[Economic Report of the President (2002)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 6

Building Institutions
for a Better Environment


The United States has achieved dramatic improvements in environmental
quality over the past 30 years. Toxic releases have been reduced since
they were first widely reported in 1987, waters safe for fishing and
swimming have doubled, and air quality has improved markedly. This
trend toward a cleaner, healthier environment, repeated in many of the
world's other developed countries, is reflected in various indicators
of environmental quality, including measures of sulfur dioxide, lead,
and carbon monoxide emissions. Box 6-1 shows how emissions of these and
other air pollutants have fallen significantly in the United States,
with similar gains in a host of other countries.
These improvements are the result of policies that sought to address
some of the most obvious risks to human health posed by air and water
pollution, leakage from hazardous waste sites, and unnecessarily
damaging mining and other extractive practices. In these early
initiatives, the benefits often far outweighed the costs. Now that most
of the largest and most glaring environmental problems have been
tackled, however, the gains to be expected from further measures have
become less obvious and more contentious. Meanwhile competition for
resources and for the attention of policymakers and concerned citizens
is as keen as ever. Medical research, national security, education,
capital investment, and consumption all make valid claims on both
government and private resources. As the environmental issues we
address become ever more complex, research and careful analysis of
both benefits and costs are required to formulate responsible policies
that will improve Americans' well-being and are cost-effective.
Put another way, the task now before us is to build the right
institutions to address these increasingly thorny environmental
issues. For example, there is evidence that further improvements in
air quality would improve health and reduce mortality, but these
improvements might be extremely expensive. Similar tradeoffs are
associated with reductions in certain toxic substances, such as
arsenic in drinking water and mercury from the burning of coal.
Although the health benefits from further reductions in these
pollutants are surely desirable, the associated expense might be
better directed toward alleviating other problems with the potential
for even larger reductions in health risks. Ongoing efforts to protect
endangered species, maintain biodiversity, and preserve ecosystems --
all of which can influence long-term land use decisions and short-term
economic activity -- could pose tradeoffs between the welfare interests
of current and future generations. Finally, concern over


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Box 6-1. Trends in National and International Environmental Quality
Some of the most dramatic improvements in environmental quality have
occurred in the air we breathe (Chart 6-1). The 1970 Clean Air Act
Amendments identified six common, nationwide air pollutants for which
emission limits were needed in order to achieve certain ambient
concentration levels based on health criteria. Since the law was
passed, emissions of most of these ``criteria air pollutants'' have
declined significantly. Perhaps the most impressive achievement is
the near elimination of lead emissions, which by 1998 were only 2
percent of their 1970 level.
One criteria air pollutant whose emissions have not fallen is nitrogen
oxides, and one might be tempted to conclude that environmental quality
with respect to this pollutant has gotten worse. But in fact the story
of nitrogen oxides regulation highlights the importance of using the
appropriate metrics in judging environmental quality: although
emissions of a pollutant are often reported, it is ambient
concentrations in the air we breathe that affect us directly and are
the target of most environmental regulation. In the case of nitrogen
oxides, and indeed for all criteria air pollutants, average national
concentrations have fallen in the past 20 years (Chart 6-2).
In addition to these reductions in criteria air pollutants, regulations
and voluntary actions on the part of companies have resulted in
substantial reductions in 188 toxic air pollutants that are either
known or suspected to cause cancer or have other serious health
effects. Nationwide emissions of these pollutants in 1996 were 23
percent below levels measured earlier in the decade. Concentrations of
some of these toxic air pollutants have been reduced even more
dramatically.
For many pollutants, such as sulfur dioxide, trends in the United
States mirror those in other industrialized countries (Chart 6-3). The
downward trend in such emissions is particularly impressive given the
substantial growth in national income over the same period. Although
it is sometimes assumed that economic growth leads to environmental
degradation, studies show that environmental improvements usually
accompany national income growth at higher levels of income, an
observation that the chart supports.
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potential climate change poses perhaps the greatest challenge. Sound
climate change policy requires striking a balance not only between the
well-being of current and future generations, but across countries as
well. Choices must be made in the face of considerable scientific
uncertainty and alongside competing concerns about energy security and
diversity of fuels.
In many of these issues, the debate is frequently cast in terms of a
tradeoff between environmental protection and economic growth. Yet the
two are not necessarily mutually exclusive. As a society becomes more
affluent, it is likely to demand a cleaner and safer environment.
Prosperity also allows us to commit ever-increasing resources to
environmental protection and to the development of science and
technology that will lead to both future growth and a better
environment. Indeed, empirical evidence suggests that growth eventually
goes hand in hand with environmental improvements.
The design of appropriate institutions plays an important role in
improving environmental quality; in particular, flexible approaches
to environmental regulation can increase the benefits and lower the
costs relative to alternative schemes. Such approaches often allow
businesses to pursue established environmental performance goals or
emission limits in the ways that they find most effective, rather than
following specific, detailed government mandates. This flexibility
encourages innovation and the development of cleaner technologies. Over
time, flexible approaches and other programs that promote technological
innovation offer the promise of less pollution at even lower costs. The
President's National Energy Plan, for example, builds on these ideas by
encouraging both increased flexibility in regulation and the
development of clean technologies.
Flexible programs also often involve a smaller, less costly regulatory
and compliance apparatus. In place of lengthy wrangling and resorting
to legal action between business and government over the interpretation
and applicability of particular rules, requirements, and regulations,
flexible approaches allow markets, financial incentives, and
business-to-business transactions to efficiently allocate resources
with minimal government supervision.
By institutions we mean not only the formal rules, regulations,
markets, monitoring, and administrative features developed for
environmental protection, but also the informal knowledge, experience,
and norms that are essential for effective outcomes. Institutions of
this kind that embody the flexible approaches described above do not
appear overnight. Part of the challenge for environmental protection
is designing and building the best institutions for the various
problems we confront today, but another part is carefully constructing
those institutions so that they can evolve to deal with emerging
problems tomorrow. In exploring ways we can build institutions for a
better environment, this chapter considers the pros and cons of
alternative flexible mechanisms such as tradable permits, tradable
performance standards, and emission charges. Several case studies of
alternative schemes then illustrate these mechanisms in practice.
Finally, we consider how this experience can be applied to the pressing
environmental concern over the potential threat of climate change.
We begin by briefly examining the motivation behind government
involvement in environmental protection.

The Government's Role
in Environmental Protection
At a basic level, environmental amenities have characteristics that
frequently make them more of a public than a private responsibility.
First, many environmental resources -- notably the atmosphere, the
oceans, and underground aquifers -- are shared without becoming the
exclusive property of anyone. Second, how one individual or business
chooses to use air, water, and land resources influences the value of
those common resources for many others. For example, marine fisheries
are an important food source, but excessive commercial fishing reduces
the ability of a fish population to reproduce and provide more fish
next season. Coal combustion provides an inexpensive and reliable
source of energy, but the resulting emissions of sulfur dioxide (SO2)
increase the acid content of lakes and forest soils. Lead in gasoline
is a convenient catalyst for boosting automobile performance, but it
has adverse effects on children exposed to the consequent emissions
from vehicles.
Economists refer to these environmental resources -- healthy fisheries,
healthy lakes and forests, and clean air -- as public goods, and to the
unintended, adverse effects resulting from the use of those resources
as externalities. More broadly, externalities are the uncompensated
effects of the activities of one individual or group on another:
because these effects have no financial consequences for the individual
or group undertaking the activity, they are external to the market. For
example, until the government intervened, those who overfished a
fishery did not bear the cost of that depletion to other fishermen and
consumers; the power plants that emitted SO2 had no financial
incentive to reduce those emissions; and the refiners and users of
gasoline faced no constraints on their use of lead as a catalyst. All
these consequences were external to the market transactions that
caused them and in some cases were not even appreciated at first.
Even when they are identified and understood, however, such
externalities by themselves are not necessarily a cause for government
intervention. So long as the externality is identified, the individuals
affected can, in theory, negotiate a solution. In our examples, some
fishermen could have paid others not to overfish, the users of
acidifying lakes and forests could have paid power plants to reduce SO2
emissions, and communities could have negotiated with refineries to
reduce the lead in gasoline.

The improbability of such solutions in the real world, however,
highlights the fact that the corresponding problems, and environmental
issues more generally, all involve public goods to some degree. This
complicates arriving at a privately negotiated solution, because it is
difficult to exclude those unwilling to pay to help solve these problems
from enjoying the benefits of the improved resource. The productiveness
of the fish stock, the recreational and commercial value of lakes and
forests, and the health improvements from reduced lead emissions are
all benefits that many if not all people can enjoy simultaneously and
that are difficult to exclude people from enjoying. Under these
circumstances, no single individual has the private incentive to
negotiate a socially beneficial solution, because most of the benefits
go to others. Nor is it easy for groups of individuals to band together
informally to pursue a solution, because each has an incentive to
``free ride,'' allowing others to take care of -- and pay for -- the
problem. Here the government can play an important role by representing
the interests of a large group of individuals and compelling all those
interested to share in the cost.

Measuring the Benefits and
Costs of Environmental Protection
Rectifying an environmental problem -- pollution in a river, for
example, or depletion of a fishery -- requires choosing both the
appropriate level of control or use and the institution best suited
to implement the controls. The level of control for many pollution
problems has traditionally been set with an eye toward benefits. A
prime example is air quality, where the Supreme Court recently upheld
a decision that national air standards must be set to protect the
public health without regard to costs, as set forth in the 1970 Clean
Air Act Amendments. At the time this and other early statutes were
passed, it may have appeared that the benefits were desirable at any
cost, or that the costs were low, removing the need to consider them.
However, as production technologies have become increasingly clean,
the further reduction of pollution has become more difficult, and costs
have risen. As a result, concern over costs has entered the regulatory
process: levels of control on hazardous air pollutants are based not
only on health concerns, but also on what control technologies are
available. This means that consideration is given to whether the level
chosen is feasible and cost-effective enough that someone has already
developed technology for it. Costs also play a role in some fishery
management policies, where the permitted annual harvest is set to
maximize the sustainable catch.
Comparing the benefits and the costs of environmental policies is
important because of the many competing needs for public and private
expenditures. The optimal level of environmental protection is that
where the benefit associated with one more unit of the resource equals
the cost of providing it, with both benefits and costs appropriately
added up across all individuals and over time. What should we include
in our cost and benefit measures? On the cost side, most expenses
associated with environmental protection arise from the use of marketed
goods and services, making calculations relatively straightforward.
For example, it is estimated that the recent decision by the
Environmental Protection Agency to lower the acceptable level of
arsenic in drinking water from 50 to 10 parts per billion will impose
a total annual cost of more than $200 million. This $200 million will
then be unavailable for other private and public activities -- including
other health and environmental programs. This therefore represents the
cost of the program, which can then be compared with the benefits. Note
that in the arsenic case -- as well as in two of the case studies
later in this chapter -- concern over the distribution of costs and
benefits was a particularly thorny issue, even though in theory it
should be possible to make everyone better off when the overall
benefits outweigh the costs.
The choice of policies and institutions to be used in achieving the
environmental objective also plays an important role in determining
costs. For example, cost estimates associated with implementing the
Kyoto Protocol vary by orders of magnitude, depending on assumptions
about the effectiveness of trading institutions. These trading
institutions allow countries with higher abatement costs to seek out
reductions in other countries with lower abatement costs. Because
certain institutions -- specifically, those that provide flexibility
-- offer the opportunity to achieve environmental goals at lower cost,
it is important to understand the differences among the major types of
environmental regulation, to which we return below.
On the benefits side, gains from environmental protection are often
divided into two categories: use value and nonuse value. Use value
refers to benefits that occur when individuals come into direct contact
with the protected environment. These benefits may be associated with
marketed goods and services, such as admission or transportation fees,
or nonmarketed activities such as hiking, swimming, camping, or just
looking at a beautiful natural landscape. They also include the health
consequences of breathing cleaner air and drinking cleaner water.
Nonuse value, which often involves nonmarketed goods and services,
refers to the less tangible benefits that arise from individual
preferences with respect to environmental amenities, as distinct from
their direct use. This includes the value derived from knowing that a
resource has been maintained and will be available to future
generations, or to oneself if one should ever decide to use it.
Use values associated with marketed goods and services can often be
estimated from observed behavior. For example, the willingness of
people to pay to use a national park -- as measured by the entrance fees
they actually pay, or their travel expenditure to get there -- can be
used to estimate the value they associate with the park. Wage studies
measuring the pay difference between low-risk and high-risk jobs can be
used to infer the value associated with prolonged life, which can then
be used to evaluate health-enhancing environmental proposals.
Expenditures on water filters or bottled water can be used to value a
reduction in water pollution. Nonuse values, as well as use values that
are not associated with market activities, are more difficult to
estimate accurately. Typically, individuals are surveyed and asked to
place a dollar value on hypothetical levels of environmental quality,
such as better visibility in scenic areas or enhanced protection of
wilderness, ecosystems, and biodiversity. This approach is still a
subject of scholarly research.

Types of Environmental Regulation
The policies and institutions used to achieve an environmental goal
often have significant consequences for the associated cost. As
environmental regulation has evolved, businesspeople and policymakers
have worked together to find more flexible approaches that achieve the
same goal at significant savings. These approaches range from standard
tradable permit and fee programs, to more complex tradable performance
standards and hybrid permit/fee programs, to more informal, flexible
regulatory arrangements.

Command-and-Control Approaches
Traditional regulations for environmental protection, such as those
legislated under the 1970 Clean Air Act Amendments, focused on
developing specific technology and performance standards for pollution
sources to meet. Technology standards mandate specific equipment that
sources must use to control emissions, whereas performance standards
mandate a limit on emissions allowed by each source. Because technology
standards typically require the same technologies for all sources, and
performance requirements require the same level of emission reductions
or emission rates at all sources, both these approaches fail to take
advantage of differences in the circumstances of each source. In
particular, they fail to encourage more reductions where the cost of
such reductions is low, and fewer reductions where the cost is high.
Over the years, numerous studies have documented the added expense of
limiting this kind of flexibility, with cost estimates of traditional
regulation ranging from as little as 7 percent to as much as 2,200
percent (that is, 22 times) more expensive than an efficient, flexible
program.

Standard Market-Based Approaches:
Permit Trading and Fees
In the cases of marine fisheries, SO2 emissions, and leaded gasoline
noted earlier, market-based policies have been used to provide greater
flexibility in meeting particular environmental goals. Fishermen, power
plants, and gasoline refiners were required to hold a volume of permits
(also referred to as allowances or quotas) equal, respectively, to the
volume of fish caught, emissions created, or lead blended into
gasoline. These permits were distributed on the basis of either past
or current production. Unlike the earlier, command-and-control
approaches, however, these permits could be freely traded, creating
highly efficient markets in which firms holding more permits than
needed could sell them to others or, in some cases, hold onto them for
future use.
These permit markets have many advantages. They ensure that the most
valuable uses of the affected resources are encouraged, they maximize
economic activity and growth consistent with a given level of pollution
reduction, and they encourage innovation in solving the environmental
problem at hand. In addition, the market price of the permits provides
a clear signal about the economic value of the environmental resource,
which can then be used for both business planning and policy evaluation.
Finally, although the permits in these programs were predominantly
distributed freely to predetermined stakeholders, the government could
choose in future programs to sell the permits, generating revenue that
could be used to reduce taxes on capital and labor, thus improving the
efficiency of the tax system.
Emission fees, where businesses pay a fee for each unit of emissions
rather than buy and sell permits, share many of the advantages of
tradable permits. They provide an incentive to engage in only the most
valuable uses of the environmental resource, send a clear signal about
its economic value, and generate revenue that can be used to reduce
other taxes. Emission fees, however, provide greater certainty to
businesses because the price associated with emissions (the charge
rate) is fixed. In contrast, because tradable permits are in fixed
supply, their price can fluctuate to reflect changes in demand --
sometimes substantially. As an example, a market for nitrogen oxides
(NOx) emission permits was established in 1994 in the area around Los
Angeles. At the end of 1999, permits for use in 2000 traded for around
$2 a pound, but by August 2000, during California's emerging electric
power crisis, they sold for as much as $50 a pound. Of course, the
greater price certainty associated with emission fees comes at a cost:
under an emission fee the actual level of emissions can fluctuate. Thus
emission fees make it trickier for regulators to achieve a targeted level
of emissions. Tradable permits also allow an administratively easier
redistribution of the value associated with emission rights. Revenue
from a permit fee can be rebated and redistributed, but this requires
the government to distribute money after collecting fees, thus
involving the government in myriad financial transactions. Under a
tradable permit system, permits can be distributed in advance of the
actual program, and financial transactions need occur only among
private firms and individuals. Perhaps because of this, emission fees
have received little attention in the United States, despite their
considerable popularity in other countries (Box 6-2).
An intriguing possibility is the coupling of a tradable permit system
with a fee-based ``safety valve.'' In this hybrid scheme, a regulatory
agency operating an ordinary tradable permit program would create and
sell extra permits on request at a fixed fee. If the fee were set
above the typical trading price -- for example, above the $2 a pound
price that prevailed before 2000 in the Los Angeles NOx permit market
-- it would ordinarily not interfere with the permit market. However,
in the event of an unusual demand spike like that


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Box 6-2. Environmental Fees in Other Countries
Whereas the United States has tended to use tradable permits to
encourage cost-effective reductions of pollutants, market-based
environmental regulation in other developed countries has more
commonly relied on fees, with particular focus on the transportation
sector. For instance, in 1995 about 90 percent of the revenue from
pollution control-related fees in 20 industrial countries came from
fees on gasoline, diesel fuel, and motor vehicles. In the last decade,
however, some European countries have developed fees specifically
designed to reduce particular industrial pollutants.
In 1992 Sweden introduced a charge on NOx emissions from large
combustion power plants. This fee of 40 Swedish krona per kilogram of
NOx emissions, equivalent to about $4 at the current exchange rate,
was extended to smaller power plant boilers in 1996. Revenue from this
fee is returned to the group of power plants that pay them in
proportion to each plant's share of total energy production. This
refund reduces the total financial burden on power plants from the
fee. But the fee still provides an incentive to reduce NOx emissions
whenever the cost for each unit reduced is less than the fee. The
Swedish government estimated that in 1995, as a result of the fee, NOx
emissions from power plants declined by 20 percent.
A Danish experiment with fees highlights one problem common to many
existing environmental fees. In 1992 Denmark introduced a fee on carbon
dioxide (CO2) emissions by households, which was followed in 1993 by a
similar fee on CO2 emissions by industry. As a result of concern about
the effect of these fees on Danish industrial competitiveness, the fees
were altered in 1995 so that certain energy-intensive industries paid
lower fees on CO2 emissions than did less energy-intensive industries.
Although this change had the desired effect of reducing the burden on
the more energy-intensive industries, it also reduced the
cost-effectiveness of the emission reduction scheme overall.
Firms facing CO2 fees will reduce emissions up to the point where the
cost of reducing another unit of emissions (that is, the marginal cost)
equals the fee. Beyond that level it is cheaper to simply pay the fee
than to further reduce emissions. Because different firms face
different fees in Denmark, they should end up with differing marginal
costs as well. This implies that the present arrangement is
inefficient, because the total cost of the prevailing level of emission
reduction could be reduced. Shifting some responsibility for emission
reduction from firms facing high marginal costs to those facing lower
marginal costs would lower the overall burden.
The Danish experience is not unique, however: throughout the
industrialized world, environmental fees have frequently been
accompanied by exemptions for particular products or industrial
sectors. The goal of some of these exemptions, to reduce the burden
of these fees on particular activities or sectors, can be achieved
through other means that do not reduce the overall cost-effectiveness
of the fee program: the revenue can be redistributed or rebated to
program participants. The administrative and practical difficulties
with such a redistribution point to an advantage associated with
tradable permits: their initial allocations can be conducted in a way
that alleviates burdens where desired.
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resulting from the California energy crisis, the fee would provide
additional flexibility and price stability, protecting both industry
and the economy. In point of fact, California enacted something like
this -- whereby a reserve of NOx permits would be available at $7.50
a pound -- after last year's permit shortage. Features like this have
been used in the SO2 trading program and in regulations for heavy-duty
engines, both discussed below.

Other Flexible Approaches:
Informal Markets and Tradable Performance Standards
In some cases it may be impractical to implement either an emission
fee or a permit trading program. For example, monitoring actual
emissions may be too expensive to make either viable. Emission fees
also face opposition because they impose on regulated firms the burden
of fee payments in addition to pollution control costs. At the same
time, tradable permits may be impractical because the transactions
costs associated with trading are too high, because there are too few
potential buyers or sellers, or because different levels of
sophistication among potential market participants are likely to lead
to inefficiencies.
In these situations, alternative institutions can arise that
approximate the efficiency of true market approaches by providing
flexibility, but trade off some of the potential economic gains in the
face of these practical constraints. One approach, discussed later in
the Tar-Pamlico case study, is a less formal trading market. Another
is a tradable performance standard.
The regulation of nitrogen oxides, particulate, and hydrocarbon
emissions from various types of combustion engines provides multiple
examples of how a tradable performance standard can work. Since 1991,
heavy-duty, on-highway engine manufacturers (who produce the engines
used in trucks and buses) have been able to comply with some of these
emission standards on new engines through a combination of averaging,
banking, and trading -- or ABT. This approach has been extended to
emission standards for many other types of engines, including outboard
boat engines, automobile and light truck engines, locomotives, and
small nonroad engines such as lawn mowers.
A typical ABT program begins with a schedule of emission standards.
For example, the NOx standard for heavy-duty, on-highway diesel engines
started at 6 grams per brake horsepower-hour for engines made in 1990,
falling to 5 grams in 1991 and 4 grams in 1998. After 2004, even
stricter standards will be applied. These are performance standards
in the sense that they specify emissions (grams of NOx) in relation to
other outputs -- in this case useful mechanical energy output measured
in brake horsepower-hours. Engine manufacturers who lower their
engines' emissions beyond the standard generate credits. The number
of credits is related to how much lower the emissions are, over the
life of the engine, than those for an engine that exactly meets the
standard. With some restrictions, manufacturers that earn credits can
use them to offset excess emissions from current-year engines that do
not meet the emission standard (averaging), reserve them for similar
use in future years (banking), or sell them to other manufacturers
(trading).

Compared with a program that requires all engines to meet the same
standard, these ABT programs make it possible to achieve the same
(or lower) emissions at a lower cost. The banking element encourages
manufacturers to overcomply in order to generate a stock of credits,
providing flexibility in the future. This overcompliance reduces
emissions below the standard in the current year. At the same time,
the flexibility to produce some engines that do not meet the standard
and others that surpass it -- while achieving the standard on average
-- allows manufacturers to reduce emissions more among those engines
where control costs are lower.
The program for heavy-duty, on-highway engines contains an additional
flexibility mechanism called a nonconformance penalty. Manufacturers
that fail to meet the standard, and fail to obtain credits from other
sources, can choose to pay a penalty based on the degree to which their
engines exceed the standard. As an example, in 1991 a manufacturer
producing a heavy-duty diesel engine that was certified at 6 grams of
NOx per brake horsepower-hour (when the standard was 5) could have
paid a penalty of about $1,600 for each engine rather than seek out
emission credits. The nonconformance penalty limits the maximum costs
that can be incurred by manufacturers seeking to comply with the
regulation, providing them an additional measure of financial
certainty. True, unlike the ABT mechanisms, which can lead to lower
emissions than the required level, this kind of penalty (if used)
allows emissions to rise relative to a program requiring strict
adherence to the standard. However, this flexibility may actually allow
the adoption of tighter standards, suggesting that such a
straightforward comparison is not valid.

Myths About Flexible Approaches
Despite the demonstrated benefits of flexible programs, popular concern
remains. Some of these concerns raise valid distributional and equity
issues. The economic and environmental benefits of flexible programs
are not always shared equally, and indeed, some stakeholders can end
up worse off. But other concerns derive from misperceptions about how
flexible approaches work. These misperceptions can be addressed by
better information. Below we discuss some of the more common myths
surrounding flexible approaches to environmental regulation, and
counter them with rational economic explanations.
Myth #1: ``It's immoral to buy the right to pollute.''
A widely held belief is that it is somehow unethical or even immoral
to allow firms to buy and sell the right to pollute. For example, it
has been claimed that turning pollution into a commodity to be bought
and sold removes the moral stigma properly associated with it, and
makes pollution just another cost of doing business, like wages,
benefits, and rent. Regarding climate change, it has also been asserted
that an emission trading program may actually undermine the sense of
shared responsibility that increased global cooperation requires.
Although it is difficult to refute arguments of a moral nature, claims
such as these contain several flaws. Certainly it makes sense to
maintain a moral stigma on pollution when polluters are making a
discrete choice whether to pollute. However, in most cases the creation
of some pollution is inevitable. Thus the question is not whether we
will pollute, but rather how much. In this context it makes sense to
evaluate pollution in terms of a tradeoff between the harm it causes
and the cost of abating it -- and tradable permits allow for this.
Furthermore, arguments based on morality seem an inappropriate
framework for the debate in light of the past achievements of tradable
permits in reducing pollution. For example, it seems strange to debate
the morality or immorality of the use of a tradable permit system to
phase out leaded gasoline, given that such a system in the 1980s
reduced atmospheric concentrations of lead more rapidly than anyone
had anticipated, and at a savings of $250 million a year. More
generally, the premise that environmental progress must be accompanied
by sacrifice is not necessarily valid. Finally, the ability of a
tradable permit program to make pollution an internal cost of business
is actually very effective, because it forces polluters to incorporate
the cost of their external environmental damages into their operating
costs.

Myth #2: ``Permit markets for pollution are unfair.''
It has also been claimed that a market-based system for environmental
control is inherently unfair, allowing some participants (those for
whom it is less costly to buy permits than to reduce their own
emissions) to evade their obligations. For example, a proposal for an
emission permit trading program for NOx in the Netherlands met
significant resistance in part because of policymakers' concern that
a free initial allocation of credits would benefit the most-polluting
companies, while penalizing those that had been more proactive in
limiting emissions. But those who oppose pollution permit markets on
these grounds overlook the fact that trading usually makes all
participants in a regulatory program better off, compared with the same
program without trading. Consider the following hypothetical example:
Suppose that company A would have to spend $50 million annually to
reduce its emissions as required by some new regulation, whereas
company B could reduce its emissions by the same amount at a cost of
$5 million but is not required to do so. Trade in emissions would make
both companies better off. If company A pays company B $30 million in
exchange for company B's agreement to reduce its emissions in place of
company A, company B would be better off by $25 million, and company A
would pay $30 million rather than $50 million to reduce emissions.
Indeed, because trade is optional, its mere existence is evidence that
trade is beneficial for both parties -- if it were not, one party would
opt out.
Along the same lines, it is often mistakenly assumed that emission
trading somehow favors larger companies, allowing them to buy their way
out of pollution reductions whereas smaller companies cannot. But in
fact, smaller companies often benefit more from permit markets: because
they may not have as many internal options for pollution reduction, the
potential to buy emission permits gives them added flexibility. The
mistaken assumption that emission trading favors large companies also
ignores the distinction between the allocation of permits (and emission
rights more generally) and their subsequent trading.
The allocation of permits provides an opportunity to assign
responsibility for emission reductions in a way that addresses this
concern. For example, one could issue proportionally more permits to
smaller companies to reduce their burden. Or one could reward companies
that have already reduced emissions by providing them with extra
permits. The smaller companies, or the ones receiving extra permits,
would then be free either to use the permits themselves -- forcing
other companies to reduce more -- or to sell them if they choose.
Moreover, almost no form of regulation (or, for that matter, of
markets) is ``fair'' under all possible definitions. For example,
consider a hypothetical industry in which some firms have invested in
newer (more costly) equipment that is less polluting, whereas other
firms still use older equipment that is more polluting. Suppose that
the government now introduces a regulation requiring, explicitly or
implicitly, that all firms in the industry use a third, new technology
that is less polluting than either of the first two. Both companies
will then have to spend money switching to the new technology. But not
only will the firms that originally invested in the intermediate
technology receive no benefit from having polluted less in previous
years; they will in fact lose more money because they invested in this
second-best technology that they now have to discard. Few would
consider such a result fair -- certainly these firms would not.
To take a real-world example, consider the United States' upcoming ban
on methyl bromide. Subsequent to the 1987 Montreal Protocol,
participating developed and developing countries agreed to completely
phase out the use of this ozone-depleting chemical by 2005 and 2015,
respectively. Currently, California strawberry and Florida tomato
production relies on methyl bromide to control for pests and weeds.
Substitutes for methyl bromide are expected to be less effective and
produce lower crop yields. Meanwhile, competing strawberry and tomato
growers in Mexico can continue to use methyl bromide for an additional
10 years, thus allowing them to increase their imports to the United
States, at the expense of U.S. production. Surely the U.S. farmers
would not consider this form of traditional regulation fair.
Finally, those who believe it is unfair for some firms to purchase
permits rather than reduce emissions or limit resource use sometimes
overlook a feature of a fully tradable permit system that they
themselves can take advantage of, to remove permits from the system.
If they are unhappy that firms are buying permits in order to comply,
they can simply purchase existing permits themselves and retire them,
thereby reducing the number of permits available to those firms. This
method has been used, for example, by people concerned about wetland
preservation to buy water rights from agricultural users in Nevada.
In thinking about fairness generally, society first needs to determine
what it believes is fair. Second, groups in society need to remember
that those adversely affected by a policy change can in principle be
compensated if it is felt that such compensation would make the policy
more fair. Compensation can occur under any form of regulatory tool,
whether traditional or market based.
Myth #3: ``Tradable permits and other flexible mechanisms will
never work in the real world.''
Flexible mechanisms do work, and we know this from real-world
experience: the successful results of many different pollution
abatement and resource management programs that have used them. These
mechanisms have been shown to be a highly effective (but certainly not
the only) means of controlling pollution and managing resources. The
case studies below document this experience for a variety of
environmental concerns. Although the setup and structure of these
programs vary considerably, each has allowed for flexible methods of
compliance. As a result, many have achieved their reduction and
conservation goals at substantially lower cost than traditional
command-and-control approaches. For these programs to work well,
however, certain conditions must prevail; these are discussed in
greater depth in the section on lessons learned, at the end of the
chapter.
Myth #4: ``Traditional regulation encourages technological
innovation and adoption of new technologies more than do
market-based mechanisms.''
As discussed above, the circumstances of some environmental issues may
favor traditional regulatory approaches, including technological
standards mandating the use of a specific technology, and performance
standards, which require each firm to demonstrate a certain performance
level, expressed as an emission rate per unit of input or output.
However, the requirement to use a particular technology prevents firms
from seeking out cheaper alternatives. And because individual firms are
usually in the best position to find those cheap alternatives, it is
likely that technological mandates retard innovation. By specifying
compliance in terms of a fixed technology or performance level, both
kinds of standards provide little incentive for ongoing improvements in
pollution control techniques. That is, firms may get no benefit from
improvements they might discover that would allow more emission
reductions for the same price. Lacking this incentive, firms may not
invest continuously in research and development to enhance environmental
quality. Barriers such as these have contributed to declining private
sector funding for environmental technology development once firms have
met the established standards.
Flexible mechanisms, in contrast, encourage firms to constantly seek
out the most cost-effective technology to reduce their pollution.
Moreover, the wider technological choice that results from such
research creates greater opportunities for still further innovation,
which cannot be predicted or captured in a government-controlled
technological mandate. One example demonstrating that flexible permit
trading programs promote innovation is the success of the Title IV SO2
program established under the 1990 Clean Air Act Amendments. This
program is discussed in greater detail in the case study below.
Because the program did not impose a technological requirement, and
consequently rewarded all emission reductions, firms began to
experiment with blending the high-sulfur coal that many of them had
been using with low-sulfur western coal. Blending worked far better
than had been thought possible, resulting in low-cost emission reductions.
Because the SO2 program also included a flexible banking mechanism,
firms had an incentive to use these low-cost opportunities to reduce
emissions substantially below the required levels. Excess emission
reductions such as these are unlikely in programs that limit compliance
to a fixed technology or performance level, because they provide no
incentive for overcompliance.
As a second example, research shows that stricter building codes have
had little effect on homebuilders' choice of insulation technology.
On the other hand, higher energy prices and adoption subsidies (which
pay homebuilders directly to use more energy-efficient insulation)
would have had a much greater effect. In this case, flexible incentives
would have led to the more rapid adoption of new technologies, where
traditional regulation failed to do so.
Finally, fisheries have long been subject to command-and-control
regulation, which, for example, set limits on the time spent fishing.
There is strong evidence that, under this type of regulation, fishing
operations built up excess capital: too many ships were acquired, and
too much equipment was installed, in order to catch as many fish as
possible in the short time allowed. In the case of the Federal
surf-clam fishery, in contrast, tradable permits succeeded in reducing
the number of ships and the amount of capital used, and thus led to a
more efficient use of existing technology than the various size limits
and time restrictions that they replaced. One of the case studies below
discusses fisheries in more detail.

Case Studies in Flexible Environmental Protection
Recognizing that flexible approaches to environmental protection can
work solves only part of the puzzle. The other part is identifying the
right institutional arrangement for the environmental problem in
question, and the right development path along which to build those
institutions. Perhaps the best way to understand how flexible programs
are put into place is to consider several examples. Below we review
three such programs that use varying approaches to address different
environmental problems.
The Sulfur Dioxide Permit Trading Program
History of Sulfur Dioxide Regulation
Sulfur dioxide, when released into the atmosphere, reacts with water,
oxygen, and other chemicals there to form an acidic deposition known
as acid rain. Acid rain has the potential to raise the acidity of
lakes, resulting in fish kills; to reduce the alkalinity of forest
soils, harming various tree species; and to degrade various other
ecosystem functions. Studies have also linked SO2 with degradation of
visibility and with increases in fine particulate matter in the
atmosphere, which can cause respiratory problems in humans. In North
America, acid rain is a concern mainly in the northeastern United
States, particularly in the Adirondacks and New England, and in
southeastern Canada. The majority of SO2 emissions come from
industrial activities, although natural sources -- volcanoes and sea
spray -- also contribute.
Historically, SO2 pollution control has focused on fossil fuel-burning
electric power generators, which are responsible for approximately
two-thirds of all SO2 emissions in the United States. The 1970 Clean
Air Act Amendments, the first significant Federal air pollution
legislation, led to the establishment of national air quality standards
for permissible concentrations of SO2 in the air. States were largely
held responsible for meeting these standards in each local area
through the development of a State Implementation Plan (SIP),
specifying actions to be taken to bring the State into compliance. As
part of their SIPs, States required some existing power plants and
others not yet built to have high smokestacks, so as to disperse
emissions over a wider area. However, because acid rain can sometimes
fall hundreds of miles downwind from its source, tall stacks may
actually have increased SO2 concentrations at distant locations. The
1970 amendments also imposed New Source Performance Standards (NSPS),
which applied only to new power plants. These standards set new
coal-fired plants' maximum allowed emission rates significantly below
the emission rates of existing plants.
In projecting States' future air quality, it was assumed that existing
plants not meeting the NSPS would gradually be retired, following
historical patterns. However, this assumption failed to account for
the strong incentives that the rules themselves created to extend the
lives of older plants, which were expensive to replace with plants
meeting the NSPS. By 1975 it had become clear that, because older
plants were continuing to operate longer than expected, many States
would not be able to comply with the air quality standards within the
mandated time period. As a result, the 1977 Clean Air Act Amendments
extended the deadline until 1982 and tightened the NSPS in those areas
unable to meet the original deadlines. These new NSPS rules required
coal-fired plants built after 1978 to remove a specified percentage
of potential emissions. This, however, reduced the advantages of using
low-sulfur coal as a means of compliance, because percentage
reductions were still required regardless of the type of coal used.
Thus regulations may actually have dirtied the air on balance, by
encouraging utilities to burn high-sulfur coal and by strengthening
the incentives to extend the lives of old, dirty plants. The NSPS
requirements also raised fairness issues, as some industries (such as
high-sulfur coal producers) benefited while others (such as low-sulfur
coal producers) suffered losses. Also among the losers were those
States, mostly in the West, that were already using low-sulfur coal to
generate electricity and were growing rapidly.
The 1990 Clean Air Act Amendments
Because current controls were not successful at achieving the SO2
emission reduction goals, a new acid rain program was launched under
the 1990 Clean Air Act Amendments. Title IV of the amendments set a
goal of reducing annual SO2 emissions by 10 million tons from the 1980
level. To achieve these ambitious reductions, the law required a
two-phase tightening of the restrictions placed on fossil fuel-fired
power plants. Phase I, which began in 1995, affected 263 units at 110
mostly coal-burning electric utility plants located throughout 21
eastern and midwestern States. An additional 182 units opted into the
program during the course of Phase I. Phase II, which began in 2000,
further tightened annual emission limits on the larger, higher emitting
Phase I plants and set emission restrictions on smaller, cleaner
plants, some of which were fired by oil or natural gas.
To achieve these goals, the 1990 amendments directed the Environmental
Protection Agency to design a trading program in SO2 emission
allowances. The program provides incentives for energy conservation
and technology innovation that both lower the cost of compliance and
increase pollution prevention. Under the program, units are allocated
allowances based on their historical fuel consumption and a specific
emission rate. The large sizeand relatively small number of plants made
it easier for emissions to be monitored continuously, increasing the
credibility of emissions accounting and simplifying verification of the
achievement of emission reduction goals. The majority of allowances are
allocated by the agency without cost to the recipient. However, every
year a small fraction (about 3 percent) of allowances are held back and
sold in an auction administered by the Chicago Board of Trade. The SO2
program also has a reserve of allowances that provides firms with the
opportunity to purchase additional allowances at a fixed price of
$1,500 (in 1990 dollars; this figure is adjusted each year for
inflation). Each allowance permits a unit to emit 1 ton of SO2 during
or after a specified year. Allowances may be bought, sold, or banked
for future use. If a plant's annual emissions exceed the number of
allowances held, the owners must pay a penalty of $2,000 (in 1990
dollars, also adjusted for inflation) per excess ton of emissions.
Violating units are also required to make additional future emission
reductions. Trading is not restricted to utility plants; anyone may
buy or sell allowances. For example, speculators have acquired some
allowances in hopes of future price increases, and environmental
groups and some individuals have acquired allowances in order to
reduce emissions more than the law requires.
Results
Participation in the trading program has been strong. Through the end
of 2000, over 11,600 transfers had taken place, involving 111 million
allowances. Approximately 59 percent of these (66 million) were
transferred within organizations, and the remainder between
economically distinct organizations. Both the number of transfers and
the associated number of allowances have increased greatly since the
program's inception (Chart 6-4). In the first year of trading (1994),
66 transactions took place, exchanging 0.9 million allowances between
economically distinct organizations. In 2000, 2,889 transactions
resulted in the transfer of 12.7 million allowances.
The trading program has lowered emissions substantially while yielding
considerable cost savings, especially compared with the previous,
command-and-control regime. Emissions data indicate that in the
program's first target year (1995), nationwide emissions by the units
required to participate in Phase I were reduced by almost 40 percent
below their required level (Chart 6-5). This overachievement was
encouraged by the provision allowing firms to bank credits for future
use when they reduce emissions in excess of current requirements. The
General Accounting Office projects that, compared with the
command-and-control approach, the allowance trading system could save
as much as $3 billion a year, or more than half the total cost of
meeting the standards. Some economists, however, believe this estimate
overstates the program's cost reduction. As low-cost options for
emission reduction emerged that had not been foreseen in 1989, there
has been over time a clear downward trend in the predicted cost of the
program. This primarily results from the fact that, as it turned out,
low-sulfur coal could be substituted for high-sulfur coal much more
easily than had been anticipated at the program's inception. On the
other hand, this less costly method was likely adopted, in part,
precisely because of the flexibility allowed for in the SO2 trading
program. A command-and-control program, whether based on performance
standards or on technological requirements, might have afforded much
less opportunity to take advantage of this low-cost alternative. In
this case, flexibility allowed adoption of the optimal, most efficient
solution available.





Tradable Quotas in the Alaskan Halibut
and Sablefish Fisheries
The preceding example focused on a national pollution problem, which
required a national solution. But flexible approaches have also been
successfully applied to local and regional environmental problems, as
the next two case studies demonstrate.

Fish in the coastal waters and open seas are the private property of
no one; they are there to be caught by anyone with a boat, a fishing
permit, and the necessary equipment. This public access nature of
saltwater fisheries results in economic inefficiencies. If fish could
be fenced in and counted like cattle, property rights could be
allocated for each fish, or for a school, or for an entire fishery.
Owners of such rights would have an incentive to limit their catch,
so that enough fish are left each year to ensure the sustainability of
the fish population, and thus of the owners' profits, in future years.
However, because rights to individual fish or to fisheries cannot be
established, and no one private fishing operation can control the
actions of others, it is often in each fisherman's best interest to
catch as many fish as possible, as quickly as possible, before the
others do. As a result, many fisheries have suffered from an excess of
capital, participation, or effort given the amount of fish available.
This, in turn, has led not only to overfishing and depletion of the
resource, but also to increased conflict and hostility, undesirable
price and market effects, and increased physical danger to fishermen.
Regulation of U.S. fisheries was established in 1976 with the passage
of the Fishery Conservation and Management Act (later renamed the
Magnuson-Stevens Fishery Conservation and Management Act). Since then
the act has been amended more than a dozen times, marking significant
changes in its course and emphasis. The 1996 amendments emphasized the
goal of biological conservation of fish stocks and protection of
habitats, along with other resource management objectives. For the
first time, the amendments made the prevention of overfishing an
enforceable obligation on the part of the Federal Government.
In some fisheries, authorities have sought to achieve these goals
through the use of a market-based output control mechanism called
individual fishing quotas (IFQs, sometimes also called individual
transferable quotas). An IFQ is defined as ``a Federal permit under
a limited access system to harvest a quantity of fish, expressed by a
unit or units representing a percentage of the total allowable catch
(TAC) of a fishery that may be received or held for exclusive use by
a person.'' Ideally, regulators should set the TAC equal to the
socially optimal catch (that is, the maximum sustainable catch). To
date, IFQs have been adopted in a number of U.S. fisheries, such as
those for surf clams and ocean quahogs, South Atlantic wreckfish, and
Alaskan halibut and sablefish. Such mechanisms have also been used in
other countries, including Iceland and New Zealand.
The experiences of the Alaskan halibut and sablefish fisheries are
particularly illustrative. When the IFQ program was launched in 1995,
the estimated coastwide biomass of halibut was above the 25-year
average, but was declining and expected to continue to drop in the
future. As of 1999, sablefish biomass had been declining since 1986
and was 30 percent below the recent average. Before the IFQ program,
efforts to maintain fish stocks took the form of traditional
management: regulators set an annual TAC on commercial fishing of
halibut and then attempted to achieve the TAC through a combination of
area, season, and gear restrictions. These regulations resulted in a
host of problems, such as gear conflicts, fish kills due to gear lost
at sea, discarded fish mortality, excess harvesting capacity, declines
in product quality, safety concerns, unmonitored catch of regulated
species in other fisheries, and economic instability within both the
fishing industry and fishing communities. Evidence of some of these
problems can be seen in the extremely short annual season for halibut
fishing: from 1980 to 1994 the season averaged only 2 to 3 days in the
management areas responsible for the majority of catches.
IFQ Design
Consideration of limits to entry began in 1977, but because of
implementation delays, IFQs for halibut and sablefish were not
approved until the end of 1991 and were implemented only in 1995. A
primary objective of the program was to eliminate the fishing derby
associated with the shortened season and the limit on the catch. This
frantic race for fish was not only unsafe but inefficient as well. To
increase their individual catch, some fishermen brought in additional
vessels, and this imposed higher costs both on themselves and on
others. These higher costs included increased harvesting and processing
costs and decreased product prices, as well as the potential for higher
debt service, additional unmonitored fish mortality, and increased
accidents.

The design and management of the IFQ programs for Alaskan halibut and
sablefish are largely the same. Landing data for halibut are collected
by individual State governments and then forwarded to the International
Pacific Halibut Commission (IPHC). Catch data for sablefish are
collected by the individual States and the National Marine Fisheries
Service (NMFS). Both programs require IFQ owners to be on board the
vessel when the IFQ is being fished. They also set limits on the
accumulation and transfer of quota shares. No person may own more than
0.5 percent of the total quota share for halibut, or 1 percent of the
share for sablefish, in particular areas. Transferability is restricted
across vessel size and across vessel categories.
IFQs were allocated to vessel owners and leaseholders who had
verifiable commercial landings of halibut or sablefish during any of
the eligibility years 1988, 1989, and 1990. Specific allocations were
based on the best 5 years of landings during the qualifying years of
1984-90 for halibut and 1985-90 for sablefish.
The catch is monitored through a combination of real-time and
post-transaction auditing. Deliveries may be made only to registered
buyers, and notice must be given to the NMFS. Real-time auditing is
through IFQ landing cards and transaction terminals. Post-transaction
auditing compares the records submitted by registered buyers with the
fishermen's landing records. Provisions also exist for over- and
underharvests: limited amounts of annual quota shares can be either
deducted or credited to the next year's allocation. In part because of
this extensive monitoring system, administration of IFQ programs is
somewhat costly. Nevertheless, it is believed that the program's
economic benefits will far outweigh the increase in management costs.
In addition, as mandated by the new Magnuson-Stevens Act requirements,
a cost recovery program to help defray monitoring and enforcement costs
was established in March 2000.

Results
Measured against the program's stated goals, IFQs for halibut and
sablefish have been highly successful. Most notably, the race for fish
was eliminated. The season has increased from less than 5 days to 245
days a year for both species, and landings are now broadly distributed
throughout the season. As a result, safety has improved. The program
also reduced the frequency with which the TAC was exceeded, in both
fisheries. In addition, the IPHC estimates that discarding of halibut
bycatch fell by about 80 percent between 1994 and 1995, as did halibut
mortality from lost or abandoned gear (although significant uncertainty
surrounds both these estimates). There does not, however, appear to be
any difference in sablefish bycatch before and after IFQ
implementation. There is anecdotal evidence of highgrading (discarding
all but the most profitable fish), but comparisons of halibut
size-composition data suggest that any highgrading that does occur is
insignificant. Underreporting of either halibut or sablefish catches
does not appear to be a problem.
Meanwhile the quota share markets have been active, with more than
3,800 permanent transfers of halibut quota shares to date and more
than 1,100 transfers of sablefish quota shares. Trading under the IFQ
program has also led to some consolidation: the number of quota
holders declined by 24 percent for halibut and 18 percent for sablefish
between January 1995 and August 1997. In both fisheries the bulk of
this consolidation has taken place among those with smaller IFQ
holdings. Although it seems likely that the overall efficiency of the
fisheries has increased, it remains uncertain how costs and revenues
have been affected.
Despite these successes, some concerns remain. Most complaints center
on the allocation of IFQ permits, while the rest tend to reflect
problems common to any fishing restriction. The primary complaint
concerning the initial allocation relates to the delay between the
qualifying years and the implementation of the program. Some
fishermen who have become active since the qualifying years received
no initial free allocations and had to purchase all their quota rights.
Conversely, some quota shares were awarded to individuals who had been
active during the qualifying years but inactive in the years
immediately preceding implementation. Crewmembers and processors also
allege that the initial allocation rewarded vessel owners and
redistributed market power in favor of quota shareholders. In addition,
there is ongoing concern about community effects, adequacy of
enforcement, the potential for localized depletion, and the preemption
of productive sportfishing grounds (which are not regulated) by
commercial fishermen. Many of these issues could plague any fishing
regulation scheme.

Informal Permit Trading in the Tar-Pamlico River Basin
In 1983 local fishermen and citizens in the basin of the Tar and
Pamlico Rivers of eastern North Carolina noticed sores on fish, algal
blooms (aquatic algae consuming the water's available oxygen), and
fish kills in their local rivers and estuaries. Because studies link
many of these problems to increased concentrations of phosphorus and
nitrogen in water systems, the North Carolina Environmental Management
Commission (EMC) designated the region a Nutrient Sensitive Water in
1989.
Laying the groundwork for future regulation was somewhat complicated
by the fact that these nutrients came from different types of sources:
83 percent of nitrogen and 66 percent of phosphorus loads originated
from non-point sources, such as agricultural runoff and natural
phenomena. The remainder came from point sources such as water sewage
treatment facilities and local industry. Given the political and
technological constraints on detecting, monitoring, and enforcing
non-point source nutrient reduction, the proposed EMC regulation
targeted point source discharges, setting strict limits on new
dischargers and the expansion of existing ones. The ultimate goal of
this command-and-control regulation was to reduce phosphorus and
nitrogen loading into the region's waters by 200,000 kilograms a year
by 1995.
Some of the publicly owned treatment works (POTWs) affected by the
regulation estimated that together they would have to spend between $50
million and $100 million to achieve compliance with the State's plan.
Concerned about these high capital costs, the POTWs, in conjunction
with a private firm, asked the North Carolina State government if a
better solution could be found. Working with the Environmental Defense
Fund (a private nonprofit group, now called Environmental Defense) and
the Pamlico-Tar River Foundation, a coalition of dischargers called the
Tar-Pamlico Basin Association proposed an alternative solution
involving collective nutrient trading.
Under the arrangement, which was approved in 1989, two types of trades
are allowed: collective trading among point sources and collective
trading between point sources and non-point sources. In the first case,
members of the association operate within a ``bubble,'' offsetting one
another's discharges to achieve a specified overall limit. In the
second case, the members collectively have the option to achieve all
or part of the total nutrient reduction goals by funding agricultural
best management practices (BMPs) through the State's Agricultural Cost
Share Program, which pays farmers to reduce nutrients and runoff.
These offset funds are used to pay willing farmers 75 percent of the
cost of adopting nutrient-reducing BMPs on farms within the basin. In
this manner the Tar-Pamlico program establishes responsibility at the
group rather than the individual level, as no transactions occur
between individual point source and non-point source polluters.
So long as the association succeeded in reducing phosphorus and
nitrogen emissions by the originally targeted 200,000 kilograms a year,
no specific emission reduction requirements would be imposed. Given
this flexibility, the association estimated that it could meet this
reduction for about $11.5 million, far less than the estimated cost of
the proposed command-and-control regulation. The agreement between the
association and the State also required the association to fund a
computer model simulating nutrients' flow and effects; to hire a
consultant to evaluate existing wastewater treatment plants, to
determine the changes needed to ensure that they are operating at
maximum efficiency; to monitor each member's weekly phosphorus and
nitrogen discharge; and to provide upfront funding for the Agricultural
Cost Share Program.
In all, 15 dischargers, contributing about 90 percent of all point
source flows to the basin, eventually joined the association. Some of
those that decided not to join cited the risk involved: there was no
guarantee that the association would achieve the required nutrient
reduction by 1995. If it failed, the investment and membership costs
would be forfeited, and the State's original command-and-control plan
would be implemented. Other point source dischargers that had already
planned or begun upgrades in plant facilities could meet the State's
stricter limits without the need to trade.
A tricky feature of this program is the arrangement for trading between
point and non-point sources. Whereas the amount of nutrient load
entering the water from a point source is easily measurable, that from
a non-point source is not. This is in part because the amount of
nutrient loading resulting from a given amount of fertilizer can vary
considerably, depending on the weather and other conditions outside
anyone's control. Because of this added uncertainty, expected non-point
source emissions are imperfect substitutes for point source emissions:
more than one unit of non-point source reductions is necessary to
equal, in quality-adjusted terms, a unit of point source reductions.
It was recognized that, because of this, trades between these two
types should not occur at a one-to-one ratio. But it was also
recognized that the choice of the trading ratio between point and
non-point sources would be key to the program's success: too high a
ratio would discourage trading, but too low a ratio might fail to
achieve abatement goals. In the end, the trading ratio was set at two
to one for effluents from non-point sources involving livestock (such
as pastureland and poultry operations), and three to one for cropland.
That is, to acquire a one-unit credit, the association must pay the
State's Agricultural Cost Share Program for the reduction of two (or
three) units of a non-point source's nutrient emissions.
To date, compliance has been achieved entirely through trade among point
sources. It is uncertain whether this indicates that the trading ratio
was set too high, or that abatement costs at point sources are in fact
the lowest-cost alternative. But an important outcome is that, thus
far, internal ``trades'' have taken place rather informally. Instead
of paying one another to undertake pollution control measures,
association members reportedly have each agreed to incorporate nutrient
removal systems whenever they expand their facilities. The association
maintains that this approach is less costly: economies of scope make
it less expensive to expand a facility and upgrade the control
technology simultaneously, rather than on separate occasions as
trading might require.
The two largest emitters in the group, both POTWs, were among the
first to implement nutrient removal systems. Smaller members have since
followed suit. The association expects to achieve the reduction
requirements through internal trading for the next 4 or 5 years, after
which members may begin to take advantage of trading with non-point
sources, or shift to a more formal trading system within the
organization, or both.
The results of this market-based program have been impressive (Chart
6-6). Because of growth in nearby communities, dischargers have had to
become even more efficient with respect to their nutrient emissions.
Even though the association's combined discharge flow increased
approximately 20 to 35 percent from 1991 to 1997, total nitrogen
concentrations fell by 10 to 20 percent, and total phosphorus
concentrations by 20 to 40 percent, in the same period.



When Markets Don't Work
The preceding case studies highlighted three examples where flexible,
market-based approaches have been used to achieve environmental goals
at substantial savings over less flexible alternatives. In each case
the institutions and their historical development differed
substantially. An important lesson is that these different settings
required different approaches in order to succeed.
In other words, flexible approaches do not succeed simply by virtue
of their flexibility. Other elements are necessary as well. First,
tradable permit markets typically require a large number of
participants to work well. As the Tar-Pamlico case study suggests,
one way around this dilemma of a small number of participants may be
to create a more informal trading association. Second, it is important
that trading not be inhibited by overly cumbersome restrictions. For
example, in 1981 the Wisconsin Tradable Discharge Permit system was
organized on the Fox River, allowing rights to biochemical oxygen
demand discharges (which decrease the oxygen available for fish and
other aquatic species) to be traded among point sources. By 1996,
however, only one trade had taken place. It is likely that trading was
infrequent because administrative impediments discouraged the transfer
of permits. Dischargers are not allowed to trade unless they can
demonstrate need, and therefore they cannot trade solely for the
purpose of reducing treatment costs. Moreover, the traded rights are
guaranteed for a maximum of 5 years, with no assurance that rights will
be renewed.
In addition to liquidity among participants at a given moment,
liquidity across time is necessary to smooth out temporary fluctuations
in aggregate permit demand. For example, the SO2 trading program allows
firms to bank unused permits for future use. By 1996, after just 2
years of operation, the total volume of banked permits actually
exceeded annual emission levels. This bank provides an effective
cushion against demand fluctuations, as the banked permits can be
increased or drawn down as needed. In contrast, the Los Angeles area
NOx program initially lacked a permit bank or other source of aggregate
flexibility. As a consequence, the permit price skyrocketed from its
historical level of around $2 a pound to nearly $50 a pound in the
summer of 2000, because of increased demand from fossil-fuel
electricity producers. Similarly, an innovative internal greenhouse gas
emission trading program at a major energy company has seen
fluctuations in demand cause the price to jump to $99 per ton of carbon
dioxide in less than 1 year from almost zero the year before, in the
absence of a substantial bank. These aggregate liquidity problems
could be solved either by developing a bank or, as suggested above, by
empowering the regulatory agency to provide a safety valve, selling
additional permits when the price reaches a specified threshold.
Finally, flexible programs work best when monitoring costs are low and
when financial incentives -- fees or permit requirements -- are easily
associated with actual emissions or resource use. Automobile emissions,
for example, are poor candidates for a trading program: it is
impractical to require the drivers of the Nation's more than 100
million registered automobiles to both monitor their individual
emissions and acquire tradable permits accordingly. Still, we see
flexible approaches -- in the form of tradable performance standards
described earlier -- applied to these sources.
Lessons for Future Policy: Climate Change
One of the most controversial and complex environmental policy challenges
facing the United States -- and the world -- is the long-term issue of
climate change. This potential problem spans both generations and
countries, implicating simultaneously the environment, on the one hand,
and the world's fundamental economic reliance on fossil fuels -- a key
source of climate change risk -- on the other. What do the lessons
learned in this chapter suggest about a reasonable approach to climate
change?
Base Policy Action on Sound Science
In each of the case studies presented in this chapter, government policy
responded to an environmental problem in a manner designed to protect
not only the environment but also economic well-being. Sound science
guided those responses and must do so in our response to climate
change, as articulated by the President in his speech in the Rose
Garden on June 11, 2001. Yet the risks arising from climate change are
less clear than the risks identified in the case studies, as is the
appropriate response. We are uncertain about the effect of natural
fluctuations on global warming. We do not know how much the climate
could or will change in the future. We do not know how fast climate
change will occur, or even how some of our actions could affect it.
Finally, it is difficult to say with any certainty what constitutes a
dangerous level of warming that must be avoided.
Therefore an important element of a reasonable climate change approach
must be more research into both the science of climate change and
mitigation technologies, in order to learn more about the risks and
the appropriate response. The President has committed the United States
to do just that, with research initiatives in both the science of
understanding climate change and the means of mitigating its effects.
This includes the President's Climate Change Research Initiative and
his National Climate Change Technology Initiative, which will add to
the more than $18 billion spent on climate research since 1990.
Choose a Flexible, Gradual Approach
The President has also directed an effort to consider approaches to
reducing greenhouse gas emissions. All of the case studies in this
chapter demonstrate that flexible approaches consistently provide
environmental benefits at a lower economic cost than traditional
methods. Flexibility is even more important when balancing climate
change and fossil energy use. An effective program must include all
greenhouse gases, all emission sources and sinks, and, given the
global nature of the problem, all countries. It should provide for
flexibility to shift emission reductions over time in response to both
short- and long-term opportunities. Flexibility is needed in the face
of changing economic conditions, scientific uncertainty, and the
development of affordable, advanced energy and sequestration
technologies. Finally, an effective program needs to consider
non-greenhouse gas emissions that contribute to climate change, such
as tropospheric ozone and black soot. Because all of these dimensions
offer promising opportunities to address climate change, each must be
used in a way that maximizes the mitigation benefit for every dollar
spent.
Ideally, this could be accomplished by creating the same incentives
for equivalent emission reductions in all these different dimensions:
across gases, across sources, across countries, and over time. These
incentives would necessarily adjust in response to changing economic
conditions and additional knowledge concerning benefits and costs. Yet
concepts such as a worldwide tax on greenhouse gas emissions or a
worldwide tradable permit system, sometimes advertised as solutions,
are at best useful theoretical benchmarks against which to measure
alternative, practical approaches. At worst, they can be a distraction
from meaningful, realistic steps forward.
Why are such proposals impractical? Because they fail to recognize the
enormous institutional and logistical obstacles to implementing any
sweeping international program. Institutionally, it is important to
learn to walk before trying to run. The United States implemented its
successful SO2 trading program only after gaining experience in the
1970s and 1980s with netting and banking programs, experimenting with
control technologies for more than 20 years, and recognizing the
limitations of alternative command-and-control approaches. Most other
countries have significantly less experience with flexible approaches.
A flexible international program would be unprecedented.
As the case studies have also shown, flexible programs have been
remarkably successful -- but sometimes they run into glitches. For
that reason, it would be dangerous to make any serious U.S. policy or
commitment dependent on newly designed and untried international
institutions -- a point highlighted by the President's Cabinet-level
climate change working group in its initial findings. Moreover, the
current uncertainty surrounding climate change implies that a
realistic policy should involve a gradual, measured response, not a
risky, precipitous one.
What would constitute a practical policy? In addition to the science
and technology initiatives noted above, we could begin investigating
reasonable ways to set emission goals and to facilitate efforts by
businesses and individuals to think about their own emissions and
opportunities for reductions. Internationally, we should continue to
expand our cooperation with both developed and developing countries.
This will build experience along the various dimensions required for a
flexible response and will set the institutional foundation for any
further policies that might be necessary in the future.
Set Reasonable, Gradual Goals
A reasonable national goal for greenhouse gas emissions could serve
as a benchmark for our progress in terms of mitigation, and thus as an
investment in one aspect of a climate change policy that encompasses
science, technology, cooperation, and mitigation. One of the problems
with climate policy over the past decade has been a focus on
unreasonable, infeasible targets. For example, reducing U.S. emissions
to 7 percent less than their 1990 level (the Kyoto target) over the
next 10 years could cost up to 4 percent of GDP in 2010 -- a staggering
sum when there is no scientific basis for believing this target is
preferable to one less costly. Worse yet, by imposing such high
economic costs and diverting limited resources, the Kyoto targets could
have reduced our capacity to find innovative ways out of the
environmental consequences of global warming. But what defines a
reasonable emission goal in the absence of better science?
The uncertainty surrounding the science of climate change suggests
that some modesty is in order. We need to recognize that it makes
sense to discuss slowing emission growth before trying to stop and
eventually reverse it. There is an unfortunate tendency to treat
greenhouse gases -- especially carbon dioxide (CO2) -- in a manner
analogous to SO2 and NOx, for which strict quantitative limits have
been imposed. SO2 and NOx can be controlled by adding equipment to
existing facilities. CO2, however, can only be reduced by either
reducing energy use or replacing fossil fuel facilities, equipment,
and transportation fleets with ones that use fuels with lower or zero
emissions (that is, unless and until capture and sequestration of CO2
become feasible). This is vastly more expensive than the end-of-pipe
treatment appropriate for SO2 and NOx, and it raises concerns about
fuel diversity, national security, and the ability to sustain our
economic strength and quality of life.
A modest, near-term goal to mitigate greenhouse gas emissions could be
described in many ways. A greenhouse gas emission target could be
indexed to economic output or other measures of economic activity. Or
one could express the goal in terms of greenhouse gas emission
intensity, that is, the amount of emissions per unit of economic
activity. Both these ideas describe targets that are flexible in the
face of economic growth, encouraging reductions without threatening the
economy.
A reasonable, gradual goal specified in this way offers advantages
over the reductions set out in the Kyoto Protocol. The Kyoto Protocol
focused on rather dramatic short-term reductions with unclear
environmental benefits. Those reductions risked damaging economic
consequences and, in turn, jeopardized the ability to invest in
long-run scientific and technological solutions. A reasonable goal
offers insurance consistent with existing climate science without
putting the economy at risk. A gradual approach balances the need for
mitigation with the need for economic growth to power future
innovation. A gradual approach also allows us to adjust as we learn
more from the science and are able to take advantage of technologies
as they develop. Finally, a gradual goal provides time to develop
stronger institutions for a long-term, global solution.
Provide Information and Encourage Reductions
In addition to setting a reasonable goal, we need to facilitate efforts
by firms and individuals to track their own behavior and to recognize
cost-effective mitigation opportunities. The government has a useful
role here, both in providing information and in acknowledging progress.
No matter how sensible the near-term national goal, firms and
individuals need to understand their role -- and opportunities -- in
order to succeed.
One portion of an information program could be the development of
procedures and pilot programs to measure both project-based reductions
and carbon sequestration. Project-based measurement is important
domestically to the extent that offsets are eventually used in certain
sectors or for certain gases. It is important internationally if the
United States wants to encourage domestic firms to seek out meaningful
reductions in developing countries where fully market-based programs
are unlikely to be implemented.
Sequestration of greenhouse gases in agricultural and forestry sinks
offers considerable opportunity, both domestically and internationally,
to achieve inexpensive near- and medium-term reductions -- if an
environmentally sound accounting method can be devised. We can continue
work aimed at reducing the concerns and uncertainty associated with
sink usage. In all cases, research, rules, and pilot programs should
be developed in consultation with other countries pursuing alternative
climate change programs, to ensure both consistency and fair competition.
In addition to educating businesses and individuals about their own
greenhouse gas emissions and the opportunities to reduce them, we can
encourage them to reduce emissions in innovative ways. This might
involve incentives, voluntary challenges, or public recognition, again
focusing on flexible, gradual efforts.
Give Technology -- and Institutions -- Time
These first steps concerning reasonable goals, information, and
accounting, along with continued international cooperation, can serve
as building blocks toward long-term institutions. To get the
institutions right and to protect the economy, however, this movement
must be gradual. Initial steps should signal our intent and thereby
encourage the development of new technologies -- technologies designed
level that does not dangerously interfere with the climate system. Such
stabilization, in contrast to an arbitrary short-term emission limit,
remains the long-term goal recommended both by the United Nations
Framework Convention on Climate Change and by the President.
These efforts and goals will require time in order to accomplish them
effectively. Science, markets, technology, and global participation
must be wound together in an effective policy response. To do so
requires building sound institutions for a better environment.