Taking up the Slack: Lessons from a Cap-and-Trade Program in Chicago

The Emissions Reduction Market System (ERMS), an emissions-trading program for volatileorganic materials (VOMs) in Chicago, Illinois, has been characterized by emissions significantly belowthe annual allocation of emission allowances, allowance prices much lower than predicted, limitedtrading, and emission allowances that expire unused. Essentially, it appears that a fundamentalprerequisite for a tradable allowance program is missing—there is no scarcity of allowances. We evaluatea variety of hypotheses that may explain why the ERMS cap does not appear to be affecting abatementbehavior and identify three that contributed to the lack of scarcity in the ERMS program: (1) a baselineprocess that inflated the cap; (2) hazardous air pollutant regulations that contributed to VOM reductions atsome sources; and (3) numerous facility shutdowns. We conclude that the ERMS experience illustratesthe inherent unpredictability of economic, regulatory, and other factors when setting an emissions target;a conclusion that resonates with the recent experience of the European Union Emissions Trading Scheme.This argues for gathering reliable emissions data, developing sophisticated emissions projections, andmaking transparent assumptions about the impacts of other policies and regulations during the programplanning and design phase. However, even with all these attributes, it is still difficult to anticipate everypossible outcome. Thus, it is desirable to have robust mechanisms to address the uncertainties ofemissions-trading markets and to make midcourse corrections if necessary. Finally, we offer somecomments on how to think about the results of ERMS versus a hypothetical command and controlprogram that might have been designed to reach the same environmental outcome.

When the state of Illinois set up a cap-and-trade program to cut volatile organic emissions in Chicago, beginning in the year 2000, something unexpected happened: Prices for emissions allowances fell far below the expected levels, and many allowances went unused. What went wrong?

Research Associate David A. Evans and former Visiting Scholar Joseph A. Kruger analyze the case in “Taking Up the Slack: Lessons from a Cap-and-Trade Program in Chicago” (Discussion Paper 06-36) . They identify three reasons for the disappointing results of Chicago’s trading experiment. First, the allocation of allowances was overly generous. In addition, unrelated regulations for hazardous air pollutants affected emissions of volatile organics, and many sources of emissions shut down during this period.

They point out that Chicago's experience demonstrates “the inherent unpredictability of economic, regulatory and other factors when setting an emissions target.” One conclusion they draw is the importance of mechanisms to make mid-course corrections. To avoid disruptive price drops, and to maintain steady pressure on sources to reduce emissions, programs could be designed to have emission allowances withdrawn from the market whenever the price reaches a predetermined minimum, Evans and Kruger suggest.

However, they also note that such a mechanism may not be necessary to ensure near-term allowance scarcity if there is a banking mechanism and there is a general expectation that abatement costs will increase or allocations will decrease in the future.

The experience in Chicago is similar, Evans and Kruger point out, to other and larger markets in emissions permits --- notably the European Union’s Trading Scheme (EU ETS). The EU ETS experienced a sharp drop in permit prices in the spring of 2006, when it became apparent that many of the participating countries had provided industry with overly generous allowance allocations. Targets in the EU ETS will be readjusted when it enters a second phase in 2008.

Despite its miscalculations, was the Chicago cap-and-trade program a success? Evans and Kruger argue that it depends on one’s perspective. Most economists would like to see allowances having a relatively high price because harmful emissions should be scarce. In the Chicago market, volatile emissions are not scarce, given their minimal price and the vast amount banked. However, from the perspective of affected sources and the state regulators, reductions in volatile organic emissions were greater than required, at what was most likely a lower cost than it could have achieved under conventional regulation.