Congress added Title IV's ETS to the CAA because they felt that ET would be a low cost way for utilities to cut emissions. Because it is presumed that utilities will choose the most cost-effective way to reduce pollution, the AR-ETS was made flexible.[EN19] The utilities were not forced to trade allowances, but could do anything to perform at the level available to them by the number of allowances they were issued. As long as utilities saw that it would be cheaper to have an ETS than CAC, an ETS would be easier to implement because compliance would be higher. The utilities could choose any one or combination of techniques, including but not limited to, trading allowances, switching to low-sulfur coal or natural gas, installing scrubbers, lowering production, and encouraging more efficient use of electricity by their consumers.

    Each allowance was worth one ton of SO2 emission a year. Once the utilities get their allowances they can decide to pollute up to that level, pollute a lot and buy more allowances, or pollute less and sell or "bank" (keep the allowances for the future) extra allowances. However, a utility cannot use so many of their bought or banked allowances in one year that they would violate the national or state health-protection standards.[EN20]

Trading Off To A Slow start

Created chart from page 26 of the report.  Click to see citation

    As depicted by the chart above, very little trading took place.[EN21Only 12 of the possibly 269 utilities that could have traded did. These utilities bought more than 5,000 allowances, but two utilities bought 61 percent (approximately 3,050) of these allowances.[EN22]  The proponents of ETS want a more "liquid market" (one with many transactions) because more cost savings will be realized in that type of market.

    The Air Pollution Report ("the report") was then commissioned to evaluate how much pollution was expected to be reduced by ET, why there is less trading than expected, and how to design a ETS for Carbon Dioxide (CO2). I will now focus on the second and third directives of the report, what was precluding more trade and how to resolve those issues.

    The report came up with a nice list of things to do in order to improve trade. The list included regulating all sources at once, including emission caps, developing an effective monitoring system, penalizing non-compliance and securing a price for allowances.

Phasing of Emissions

    Title IV set up the ETS in two phases of implementation. In Phase I, about 14 percent of all, the older and dirtier, plants are required to reduce their emissions by 3.5 million tons.[EN23Phase I begian on Jan. 1, 1995, while Phase II, when the newer cleaner electric companies are asked to cut back emissions, start on Jan. 1, 2000. At this time, all plants are required to decrease emissions by yet another 5 million tons of SO2.[EN24]

    Even though this strategy will reduce emissions to the level wanted, it is not seen as the most efficient means of getting the desired result. The utilities under Phase I are low cost abaters, making them sellers and Phase II utilities are high cost abaters because they are already more efficient, making them buyers. It will most likely be more cost effective for many Phase II utilities to purchase allowances.[EN25]  This separation of buyers and sellers will impact the choices of the Phase I abaters. By not being able to receive the revenue of selling their extra emissions, they might not choose the same types of abatement.

Emission Caps

    The AR-ETS puts a cap on SO2 of 8.95 million tons in the year 2010. Each allowance certificate is worth one ton of SO2, so in order to reduce emissions to this level one has to do is issue that amount of credits for the year.[EN26The beauty about the way the emissions caps are used in the AR-ETS is that they must be met even if trading does not go as planned.[EN27]  As mentioned earlier, the utilities can choose how they want to meet the limits set.

The CAA itself is also a cap to the level of emissions that can be produced. No matter how many credits a utility has, it cannot violate other provisions of the CAA.[EN28]


    It is all well and good that there are emission caps, but how does one know that they are being met? AR-ETS stipulated that each utility must install Environmental Protection Agency ("EPA")-certified continuous emissions monitoring ("CEM") equipment and report the emissions to the EPA. This is to ensure that companies are not emitting more than they are allowed. At the end of the year, the utilities have 30 days to acquire any additional credits that they may need. At the end of the grace period, the EPA deducts all of the allowances needed to cover the level of emissions for that utility.

The issuance, transfer, deduction, and tracking of the allowances are done through the EPA's automated allowance tracking system.[EN29]  Unfortunately, the allowance tracking system was deployed behind schedule because the programs were not finished in time. This subsequently, slowed the prospects of trading because the tracking system was needed to establish who owned the allowances, how many they owned, to track the trades, and convey the trading information to the market.


    So what happens to a utility if they have not acquired enough emissions credits to cover their generation of SO2 for that year? The EPA fines the utility $2,000 for each ton of SO2.[EN30] That is a price way above the estimate cost of an allowance credit. Allowances auctioned off start at $0, because the EPA has no minimum asking price.[EN31They also lose one allowance for each extra ton of SO2 produced in the following years issuance.[EN32]

Setting a Price

    Utilities will be skeptical about investing in allowances as long as they bare the brunt of the risks, while ratepayers reap the benefits. One solution would be to set a bottom line price allowances to be traded. If one receives less than this bottom line they will get the difference up to that amount.[EN33]  This price could also be incorporated into the EPA's auction as the selling price of an allowance. The desired bottom line price would be the market-clearing price [EN34], the price at which the demand curve and supply curve for allowances intersect.[EN35]

    Because the utilities are expected to choose how to abate based on cost, it is important to know how much it will cost to buy an allowance. The report identified some factors that could or did influence the decision of whether to reduce emissions through trading or other means by changing the values of the tradable allowances. These factors were: the EPA's auctioning practice, the uncertainty of future and state regulations, and the fluctuations of other abatement costs.

Auctioning of Extra Allowances

    Under the AR-ETS, the EPA was given 3.5 million extra allowances to sell at auction. These allowances can be sold to utilities, brokers, private citizens, and environmental groups. Because the EPA does not set a minimum bid, the allowances sold by them at the auctions generally go for a lower price than those traded between the utilities.[EN36] The uncertainty of how much an allowance was worth was affected by the varying prices that could be obtained at these auctions.

Future Regulations

    Due to uncertainty of what substances will be regulated in the future, utilities will try to choose an emission reduction scheme that they feel will best match future environmental regulations. In some cases, one type of abatement will cause an increase in another type of emission.

State regulations

    Of course, as with most types of federal regulation, the states tried to protect their interests by passing new laws. Many states passed laws that protected there coal mining operations by giving incentives to utilities that used coal. This might encourage utilities to forego trading allowances, even though, that might be the most cost-effective manner of getting reductions. Fortunately, the federal courts have ruled that these types of laws interfere with interstate commerce.[EN37]

Fluctuating Abatement costs

    The cost of coal was expected to be $40 a ton a year in 1995, but it was at around $25 a ton in Dec. of '94. This is due in part because the demand for low-sulfur coal has increased to meet the emissions limits. Because of a larger market more low-sulfur coal is being extracted and the western coal is now competing with eastern coal.[EN38]

    The switch to low-sulfur coal has also affected the scrubber market. Scrubbers work by spraying calcium sorbents which reacts with and captures SO2 before it is emitted into the air.  Because of less demand for their product, scrubber manufacturers have to make their products more appealing. They have made cost reducing innovations, used anticorrosive materials, and found ways to recycle the wastes into marketable products. They have also made the scrubbers more efficient, which increases compliance, reduces costs, and allows for trading of more allowances. One company has made a kind of leasing agreement, in which they operate and maintain the scrubbers at a price per ton of SO2 removed.[EN39] I guess that goes to show that necessity truly is the mother of invention.