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William S aylor III is a scientist at the Illinois State Water Survey

Title IV of the Clean Air Amendments of 1990 (CAAA90) introduced the largest-scale market-based environmental regulation program in the nation. The program consists of a cap-and-trade mechanism that limits the aggregate sulfur dioxide (SO2) emissions from electric utility generators nationwide to half of the 1980 level. Central to the new program is the SO2 emission allowance market system. An emission allowance is a tradeable and transferable permit to emit a ton of SO2 during or after a specified year. CAAA90 specified the total number of allowances issued to all generating sources in the U.S. The rationale behind the introduction of a market-based mechanism was to encourage technical and economic efficiencies in achieving emission abatement. The objective of this report is to investigate the implementation of this program, to analyze its salient characteristics from a policy perspective, and to assess the performance of the market-based regulation. The scope is limited to the introductory phase (Phase I) of the program. The application of a market-based mechanism in environmental regulatory compliance is a major shift from the historical approach of direct “command-and-control” regulation, which often employed resource-intensive, sourcespecific requirements with very limited flexibility. Under the CAAA90 SO2 provisions, source-specific emissions limits are not specified; to be in compliance, sources must simply have obtained—through allotment, trade, or purchase—a sufficient number of allowances to cover their actual emissions each year. Each source has multiple choices: it may choose to implement any of a number of available abatement methods including operational changes, it may choose not to abate its emissions if it can obtain sufficient allowances on the market, or it can choose a combination of several strategies. In concept, the flexible provisions allow each source to minimize its compliance costs; trading, in particular, allows costs to be efficiently distributed among sources. Most allowances available for transfer originate from sources that have reduced emissions below their allotted allowances. A reserve of allowances was set aside for annual public sealed-bid auctions, to guarantee some degree of open access to allowances and to force public price signals into the market. This report presents the framework of the regulation, summarizes the compliance methods chosen by utilities during Phase I planning, and analyzes allowance prices and market volume exhibited in the first years of compliance activity. It also examines the structure and results of the annual allowance auction administered by the U.S. Environmental Protection Agency (EPA). It presents a case study of one electric utility that actively pursued allowance purchase as a compliance strategy. Allowance trading, especially internally among sources within a utility company, has become a matter of course in CAAA90 compliance, and a commonly recognized market price appears to have emerged by the year that Phase I emissions compliance was first required, after some initial trading activity. The EPA auction functions as a price-reflective lottery rather than a price-setting market mechanism. Policy aspects of the paradigm shift in regulation to a market-based approach are identified. The role of uncertainty and of exogenous influences on compliance planning are discussed, and suggestions for future research are provided. A more definitive policy evaluation will be possible after 2000, when final emissions requirements apply to all subject sources in Phase II.