Cap-and-trade for carbon may be dead in the US Congress for now, but the basic strategy remains a strong, if complicated, means of reducing sulfur dioxide, nitrous oxide and other types of air pollution.

Researchers at Resources for the Future have looked at how one complication, the way in which "banked," or deferred, allowances for emissions have effected the way air pollutant credits have been valued and used.

Cap-and-trade strategies seek to transfer money to facilities that have found cost-effective ways of reducing pollution. Older plants, which would find pollution abatement very expensive, may buy credits from more efficient plants to offset their own emissions. The idea is that, as a whole, a region or country could enjoy greater reductions in pollution with a smaller financial burden.

Banking Pollutant Allowances under Cap-and-Trade
However as regulatory conditions change, due to new rules being issued or existing ones being overturned by courts, producers holding banked credits face economic uncertainty about the value of their allowances.

RFF researchers Nathan Richardson and Art Fraas in their paper "Banking on Allowances" note that the EPA has handled the transfers by establishing exchange rates.

Over time, the caps on pollution become tighter. This can create a tension between the environmental goals of reducing emissions (such as reducing sulfur dioxide emissions to fight acid rain) and the economic incentives of creating value in pollution reduction allowances. If industries can use deferred pollution credits to skirt tougher rules, then the pollution abatement of the new rules are delayed or diluted.

To maintain the incentives, regulators often opt to permit a one-to-one trade for credits banked under the old rules for credits applicable to the new. However, in 2002 nitrous oxide polluters had to trade in 9 credits banked under the old regime to get 2 under the new rules.

However, the change in rules can effect the price of allowances, thus causing a major change in the value of those held. For instance, when rules were announced in July 2010, the price of nitrous oxide allowance fell significantly.

Litigation Risk
In 2005 the EPA established its Clean Air Interstate Rule (CAIR) which set emission limits, based on generating capacity, in different states and established a cap-and-trade program as one means for states to comply. The program permitted the banking of pollution allowances.

CAIR was established because pollutants, such as nitrous oxide and sulfur dioxide, from upwind states are transformed into other pollutants, specifically ozone, in downwind states. Thus downwind states are penalized for not attaining ozone standards even though they are not emitting all the precursor pollutants.

In 2008 a Federal court vacated CAIR, stating that the EPA overstepped its authority in creating this cap-and-trade program for the states. (NC v EPA 531 F.3d 896)

When the Court vacated CAIR, the price of nitrous oxide allowances fell from over $5,000 a ton to under $1,000, severely discounting the value of banked allowances.

Yet, when later that year the court decided to remand the CAIR rule back to the EPA rather than abandon it altogether, nitrous oxide allowance prices immediately climbed to the $5,000 level again. They subsequently have fallen, but the court rulings show how volatile allowance prices can be in the wake of government policy changes.

Future Rules
In response to the court ruling, the EPA has proposed a "Transport Rule" to replace CAIR. It would reduce the emissions of NOx and SO₂ in 31 eastern states and DC.

In the coming year, the EPA will take up air quality regulations that will have an impact on the value and use of cap-and-trade allowances. (see chart to left) National Ambiant Air Quality Standards (NAAQS) for ozone rules are expected in December 2010, and this rule could influence trading in the precursor pollutants of NOx and SO₂.

But other rules would affect overall coal-fired generation. Rules on particulate matter, cooling water intake and coal combustion waste are to be finalized in 2011. By some estimates, over time this could retire more than 50 gigawatts of coal-fired generating capacity. These plants would eventually be replaced by cleaner generating facilities, such as natural gas generators, wind farms or solar installations. But a reduction of this size (15% of present generating capacity) would would constitute a serious shift in the level of pollutants which are subject to cap-and-trade regimes, and by extension the value of banked credits.
by Robert Thomason, Global Resources New

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