Smog Swapping :
New Rules Harness
Power of Free Markets
To Curb Air Pollution
--Under the 1990 Clean Air Act,
Firms Can Trade Credits
To Emit Sulfur Dioxide
--Trading Futures on Vapors
By Jeffrey Taylor
04/14/1992
The Wall Street Journal
PAGE A1
(Copyright (c) 1992, Dow Jones & Co., Inc.)
TORRANCE, Calif. -- In this tidy community of bungalows and palm trees, where even lawn mowers and gas
pumps are strictly regulated to fight pollution, Mobil Oil Corp. has just gained the right to spew an additional 900
pounds of noxious gas vapors each day.
So why aren't environmental activists storming the gates of the refinery?
Actually, Mobil is helping usher in a new era in environmental protection. For about $3 million, Mobil's refinery
here recently acquired pollution "credits" from the nearby city of South Gate, Calif. South Gate had acquired the
credits from General Motors Corp., which closed a plant there in 1985 and sold the city the property. The Torrance
refinery will be emitting far less additional pollution than did General Motors.
Mobil bought the pollution rights under a rudimentary version of market-based environmental regulation. The
program has been around since the 1970s, but its rules are so cumbersome that pollution "trades" like Mobil's are
rare.
That will soon change. A growing number of regulators believe conventional "command and control" regulation -which allows each plant to pollute so much but no more -- is failing to stop destruction of the environment. These
authorities, encouraged by economists, want to harness the Earth's atmosphere to financial markets and let the
markets rid the world of acid rain and global warming.
"The 21st century is going to be about using markets to solve social and environmental problems," says Richard L.
Sandor, an economist and a director of the Chicago Board of Trade. "Otherwise, the world is going to look like it
does in the movie 'Blade Runner.' We're going to be stopping on the road for oxygen tanks."
Commodities exchanges such as the Board of Trade are competing to run legally sanctioned markets that would
trade rights to emit sulfur dioxide, nitrogen oxide and reactive vapors like those emitted by Mobil's holding tanks.
Utilities, refineries and manufacturers would buy and sell pollution rights, which are supposed to ease the transition
to increasingly stringent emission limits. And investors will be able to use the instruments to speculate on the price
of eliminating smog.
Not everyone is thrilled about market-based regulation of the environment. Some environmentalists think it is
immoral to buy and sell the right to pollute. Others doubt regulators have the tools to enforce market-based
programs, which require pinpoint accuracy in monitoring emissions. And some polluters are skeptical that regulators
accustomed to commanding and controlling can give a market the freedom it needs to function.
Yet in Washington, California and elsewhere, proponents have won over opposition by arguing that traditional
regulation gives polluters no incentive to reduce emissions lower than what is allowed. Markets, they say, will create
strong competition among companies to find the cheapest and most technologically advanced ways to cut pollution.
A major catalyst for change was the 1990 U.S. Clean Air Act. Starting in 1995, the act will use a market-based
program to force power plants across the country to cut emissions of sulfur dioxide, a pollutant that smells like
rotten eggs and mixes with clouds to produce acid rain.
Southern California's air-quality regulator, struggling to reduce pollution that regularly violates federal health
standards, is now developing markets in each of the three pollutants most responsible for smog. "Previous emissiontrading programs, including the sulfur-dioxide program, are like playing checkers," says Joseph Goffman, senior
attorney at the Environmental Defense Fund in Washington, who helped write the Clean Air Act. "What they're
doing in California is more like elevating it to chess."
Other, even more ambitious programs are in the works. Economists working for the United Nations and the
Environmental Defense Fund are researching an international market to reduce emissions of carbon dioxide, the
main cause of global warming. This would link countries with vastly different economies and environmental laws in
a single pollution-control system. The U.N. will co-sponsor a conference on the proposal at the June Earth Summit
in Rio de Janeiro.
The idea of turning pollutants into a marketable commodity isn't new. Early this century, a British professor named
A.C. Pigou argued that a market price for cleaning air and water ought to be established and included among a
polluter's expenses, like costs for labor and materials. It wasn't until 1975, however, that the U.S. Environmental
Protection Agency created a limited pollution market by authorizing regional air-quality regulators to let companies
buy and sell pollution credits.
The rules: To open a plant or add equipment, a company must offset new pollution by buying credits from a polluter
reducing its output. The credits are denominated in pounds of pollution allowed per day and typically sell for $1,000
to $4,000 a pound.
A few offset trades have occurred in the Midwest, Maine, Massachusetts and New Jersey, but most -- about 100 in
the past 10 years -- have taken place in California. The pace of such trading has picked up lately, driven by publicity
about the Clean Air Act. Among the companies that traded pollution rights last year: Northrop Corp., Allied-Signal
Inc., Shell Oil Co. and Mobil.
One argument in favor of emissions trading is that it encourages initiative. That was certainly the case recently at a
U.S. Air Force base east of Los Angeles.
Forced to absorb the staff and equipment of a nearby base that is closing, March Air Force Base will soon double the
pollution it spews from boilers, vehicle fueling stations and jet-servicing machinery. Base officers were told they
would have to offset the increased pollution by buying emission credits.
March recruited pollution-credit brokers that act as middlemen in trades between polluters. Officers also scoured
local newspapers and hunted for potential sellers among public documents of previous pollution-credit trades. They
made cold calls to refineries and utilities.
Eventually, March managed to buy the credits it needed from five sellers, for a total of about $1.2 million. They
even found a bargain or two, including the right to emit 24 pounds of nitrogen oxide and six pounds of carbon
monoxide a day for the rock-bottom price of $975 a pound -- from a machinery company that got the credits by
closing down a plant. "This company didn't know what it had," says Air Force Lt. Col. Bruce Knapp.
The net effect of the trades: less pollution in the air over California. For every 1.2 pounds of pollution eliminated in
a shutdown, the program allows creation of only one pound of new credits.
This version of pollution trading does have drawbacks. It has created a crude and illiquid market run mainly by
brokers. Trades can't happen until pollution credits are certified, a process that can take two years. Prices often are
arbitrary. "It operates in case-by-case, let's-make-a-deal mode, which favors big companies with lawyers and
economists," says Mary Nichols, senior lawyer for the Natural Resources Defense Council, a nonprofit
environmental group based in New York.
The U.S. EPA hopes to do better with its new sulfur-dioxide program. The first phase targets 110 coal-burning
utilities mainly in the Midwest and along the East Coast. Weather patterns move much of the sulfur dioxide these
plants emit to New England, where it becomes acid rain. Phase two imposes even stiffer overall reductions on the
nation's other 2,400 power plants.
By the year 2000, the law limits total sulfur-dioxide emissions by all utilities to 8.9 million tons a year, 10 million
tons less than in 1985. This cap helped win support from environmental groups initially leery of hitching the
environment to a market.
In 1995, the first 110 plants will begin receiving pollution credits from the EPA, each of which allows one ton of
sulfur-dioxide pollution a year. The EPA also will sell a few thousand extra credits in an annual auction. The hitch:
Companies will only get enough credits for 30% to 50% of what they used to pollute.
For example, in 1985 Illinois Power Co.'s Baldwin No. 1 power plant in Baldwin, Ill., pumped out 89,300 tons of
sulfur dioxide. In 1995, Baldwin will get 40,834 one-ton emission credits.
To manage this reduction, Illinois Power had several options under the Clean Air Act. It could burn coal with a
lower sulfur content; install a smokestack "scrubber" to remove sulfur dioxide; or simply operate the plant less
often. Or it could buy pollution credits, as available, from other utilities.
Illinois Power is investing in a scrubber that will cut the plant's emissions to 6,000 tons a year or less. The company
plans to use the credits to offset pollution at some of its other power-generating stations, and may even have extra
credits to save for the future or sell to other utilities.
The net effect? "Cleaner air," says Gerald M. Keenan, senior vice president of Palmer Bellevue Corp., a Chicago
consulting firm that helps utilities manage Clean Air Act reductions. "This changes the whole calculus of what
companies are going to do: how they fuel their plants, the capital improvements they'll make, how much they
operate plants, everything." Sulfur Futures Starting in 1993, the Chicago Board of Trade wants to offer futures
contracts on sulfur-dioxide credits. Each contract is a commitment to buy or sell 25 one-ton credits. By buying them,
a company could lock in pollution rights for the future. The Board of Trade probably would trade the contracts
electronically rather than in a pit of traders, but speculators would still be able to buy and sell them. This,
economists say, would make the sulfur-credit market more fluid and flexible than the EPA offset program.
Exchange trading also would standardize national prices for sulfur-dioxide credits, as the CBOT now does for such
commodities as corn and soybeans. The credits are expected to sell in the range of $500 a ton, subject to laws of
supply and demand. A technological breakthrough lowering the cost of scrubbers would pull down the price of
credits, while a surge in electricity use would push credit prices higher.
Utilities aren't waiting for the opening bell to arrange contracts for the future. "We're already getting solicitations
from companies in the Midwest and New Jersey looking for sulfur-dioxide emission credits," says Michael Hertel,
environmental affairs manager at Southern California Edison Co. The EDF's Mr. Goffman estimates that utilities
will arrange at least six trades by the end of the year.
The sulfur-dioxide program is the model for a broader plan being developed by Southern California's Air Quality
Management District. High Cost of Cleaning Up In Los Angeles, strict emission limits have forced companies to
spend billions of dollars to cut pollution, and the air is cleaner now than it was 15 years ago. Even so, pollution
reached hazardous levels on 184 days last year, and the region, by state law, must reduce emissions by 5% every
year until 2010. Meanwhile, industry has begun fleeing Southern California, in part because of high pollutioncontrol costs.
After a year of hearings and feasibility studies, the AQMD board last month approved a shift to market-based
regulation and told its staff to design markets for three of Los Angeles' most prevalent pollutants -- sulfur oxide,
nitrogen oxide and reactive organic gas. The process has produced unprecedented cooperation among rival interest
groups and changed many minds about market-based regulation.
One of them belongs to the AQMD's executive officer, James Lents, who wrote to the EPA in 1988 that the
disadvantages of emissions trading outweighed the benefits. Now Mr. Lents is a believer. "How can it not work?" he
says. "You tell each company that it's responsible for reducing emissions by a certain amount every year, and then
you let them go out and find a way to do it."
He thinks the program will get big polluters to go looking for smaller polluters that might "sell" their pollution
credits. For example, utilities and refineries, he says, might provide equipment for dry cleaners and furniture makers
in exchange for their pollution credits.
Some skeptics reiterate that the AQMD hasn't proved it can monitor emissions accurately enough to enforce the
program. Mr. Lent counters that his agency is testing new methods: individual smokestack monitors that relay
emissions information to AQMD computers and supermarketstyle computer bar codes to track the movement of
cans of vapor-emitting solutions.
One shortcoming of market-based regulation is that no one has yet devised a comprehensive way to apply it to the
biggest polluter of all: automobiles. Another concern is that while it may result in cleaner air overall, it doesn't force
a company to clean any particular plant. In fact, in some cases, it is possible for a plant to buy the right to pollute
more than ever.
Orlando Minelli, a retiree who lives in the shadow of Mobil's Torrance refinery, is trying to sell his house and isn't
happy that Mobil recently bought the right to increase the refinery's output of pollution. "It's hurting this area," he
says.
Environmentalists say Mobil's pollution buy in Torrance underscores a broader theme of market-based regulation:
As emissions trading becomes reality across the country, regulators need to be wary of sacrificing people like Mr.
Minelli for some perceived greater good. "You have to have strong local health standards that supersede the
emissions-trading program," says Mr. Goffman of the EDF.