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Banking on Allowances: The EPA’s Mixed Record in Managing Emissions-Market Transitions
RFF Feature
October 7, 2010

Climate Policy's Uncertain Outcomes for Households

The adoption of emissions-trading markets beginning in the early 1990s—mainly cap-and-trade regimes regulated by the U.S. Environmental Protection Agency—has led to reduced emissions of major air pollutants, particularly nitrous oxides (NOx) and sulfur dioxide (SO2).

In an RFF Discussion Paper, “Banking on Allowances: The EPA’s Mixed Record in Managing Emissions-Market Transitions,” Visiting Scholar Arthur G. Fraas and Resident Scholar Nathan Richardson note that banking of allowances—that is, allowing sources to save excess allowances for future time periods—increases the efficiency of an emissions-trading program by shifting reductions to lower-cost time periods and smoothing price variations between different allowance periods.

There is a tension, the authors observe, between the efficiency benefits of banking and environmental certainty, especially when one program is replaced by another. At the same time, they observe, clear and consistent cap-and-trade regulations are vital in order to limit uncertainty and assure a smoothly functioning market. This clarity has not always been present for rules regarding banking.

“After the basic rules for an emissions-trading program are in place, changes by regulators in the rules governing the use of allowances can significantly affect the certainty and credibility of the emissions-trading programs and the value of allowances,” Fraas and Richardson write. “Such changes may lead to undesirable market behavior, including an emissions increase as sources use up or dump their banked allowances.”

The authors examine the aftermath of the 2008 decision by a federal court that rejected the EPA’s Clean Air Interstate Rule, which has created substantial uncertainty about future regulation of NOx and SO2 emissions through emissions-trading programs. Members of Congress and the EPA have both reacted to this uncertainty with proposals for new cap-and-trade programs for these pollutants.

While none of these proposals has been implemented and they could change significantly before being finalized or passed, discussing them is still useful, say Fraas and Richardson. Both would create new markets and therefore face questions about transition from current programs and the treatment of banked allowances from those existing markets. The authors argue that the EPA’s Transport Rule proposal deserves particular attention because it would prohibit transfer of substantial volumes of banked allowances, a move that is at odds with the agency’s traditional practice, that upsets the settled expectations of regulated parties, and which Fraas and Richardson suggest could have negative long-term results for the effectiveness of trading programs.

Excerpts From the Paper

“We noted that emissions allowances do not convey full-fledged property rights but instead carry some (but not all) of the rights in the property bundle. One key element in the property bundle is the extent to which banked emissions allowances hold value as emissions caps decline and new programs are created. Our discussion of the transition between cap-and-trade programs for NOx and SO2 highlights this issue. State policies, EPA policies, and federal court decisions have limited the use of banked allowances over the course of these programs, significantly altering their value and introducing a substantial element of uncertainty in the markets for emissions allowances."

“The transitions between the programs discussed here provide evidence that these transitions are manageable—but also that regulatory decisions affecting these transitions can have large, disruptive effects on allowance markets if expectations of the value of banked allowances are not respected and early reductions go unrewarded.”

“We are not ready to close the book on the history of emissions-trading programs—particularly cap-and-trade programs. They have been successful in reducing pollution at relatively low cost, and other pollutants—most notably carbon dioxide—could well be regulated with broadly similar tools. Just as with regulation of SO2 and NOx, these new programs will not be static. New information about the adverse effects of emissions and the function of markets, international agreements, and other economic and political changes will require adjustments of these programs."

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