Air Quality and Emissions Trading: A Primer

Air Quality and Emissions Trading: A Primer

Order Code RS20891
April 16, 2001
CRS Report for Congress
Received through the CRS Web
Air Quality and Emissions Trading: A Primer
David M. Bearden
Environmental Information Analyst
Resources, Science, and Industry Division
Summary
Emissions trading is a market-based mechanism used to lower the costs of
complying with air quality regulations. It allows sources facing high pollution control
costs to meet their emission limits by purchasing excess reductions from other sources
that can afford to lower their emissions further than federal or state regulations require.
Despite the potential for cost savings, the use of trading has been relatively limited, due
to its suitability for only certain types of pollutants and the complexities of
implementation and enforcement. Trading is best suited for reducing diffuse pollutants
that easily spread across broad geographic areas. However, it is not effective in
addressing problems with pollutants that remain locally concentrated because excess
reductions made in one location would not improve air quality elsewhere. The extent to
which trading can improve overall air quality also depends on many other factors related
to the geographic extent of the trading area, whether a cap is placed on total emissions,
the reliability of mechanisms for determining compliance, the adequacy of penalties to
discourage noncompliance, and whether pollution sources are allowed to bank excess
emission reductions for future use. While trading is a popular concept due to its
potential for cost savings, it also can be controversial if there are difficulties with
enforcement or problems with localized emissions. In addition, some critics are opposed
to trading based on principle alone. Due to all of these factors, trading is not likely to
replace conventional regulation entirely. However, it will likely continue to be
considered to control air quality problems with diffuse pollutants that affect large areas
and in cases where lower costs are essential to achieve the largest reductions in overall
emissions. This report serves only as a primer on the concept of emissions trading and
will not be updated to track relevant legislation, issues, or programs.
Introduction
Conventional air quality regulations place fixed limits on emissions from individual
sources and/or require the installation of specific technologies to control pollution.
However, compliance may be more costly for some pollution sources than it is for others.
Emissions trading is a market-based alternative which has the potential to offer each
pollution source the most economically feasible option to meet its individual limit on
emissions while ensuring that overall air quality goals are still achieved. To accomplish
Congressional Research Service ˜ The Library of Congress

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this objective, trading uses market mechanisms that allow sources facing high pollution
control costs to comply with their emission limits by purchasing excess reductions from
other sources that can afford to lower their emissions below what federal or state
regulations require. The cost of trading is potentially less than would occur under
conventional regulation since the largest reductions in pollution are made by sources that
can limit their emissions at the least cost. In addition to the potential for cost savings,
trading also can provide an economic incentive to develop more effective and less
expensive technologies to control pollution, since there would be a market for excess
reductions that can be achieved more easily at lower costs. While trading offers certain
advantages over conventional regulation, it only has the ability to improve overall air
quality in circumstances where a pollutant disperses easily over a broad geographic area
and the environmental objective is to control total emissions rather than to limit local
concentrations of pollutants.1
This report briefly discusses the extent to which emissions trading has been used in
the United States, explains how trading programs work, analyzes factors that can influence
the effectiveness of trading, and examines some of the principal arguments related to the
use of trading to control air pollution.
To What Extent Has Trading Been Used in the United States?
Various forms of emissions trading have been used in the United States since the
1970's when the Environmental Protection Agency (EPA) developed more flexible policies
on pollution control measures that states could pursue to comply with the National
Ambient Air Quality Standards (NAAQS). To encourage the use of trading by states to
attain these standards, Congress amended Section 172 of the Clean Air Act in 1990 to
allow the incorporation of economic incentives, such as fees, marketable permits, and the
auction of emission rights, in state implementation plans to help control air pollution.2
While such plans have relied primarily on conventional regulation, some states have used
this authority to incorporate trading into their pollution control efforts. For example,
trading has been used in California since 1994 to assist the Los Angeles area in reducing
emissions that contribute to the formation of ground-level ozone.3 Twelve northeastern
and mid-atlantic states also worked together to establish a trading program in 1999 to help
control regional problems with ozone transport.4 In addition to state efforts, trading has
1 For further discussion of emissions trading, refer to CRS Report 94-213 ENR, Market-Based
Environmental Management: Issues in Implementation, coordinated by John Moore.
2 42 U.S.C. 7502(c)(6).
3 California’s South Coast Air Quality Management District introduced the Regional Clean Air
Incentives Market (RECLAIM) in the Los Angeles Area in January 1994 to provide greater
flexibility for stationary sources to achieve reductions in precursors to ground-level ozone
pollution, which are needed to help the area attain the NAAQS.
4 Ozone transport can occur when emissions of ozone precursors drift across state borders and
cause pollution levels to increase in areas where actual emissions are relatively low. The Ozone
Transport Commission, representing twelve northeastern and mid-atlantic states and the District
of Columbia, established a regional trading program to control ozone transport. The participating
states include Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New
(continued...)

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been used at the federal level since 1995 to provide greater flexibility for electric utilities
to reduce emissions of sulfur dioxide that contribute to the formation of acid rain.5 While
trading has been used in several instances such as these, it is complicated to implement and
is not suitable for concentrated pollutants or localized air quality problems. Consequently,
the use of trading has been relatively limited, and conventional regulation remains the most
common way to control air pollution.
How Do Trading Programs Work?
Trading programs are based on the use of either credits or allowances. Under a
credit-based program, each pollution source receives a limit on its emissions within a
specified time frame. A credit is generated when actual emissions are reduced below the
required amount. Pollution sources that have earned credits can sell them to other
pollution sources that need additional reductions to meet their emission limits. Allowances
differ from credits in that they represent the amount of a pollutant that a source is
permitted to release during a specified time in the future. If a pollution source estimates
that its actual emissions will be less than its allowances, it can sell its excess allowances to
other pollution sources that need them. However, some risk is involved in selling
allowances because actual emissions may end up being greater than expected. In such a
case, the pollution source that sold some of its allowances would be required to go back
and purchase additional ones from another source to demonstrate compliance. Some
trading programs also allow pollution sources to save credits or allowances for meeting
limits on emissions in future years. This practice is commonly referred to as banking.
For Which Types of Pollutants is Trading Well Suited?
Trading can be a viable option when the environmental objective is to decrease total
emissions over broad geographic areas rather than to limit emissions to the same extent
from each source of pollution. In such cases, trading has the potential to improve overall
air quality if the pollutants that need to be reduced are diffuse and easily disperse
throughout the atmosphere. For example, trading is well suited for diffuse gases such as
nitrogen oxides (NO ), sulfur oxides (SO ), and carbon dioxide (CO ) because of their
x
x
2
tendency to drift far from their points of release.6 However, trading is not well suited for
pollutants that remain locally concentrated, because excess reductions in one area would
not improve air quality elsewhere. Additionally, localized problems with air quality could
arise from trading if pollution sources clustered in one area are allowed to increase
4 (...continued)
Jersey, New York, Pennsylvania, Rhode Island, and Vermont. Virginia chose not to participate.
5 To combat acid rain, Title IV of the Clean Air Act Amendments of 1990 established a trading
program to reduce emissions of sulfur dioxide from electric utilities. Phase I began in 1995 and
involved over 400 coal-fired electric utility generating units. Phase II began in January 2000, at
which time the number of participating units increased to more than 2,000.
6 NO is a precursor to ozone, and along with SO , can contribute to the formation of acid rain.
x
x
CO is a greenhouse gas that may contribute to global warming. NO and SO are currently
2
x
x
regulated by EPA, but CO is not. For a discussion of the potential use of trading to reduce
2
greenhouse gas emissions, refer to CRS Issue Brief IB97057, Global Climate Change: Market-
Based Strategies to Reduce Greenhouse Gases, by Larry Parker.

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emissions significantly through purchasing excess reductions from other pollution sources
located in different areas.
What Factors Can Influence the Effectiveness of Trading?
Aside from the question of whether a particular pollutant is suitable for trading, the
extent to which trading can improve overall air quality depends on many other factors
related to program design, implementation, and enforcement. Some of the principal
factors that determine the amount of real air quality gains that can be achieved through
a trading program are the definition of the geographic boundaries of the trading area,
whether a cap is placed on total emissions, the reliability of mechanisms for determining
compliance, the adequacy of penalties to discourage noncompliance, and whether pollution
sources are allowed to bank excess emission reductions. Each of these factors is examined
below.
Defining the Trading Area. The geographic area within which trading is allowed
to occur depends on how far a pollutant travels from its points of release. For example,
if a pollutant disperses over a region of states, sources in different states could trade
emission reductions and improve overall air quality. However, if emissions remain largely
within a state or a portion of a state, trading would need to be confined within these
boundaries because reductions in other locations would not improve air quality in the
affected area.
Capping Emissions. Placing a cap (i.e., a limit) on total emissions from all
participating pollution sources can help to protect overall air quality regardless of the
volume of trading, because the aggregate level of pollution would not exceed a
predetermined amount. However, using a cap can be a complicated issue for at least two
reasons. First, a limit on total emissions must be determined which would accomplish a
particular environmental objective. Second, a formula must be developed for distributing
the amount of the cap among the pollution sources involved.
Determining Compliance. A system or mechanism to accurately record each
trade and precisely monitor emissions is necessary to determine whether the amount of
pollution that a source generates exceeds the credits or allowances that it holds. However,
if the transaction process to record trades is too complex, the monitoring equipment is
unreliable, or the cost of such equipment is too high, determining compliance would be
extremely difficult. Under these circumstances, trading might prove infeasible.
Penalizing Pollution Sources for Noncompliance. To provide an economic
incentive for pollution sources to comply with their emission limits, penalties for
generating excessive pollutants must be significantly higher than the cost of reducing
emissions or purchasing excess reductions from another pollution source. If penalties for
exceeding emission limits are too low, sources facing high expenses to control pollution
might prefer to pay a penalty that is less than the cost of purchasing credits or allowances
to meet their emission limits.
Banking Credits or Allowances. Allowing pollution sources to bank (i.e., save)
allowances or credits for use or sale in the future can provide an incentive to keep
emissions below allowable levels in the short-term. A trading program that permits

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banking could help to improve overall air quality more quickly than expected if enough
pollution sources choose to bank their credits or allowances rather than use them.
However, such gains could begin to diminish at a later point in time, if pollution sources
use their banked reductions to increase emissions significantly.
What Are Some of the Arguments Related to Trading?
While trading is often a popular concept among pollution sources and federal and
state regulators due to its potential to improve overall air quality at lower costs and with
greater flexibility, it can be controversial. Since the use of trading began in the United
States, there has been some opposition among environmental organizations and concerned
citizens based on at least three principal arguments. First, the absolute need for precise
monitoring and accurate reporting to ensure that credits or allowances represent actual
reductions in emissions has caused some critics to claim that the potential for fraud, or
unintentional error, is too great to make trading a dependable option to control air
pollution. Second, some opponents argue that trading could lead to violations of
environmental justice if localized emissions are allowed to substantially increase through
the purchase of excess reductions, because the pollution sources that purchase such
reductions are often older facilities located in or adjacent to low-income and minority
communities. Third, some of the criticisms of trading are based on principle alone.
Certain critics hold the belief that pollution is not a right to be bought or sold on the open
market and that pollution should be controlled to the same degree from each source
regardless of cost to guarantee that residents in all locations enjoy comparable
improvements in air quality. Due to all of these concerns, proposals to use trading
frequently face opposition and scrutiny among communities that lie within the geographic
boundaries of a potential trading area.
Conclusion
While trading can be an attractive option due to the potential that it offers to control
pollution at lower costs and with greater flexibility, it is not necessarily an ideal solution
to all air quality problems. The ability of trading to improve overall air quality depends
primarily on the nature of the pollutant involved and whether there is a need to limit
aggregate emissions over a large geographic area, rather than to control emissions from
each source to the same degree. Even if trading is well suited to address a particular air
quality problem, trading programs are complicated and difficult to implement effectively
due to numerous factors such the geographic extent of the trading area, whether aggregate
emissions from all sources are capped sufficiently to achieve an environmental objective,
the ability to obtain accurate monitoring data to verify that transactions between pollution
sources represent actual reductions in emissions, the adequacy of penalties to discourage
noncompliance and encourage sources to purchase pollution credits or allowances instead,
and whether pollution sources that are allowed to bank excess emission reductions will use
them in large quantities in the future and reverse initial improvements in air quality. In
addition to these factors, controversies and opposition that sometimes arise in response
to trading can impede implementation in other ways, especially if litigation is involved.
Due to these considerations, trading is not likely to replace conventional regulation as the
primary approach to controlling air pollution. However, it will likely continue to be
considered as an option to address air quality problems with diffuse pollutants that affect

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large geographic areas and in cases where lower costs and greater flexibility are essential
to achieve the largest reductions in overall emissions.