Trading Programs for Environmental Protection: Lessons and Experiences

1. Trading Programs for Environmental Protection: Lessons and Experiences Kurt Stephenson Virginia Tech May12, 2005

2. Objective for this afternoon • Rationale & Requirements for Market- based Environmental/Natural Resource Trading Policy • 2. Experiences and Lessons • Cap and Trade Programs • Trade outside a cap – credit offsets

3. Buyers Sellers Compensation ($) Rights to the Car Government Facilitate trade Address third-party effects Police (Monitor & Enforce) First Principles: Anatomy of an Market Exchange

4. Characteristics of Well-Functioning Markets • Decentralized (private) decision-making • Low transaction costs • Stable system of rights that limit uncertainty, • but define unacceptable behavior • Clear and timely penalties for rule violation

5. Why Markets? • Private incentives that create public benefits • Dynamic incentives, discovery/creation • Incentives for cost-effectiveness (least cost) • Knowledge is disperse, sometimes tacit, and incomplete

6. Application of Market-basedPrinciples to Environmental Protection: Cap and Trade

7. 125 100 100 75 Allowances/Rights Compensation ($) 100 Allowances 100 Allowances 125 Allowances 75 Allowances Cap and Allowance Trading Government Protect Environmental Quality (Define Cap/Commodity) Address Third-Party Effects Monitor and Enforce

8. Characteristics of Well-Functioning Markets • Decentralized (private) decision-making (“internal” and “external” flexibility) • Low transaction costs • Stable rules that limit uncertainty about allowance ownership and use, but • Define unacceptable behavior • Clear and timely penalties for rule violation

9. Why Markets for Environmental Protection? • Caps provide the public assurance that EQ goals are achieved over time • Opportunity to trade • allows movement of resources to higher valued uses • creates continuous private incentives to discover new EQ technologies & strategies • Compliance more timely and effective

10. 100 100 Allowances/Rights Compensation ($) 200 acre ft 200 acre ft Government Protect Environmental Quality (Define Cap/Commodity) Address Third-Party Effects Monitor and Enforce

11. Conventional Market-based System-wide “best” options can be calculated “Knowledge problem” Regulator’s job: technical engineer Regulator’s job: police officer “Push” mentality “Pull” mentality No negative impact Balancing Market-based environmental policy and conventional policy

12. Experiences from the Clean Air Act: • Air program has the most extensive experience with EQ trading programs. • SO2 cap and allowance trading • Emission Reduction Credit Programs (ERC) • Not all programs are designed the same & not all programs produce same outcomes.

13. SO2 Cap and Allowance Trade • Congressionally identified annual national SO2 allowance cap. Allowance defined in advance as permission to discharge 1 ton of SO2/yr. • Utilities have discretion to determine control strategies • Utilities may bank, buy, or sell allowances with minimum cost of transacting. • EPA tracks allowances (trades and use) and monitors/enforces

14. SO2 Cap and Allowance Outcomes • SO2 prices (control costs) lower than estimated • Mining industry response • Rail industry response • Scrubber industry response • Trading light during initial stages • 100% Compliance

15. Other Experiences: ERC Programs • Extensions of conventional regulator-directed technology-based standards & permitting • Standards define baseline & transferable commodity (“credit”) created if documented discharges below baseline • Buyers are other regulated parties

16. ERC Program: Experiences • Disincentives for participation • Uncertainties with credit (Will baseline be lowered in the future for superior performance? Will credits be certified?) • High cost of transacting – negotiating a credit sale • Limited decision-making flexibility for regulated parties. • Possibilities for net increases in emissions

17. Lessons: Market Design Matters • Market design is difficult – often requiring significant change (behavior & rules) • Different programs designs for the same environmental “medium” can produce very different behavior and outcomes. • Cap and trade programs based on market-like principles create new incentive structures & behavior

18. Trading Beyond Caps: Credit Offsets

19. 100 Compensation ($) Credits Trade Outside a Cap Government Regulatory Requirement

20. Opportunities • Create markets for conservation activities • Create “win-win” situations for regulated community and larger community • Get more ecological bang per $ spent. • Regulatory compliance flexibility

21. Experiences • To date reality hasn’t equaled promise or rhetoric • Very little market development/activity • Examples: • Point-Nonpoint Offset Trading • Wetland Mitigation Banking

22. Experiences • Challenges: • Regulatory rigidities that limit choices and dampen incentives (high transaction costs, uncertainties, inflexibilities limit supply and demand of credits) • Defining a “credit” -- Agreement on environmental “equivalency” and accounting.

23. 100 Government assigns responsibility for nonpoint controls to point source 50 50 Government: Identify and approve acceptable N control technologies Government: Define and Impose limits of control technology 100 100 Government: Impose limits more stringent than LOT (e.g. zero discharge) Point-Nonpoint Source Offsets Compensation

24. Offset Examples • Rahr Malting, MN • Sacramento Mercury, CA • Delaware Inland Bay, DE • Sediment, IL • Dillon Reservoir, CO • Charles River, MA • Others …

25. Nonpoint Source Offsets: Experiences • Most NPS offsets are isolated individual permit modifications • Not market-oriented – • No competitive market for NPS credits. • Regulated parties have few choices/flexibility • High transaction costs • No transfer of control responsibility.

26. Private Mitigation Bank 100 Compensation Credits Government: Sets conditions and approves trade Government: 1. Avoid & minimize to max extent practicable Government: Approves banks, establishes performance criteria & certifies credits 2. Preference for on-site, “in kind” mitigation Defines geographical scope of potential credit transfers Wetland Mitigation Credits

27. Mitigation Banking Experience • Case by case “tri-lateral” deals & no real “market” for wetland credits. • Regulatory program creates credit demand uncertainty. • Limited scope of trade and high approval costs limit supply and competition • Limited discretion based on cost effectiveness.

28. Water Quality (NPS) and Wetland Program: Lessons • Offers some options for compliance with regulatory conditions. • Common Themes: • Regulatory control over decision-making • High uncertainties and transaction costs • “No negative impact” perspective • Consequences: • No markets • No credit creation in advance

29. Environmental Equivalency in Credit Creation/Transfer Compensating one type of loss in environmental services for an equivalent “lift” (conservation credit) elsewhere. How many credits is enough? What type of credit? (type and location) Obviously important because it defines the “commodity” to be traded The challenge to defining a credit is as much a social/political problem than it is a technical one.

30. Defining an Equivalency: Experiences Water Quality – NPS Credits for PS loads • Load for load (BMPs, land conversion, temp) • Water quality impacts (cross pollutant trading) • Load for flow (GW recharge, proposed) Wetland (Section 404) • Stream restoration credits (dam removal) to compensate for wetland/stream fills • Water quality credits for steam fills Natural Resource Damage Assessments • Habitat equivalency procedures

31. Defining an Equivalent Credit • Determining “environmental equivalency” is: • most often site specific • subject to some irreducible uncertainty • These features then force case-by-case determination of an “equivalent credit” • How much flexibility, “burden of proof”, and negotiation (costs) will be needed to reach agreement on equivalency varies from case to case and is a function of trust among all of the negotiating parties.

32. A Few Parting Thoughts Conventional markets for credit offsets have not developed. • A variety of institutional arrangements, however, can accomplish many of the same objectives: • Government Credit Resale Arrangements (reduce credit demand uncertainty and create competition among credit suppliers) • Associations/Cooperatives of regulated parties (reducing transaction/regulatory costs)