each


------------------------------------------------------------------------
Box 7-6. Expanding the Scope of the Market Through Developing Country
Participation

The Kyoto Protocol stipulates that countries must have a binding
emissions target before they may engage in international emissions
trading. Since the Kyoto conference, developing countries have
expressed interest in emissions targets. Consistent with the
Framework Convention on Climate Change, targets for developing
countries should help promote their sustainable development. For
them to do so, such targets should accommodate emissions growth,
because some growth in emissions is an unavoidable consequence of
development. Unlike the current targets in the Kyoto Protocol, which
were set below most countries' current emissions levels, such a
target for developing countries could be set above current levels.
At the same time, to contribute to the international effort to
address climate change risks, such targets should result in real
abatement of emissions below levels that would otherwise be reached
during the commitment period--that is, below the projected
business-as-usual emissions level. This kind of target, often
referred to as an emissions growth target, could provide for
continued economic development but with a lower emissions growth rate.
Such a target could be expressed as some percentage of a base year,
in a fashion similar to current Kyoto Protocol targets, but perhaps
with a different base year and/or a percentage greater than 100
percent to account for expected emissions growth. An emissions
target could also take other forms. It could, for example, be
indexed to a country's economic performance (such as GDP) between
now and the 2008-12 commitment period. Such targets could avoid
the risk of a crunch arising from faster than projected economic
growth between now and the commitment period. Developing countries
would face only the much smaller risk that emissions would be higher
than expected, given the economic conditions during the commitment
period. Similarly, such targets would also avoid the risk of
inadvertent laxness associated with lower than expected economic
growth between now and the commitment period. This indexed target
formulation is reflected in the emissions commitment announced by
Argentina at the climate change negotiations held in Bonn, Germany,
in the fall of 1999.
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gas on the climate. For example, a pound of methane contributes 21
times as much as 1 pound of carbon dioxide to global warming. Thus,
reductions in one kind of gas can substitute for increases in another.
Absorption of carbon dioxide by planting trees and creating other
carbon dioxide ``sinks'' could also serve as a low-cost substitute
for reducing carbon dioxide emissions. Some modeling analyses indicate
that efficient intergas trading could reduce costs to the United
States by 25 to 40 percent relative to a policy that only reduces
carbon dioxide to achieve the target.



Quantitative Restrictions on Trading

Some countries have argued that trading should be quantitatively
restricted to ensure substantial domestic emissions abatement. This
is somewhat analogous to early Clean Air Act trading rules that
required firms to undertake significant emissions abatement before
they could buy emissions permits from other firms with lower
abatement costs. If this earlier experience is any guide, these
types of restrictions on trading would likely raise the cost of
compliance significantly, result in a less liquid tradable permit
market, and deliver no benefits to the climate over those from a
trading system with no quantitative restrictions. Interestingly,
the proposal by the European Union to establish quantitative limits
on international emissions trading, JI, and CDM would exempt the
bubble mechanism, which the European Union has indicated it will
use (Box 7-7).



Liability Rules for Trading

Some countries propose that buyers of emissions permits should be
liable if the seller does not comply with its emissions target.
But such a buyer's liability scheme could present significant
uncertainty in the market, increase transactions costs, and risk
the further development of the market. The uncertainty about
allowance value (that is, whether allowances can be used for a
country's compliance) is greatest in a new market where there is
no track record for sellers and where market institutions to handle
risk have not yet evolved. This uncertainty may preclude trades
and prevent a robust allowance market from being established.
Bearing risk, or acquiring information to reduce risk, imposes costs
on buyers. The imposition of additional costs for undertaking a
trade will make some trades unprofitable, thereby increasing
compliance costs unnecessarily.



Making Trading Across Countries Work

Finally, the efficiency of an international trading system may be
influenced by heterogeneity in domestic abatement programs as well
as by lack of experience with trading. For example, some industrial
countries may undertake traditional regulatory policies such as
mandating fuel economy standards and requiring greenhouse gas
performance standards for stationary sources. Such an approach
would not provide explicit information about the cost of reducing
emissions as would a domestic emissions trading program or a
charge program. These countries may find it difficult to assess
the nature and extent of their proper economic role in an
international emissions market. Without the explicit cost
information revealed in a domestic trading program, these
countries may buy or sell emissions allowances to a degree that
is inconsistent with what is economically optimal. With an efficient


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Box 7-7. The EU Bubble Allocation and Restrictions on Kyoto Protocol
Mechanisms
In May 1999 the European Union proposed quantitative restrictions
on international emissions trading, Joint Implementation, and the
Clean Development Mechanism that would limit industrial countries'
opportunities to buy and sell emissions. The buying restrictions
would take the form of two formulas; countries could choose the
less binding of the two. If a country could demonstrate to a
review team that domestic abatement measures produced emissions
reductions in excess of the binding level, the buying cap could
be raised such that purchased allowances equaled verified domestic
abatement. The selling restriction also would take the form of
a formula, with the opportunity to raise the binding selling cap
equal to the amount of verified domestic emissions abatement.
The proposed restrictions do not apply to the ``political trading''
under the bubble provision of the Protocol.
In 1998 the European Union announced its bubble allocation under
the Kyoto Protocol. EU members will transfer portions of the group's
assigned emissions targets to other EU countries. In the Kyoto
Protocol, all EU countries are assigned targets of 1990 -8; under
the bubble allocation these adjusted targets would range from 1990
-28 to 1990 +27. The United Kingdom's emissions have fallen since
1990 as a result of liberalizing its electricity sector; Germany's
emissions have fallen in the same period in part because of
restructuring related to unification with eastern Germany. Therefore
these two countries accepted bubble allocations of 1990 -12.5 and
1990 -21, respectively. Since Ireland, Portugal, and Greece are
expected to grow faster than most other EU countries, they received
bubble allocations ranging from 1990 +13 to 1990 +27.
EU data indicate that several of the political transfers under the
bubble allocation would probably not comply with the restrictions
proposed by the European Union itself for the other Kyoto Protocol
mechanisms. Indeed, 10 of the 15 EU countries could violate the EU
proposal to restrict flexibility: 6 could receive transfers in excess
of their binding buying constraints, and 4 could transfer emissions
in excess of their selling constraints. Thus, two-thirds of EU
members might benefit from political trades under the bubble that
could not occur as economic trades under its own proposal to restrict
international emissions trading, JI, and CDM.
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domestic trading program, participating firms would have explicit
price-of-abatement information on domestic abatement opportunities
to guide their buying and selling in an international emissions
market. Even if some countries implement domestic trading programs
for one or a few industries, they may still forgo significant cost
savings associated with a more comprehensive domestic trading system.
Integrating an international emissions market with private firms and
national governments may result in some efficiency losses. The U.S.
experience in other emissions markets suggests that countries and
firms with very little experience at trading may not be as active
participants as others.
To promote an efficient international trading system, the
Administration has proposed a set of rules for trading based on
its experiences with various trading programs. The Administration
opposes quantitative restrictions on trading. The Administration
supports a system of seller liability for trading, coordinated with
a strong compliance system. To promote cost-effectiveness in the
trading system, the Administration supports involving interested
private entities in international emissions trading, JI, and the
CDM. In addition, the Administration has proposed a domestic trading
system for greenhouse gases for the 2008-12 commitment period and
aims to have this domestic system integrated with international
emissions trading. For the near term, the Administration has included
a hybrid trading and charge system in its electricity restructuring
bill to promote renewable power as a way to encourage the development
of emerging renewable energy technologies (Box 7-8). In addition,
the Administration has promoted the development and diffusion of
more climate-friendly technologies through a variety of R&D and
information programs (Box 7-9).


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Box 7-8. The Renewable Portfolio Standard

The generation of electricity can result in an array of environmental
problems, from emissions of air pollutants, to nuclear waste, to
damage to aquatic ecosystems. Renewable sources of energy, such as
wind, biomass, solar, and geothermal power, have the potential to
deliver electricity while having a more modest impact on the
environment. The Administration's bill to restructure the electricity
industry--the Comprehensive Electricity Competition Act--calls for a
renewable portfolio standard (RPS) to promote the development and use
of renewable electricity.
The RPS would require all retail electricity sellers to cover a certain
percentage of the electricity they generate with nonhydropower renewable
sources of electricity; this percentage would rise from its 1997
level of 2.3 percent to 7.5 percent by 2010. A seller could meet
this percentage requirement by generating electricity from its own
renewable energy sources or by purchasing tradable renewable
electricity credits from others who generate electricity from such
sources. In addition, the RPS would be governed by a cost cap of
1.5 cents per kilowatt-hour. If the cost of generating renewable
electricity reached 1.5 cents per kilo

Box 7-8.--continued
watt-hour above the price of nonrenewable electricity, an electricity
seller could go to the Department of Energy and purchase an RPS
credit for 1.5 cents per kilowatt-hour instead of incurring the
greater costs of generating more expensive renewable energy.
Revenue from these sales would contribute to a Public Benefits
Fund, which is envisioned to support renewable power R&D, energy
efficiency programs, and low-income assistance.
The combination of a tradable permit system with the cost cap would
allow for considerable flexibility for electricity vendors in
meeting the renewable standard. The costs of generating nonhydropower
renewable electricity, especially in quantities more than three
times that of today, are uncertain. The cost cap would provide
additional certainty and a form of insurance to electricity sellers
as they plan for investment in new generating technologies. It
would also insure their customers against unexpectedly large
electricity price changes.
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Box 7-9. Climate Research and Development and Information Programs

Potential new technologies often do not receive sufficient private
sector investment when investing firms cannot fully capture the
benefits of these technologies. For example, some of the benefits
of improved solar power technology accrue to society at large, in
the form of improved local air quality and reduced carbon dioxide
emissions relative to a fossil fuel power alternative. In such
cases, producers have less economic incentive to invest in carbon-
free power technologies than is socially optimal. Federal support
for research and development in cleaner and more energy-efficient
technologies can address this problem. Through the President's
Climate Change Technology Initiative (CCTI), the Administration has
invested $2.12 billion over the past 2 years in clean, energy-
efficient technology development and has proposed to spend $1.43
billion in fiscal 2001. The CCTI has funded R&D in technologies
associated with the four major sources of carbon dioxide emissions--
buildings, industry, transportation, and electric power--and
investments in carbon removal and sequestration.
Complementing these R&D programs, efforts to provide more
information about the energy and environmental effects of products
can promote the deployment of more climate-friendly technologies.
Evidence suggests, for example, that better information about the
potential cost savings from improving energy efficiency may
increase

Box 7-9.--continued
the use of energy-efficient technologies. Lacking this information,
consumers may simply purchase the product with the lowest upfront
cost, all else equal. However, information about the costs of
operating a product over its lifetime may illustrate to the consumer
that the life-cycle costs of the more energy-efficient product
could be lower than those of the product with the cheaper price tag.
The Energy Star Program at the Environmental Protection Agency
provides consumers with information about the energy efficiency of
a wide variety of products through a readily identifiable label.
Products bearing the Energy Star label appeal to consumers interested
in both long-term energy costs and the environmental effects of
using energy. Thus, Energy Star office equipment like computers,
which are, on average, 50 percent more energy efficient, would be
especially attractive to these consumers. In addition, the
Administration's electricity restructuring bill includes a labeling
provision that requires electricity generators to provide consumers
with information about the environmental characteristics of the
electricity provided, such as the fuel source. Under this bill,
consumers who want to purchase ``green'' electricity will have
the information they need to make such a decision.



Conclusion

Economic activity has long contributed to environmental pollution in
one form or another, but the application of incentive-based approaches
to repair the damage of pollution has only really come into vogue in
the United States over the past 25 years. Experience with tradable
emissions permits and emissions charges illustrates the potential
for substantial cost savings in achieving environmental goals, as
well as some of the pitfalls in designing these policy tools. Taking
the characteristics of environmental problems properly into account
makes it easier to identify and apply an appropriate regime.
Drawing on the U.S. experience with market-oriented regulatory
policies, the Administration has advocated and secured the
inclusion of international emissions trading, Joint Implementation,
and the Clean Development Mechanism in the Kyoto Protocol as ways
to achieve the world's climate goals as cost-effectively as
possible. Future efforts in negotiations to design rules for
greenhouse gas emissions permit trading and to expand the scope
of trading will seek to ensure even greater cost-effectiveness.
Among the challenges that lie ahead include an improved application
of these tools internationally. Besides the United States, many
other industrial countries have employed incentive-based approaches,
especially emissions charges, to address environmental pollution.
Other countries, especially developing countries with substantial
air and water pollution problems, can learn from the experience
of the United States and other industrial countries and employ
these instruments to achieve better environmental quality with the
scarce resources they have available. Further, as countries begin
to recognize and address cross-border environmental problems such
as greenhouse gas emissions, the potential for cooperative use of
incentive-based instruments could provide countries significant
cost savings and environmental benefits.