History's evaluation of this generation will surely depend to an important extent on its handling of the climate problem—not just on what gases we leave in the atmosphere but also on what durable climate policy architecture we leave to our heirs. This valuable collection sheds new light on what I believe to be the most difficult and important dimension of the climate policy problem. All who have had a hand in the creation of this volume deserve thanks and applause. In this brief essay I offer some thoughts on what makes the international dimension of the climate problem so difficult and important, on the history of climate policy debates, and on some key elements of policy architecture that those debates have so far produced.

The international dimension

Climate change would be a very difficult issue even without its international dimension, of course. Because much of the benefit of limiting greenhouse gas emissions would accrue to future generations, it would be both economically and politically hard to compare the costs and benefits of mitigation policies even if both were known. But the future benefits of reducing emissions are highly uncertain, both because we cannot confidently predict important regional-scale climate changes and because the adaptation technologies available to future generations are unknown. Similarly uncertain are the pace of technological innovation and the quality of future climate policy design and implementation, both critical factors in determining future costs of emissions reduction.

EARLY HISTORY OF FEDERAL REGULATION OF SO2 EMISSIONS

The 1970 Clean Air Act Amendments

The 1990 Acid Rain Program and the factors that influenced its structure cannot be understood in isolation from the earlier history of the federal government's efforts to limit SO2 emissions produced in conjunction with the generation of electricity. The 1970 Clean Air Act Amendments, the first significant U.S. federal air pollution legislation, led to the establishment of national maximum standards for ambient concentrations of SO2, as for those of carbon monoxide, nitrogen dioxide, particulates, ozone, and lead. The states were largely responsible for meeting these standards in each local area. Each state was required to develop and have approved by EPA a state implementation plan (SIP) specifying actions to be taken to bring the state into compliance with the standards before the deadlines specified in the statute. The motivation for controlling SO2 emissions at this time was not concern about damage caused by acid rain. Rather, it rested on concerns about the effects of ambient SO2 concentrations on human health (for which “primary standards” were specified in the statute) and on other aspects of human welfare such as visibility (for which “secondary standards” were specified in the statute).

The 1970 Amendments also imposed New Source Performance Standards (NSPS) applicable only to SO2 emissions from new power plants. According to the NSPS, the emissions rate (ER) for new coal plants could not exceed 1.21b of sulfur dioxide per million Btu of fuel burned (0.81b/mmBtu for oil).

The argument for the cost-minimizing properties of emissions trading rests, of course, on the assumption that an external market for permits exists and that it is reasonably efficient. By “efficient” we mean that the prices for permits are transparent to buyers and sellers, transaction costs are low, arbitrage opportunities are quickly exploited, and buyers and sellers take full advantage of the opportunities to reduce compliance costs by engaging in trading activity. The limited experience with emissions trading prior to 1990 was not particularly encouraging in this regard (Hahn, 1989; Hahn and Hester, 1989), and there was considerable doubt whether the tradable permit feature of Title IV would meet with any greater success than did earlier programs involving emissions trading.

Unlike previous tradable permit programs, Title IV embraces emissions trading among utilities with remarkably few restrictions. First, allowances can be traded nationally. Second, no review or prior approval of trades is necessary. Third, the purchase and holding of allowances is not restricted to utilities for which these permits would become a necessary input for the coal- or oil-fired generation of electricity. All sources receiving allowance allocations as well as third parties, such as brokerage firms and individuals, are free to buy allowances from or sell them to any other party. Fourth, neither the frequency nor the mechanisms for trading allowances is limited. Finally, allowances that are good for use in one year may be saved and used in future years.

A STAR IS BORN (?)

More than thirty years ago, Dales (1968) demonstrated that, in theory, an emissions-trading system, in which rights to emit pollution are available in fixed and limited aggregate amount and are freely tradable, would induce rational firms to reduce pollution at the least possible cost. This basic theoretical argument has been refined and elaborated many times since. Over this same period, the alternative command-and-control approach to environmental policy, in which the design or performance of individual pollution sources is specified, has been applied to a wide variety of problems and has generally performed poorly, with excessive costs and, often, failure to achieve environmental objectives. Nonetheless, until quite recently, emissions trading and related approaches (such as emission taxes) attracted little but hostility from noneconomists and were rarely employed in practice.

Then, with relatively little fanfare, Title IV of the 1990 Clean Air Act Amendments (1990 CAAA, Public Law 101–549), the U.S. Acid Rain Program, passed by the U.S. Congress and signed by President George Bush in 1990, established the first large-scale, long-term U.S. environmental program to rely on tradable emission permits (called “allowances” in the legislation) to control emissions. Its target was electric utility emissions of sulfur dioxide (SO2), the major precursor of acid rain.

Since 1990, policymakers' interest in emissions trading has grown rapidly. This growth accelerated in 1995, when Title IV came into effect. Most observers quickly judged the program to be a great success, largely because the price of emission rights (allowances) was well below expectations.

This book brings together the results of more than five years of research conducted by the Center for Energy and Environmental Policy Research at the Massachusetts Institute of Technology, with which all of the authors have been affiliated. The Center seeks to provide rigorous, empirically grounded, and accessible economic analysis to inform the public policy debate. It has been the focus of applied economics research on energy and environmental issues at MIT for more than twenty years. The Center historically has concentrated on topics – like emissions trading – that are both interesting to academics and relevant to policymakers and industry analysts. Market-based emissions control instruments are increasingly in vogue, and we are pleased to provide this evaluation of the remarkable public policy experiment with emissions trading that was initiated by Title IV of the 1990 Clean Air Act Amendments, the U.S. Acid Rain Program. We hope that our research will contribute to the consideration of market-based systems as tools for meeting at least some demands for environmental amenities.

As is the case for any major endeavor, there is a long list of people without whose assistance this book would never have appeared. This research has grown out of the inspired suggestion and accompanying funding by the National Acid Precipitation Assessment Program (NAPAP), which initially encouraged us to combine our collective experience to provide an evaluation for NAPAP's Quadrennial Report to the U.S. Congress.

The U.S. Acid Rain Program – Title IV of the 1990 Clean Air Act Amendments – was passed by Congress and signed by President Bush to reduce SO2 emissions that contribute to acid rain. Neither Congress, nor President Bush, nor most of Title IV's other supporters conceived of the program as a policy experiment. Our analysis indicates that the Acid Rain Program has thus far been a notable success. Title IV more than achieved the SO2 emissions-reduction goal established for Phase I, and it did so on time, without extensive litigation, and at costs lower than predicted. Moreover, there has been 100% compliance by all affected sources. Not only have there been no violations of the law, but no administrative exemptions or exceptions have been granted to permit noncompliance. After all, no affected source has been able to claim that compliance would be a special hardship, since it could always meet its compliance obligations simply by purchasing allowances on the open market. We are unaware of any other U.S. environmental program that has achieved this much, and we find it impossible to believe that any feasible alternative command-and-control program could have done nearly as well. This performance justifies emission trading's recent emergence as a star on the environmental policy stage.

But, just as no single actor can excel in all roles, neither emissions trading nor any other approach to environmental policy can provide low-cost solutions to all environmental problems.

COMPETING THEORIES OF DISTRIBUTIVE POLITICS

In this chapter, we analyze how Congress, influenced by the executive branch and various special interests, distributed SO2 allowances among electric utilities as an integral part of the process of crafting acid rain legislation that could pass both houses of Congress and be signed by President Bush. The environmental economics and regulation literature contains essentially no empirical work on the economic effects of alternative market-based control mechanisms on different interest groups, largely because the historical record contains few applications of such mechanisms. In particular, little attention has been devoted to how interest-group politics and associated rent-seeking behavior affect the allocation of rights to pollute in the context of a tradable-permit system. Without this type of knowledge it is impossible to understand the political feasibility of alternative control instruments or how they might be structured to have a better chance of gaining acceptance in the political process. The ability to structure market-based mechanisms for internalizing environmental externalities that are acceptable politically will depend heavily on their incidence; that is, on their effects on different interest groups who are represented in one way or another in the branches of government that ultimately make policy decisions. Whenever valuable property rights are created by legislation, the associated allocation decisions are likely to be highly politicized in much the same way as is tax legislation or appropriations bills. Understanding better how the political process deals with such issues, in which costs and benefits are distributed among the population, can help in designing environmental control programs that are politically acceptable as well as theoretically appealing.

CONFUSION ABOUT CONTROL COSTS

The initially low price of allowances in Phase I led to some misunderstanding and controversy about the cost of compliance with Title IV. Specifically, the initially low and declining allowance prices were interpreted as an indication that the costs of complying with Title IV were dramatically less than had been anticipated. For instance, prominent representatives of President Clinton's Administration asserted that:

and

These statements err both in the interpretation of allowance prices and in the recollection of what earlier studies had estimated Title IV's costs to be. Our interpretation of the low allowance prices early in Phase I and of the subsequent doubling of allowance prices in 1998 is provided in Chapter 11. In this chapter we develop an estimate of the cost of complying with Title IV in Phase I and compare it with the predictions of the same cost made in earlier studies of Title IV. The objective in this chapter is not to estimate the cost savings attributable to emissions trading when compared to some hypothetical alternative emissions control mechanism. That more difficult analytic task will be addressed in Chapter 10.

As noted in Chapter 1, Title IV includes a voluntary compliance program intended to enable owners of the 263 Table A units subject to Phase I to make some of the required emission reductions at other units, which then become Phase I-affected units. As we have also noted, the response to this program has been much greater than expected. More than half the electric utilities with Table A units have voluntarily brought units into Phase I in each of its first three years: 182 units in 1995, 161 in 1996, and 153 in 1997. One hundred thirty-eight units – more than half of these units – were subject to Phase I in all three years.

Yet, as encouraging as this response has been, on closer examination it serves to illustrate a general problem with such voluntary provisions. In principle, allowances should be allocated to voluntary units equal to what the emissions of these units would be if they were not part of the program (i.e., counterfactual emissions). If this could be done exactly, participation would be attractive only to units with particularly low abatement costs. In practice, however, allowance allocations generally differ from counterfactual emissions. Units with relatively low control costs that would receive an allocation below their counterfactual emissions are thereby discouraged from participation, while units with relatively high control costs are encouraged to participate by an allocation above their counterfactual emissions.