February 10, 2000

Wirtschafts Woche
Germany's Business Weekly

Environmental Policy: Victory of the free market

The traders are nervous. This market is not concerned about Coca Cola shares, the price of gold or the euro exchange rate. Rather, this market revolves around a gas called sulfur dioxide (SO₂) or, more specifically, the credits that allow a ton of SO₂ to be emitted into the atmosphere. It is a unique concept. And the US is the first and only country to put into practice what economists regard as the most environmentally effective and cost efficient way to reduce SO₂ pollution and allow for the free trade of pollution rights.

Under the US scenario, the government decides upon a maximum total SO₂ emission level for the entire country for a given year, and then issues an appropriate amount of credits to SO₂ emitters. The remainder of the credits are open for trading. Emitters can use all of their credits, sell their surplus credits or retain them for future use. Companies that cannot sufficently control their emissions must buy additional credits to meet their emission requirements.

The SO₂ credit trading system was established under the 1990 Clean Air Act. The law mandates that operators of large utilities reduce their annual SO₂ output below 9 million tons collectively by the year 2010, approximately 50% less than the 1980 SO₂ level.

The decision of how to comply with the emissions standards, whether it be through the purchase of additional credits or the installation of better filtration systems, is left to the emitter. However, companies who do not acquire a sufficient number of credits for their SO₂ output can count on stiff punishment.

"The SO₂ emissions credit trade is an example of enoromous creativity by the private sector," praises Richard Sandor, chairman and CEO of Environmental Financial Products and former vice chairman of the Chicago Board of Trade. "Solutions to social problems can be solved, if one lets market forces work."

The numbers speak for themselves: by the end of last September, there were 29 million credits on the market, and this is only the start. Encouraged by the success of the SO₂ credit market, twelve US states have developed a model for a similar market for NOx (nitrous oxides).

Here’s how the model fuctions in practice: the historical emission rates for each power plant are submitted to the U.S. Environmental Protection Agency (EPA) which then assigns SO₂ credits, eaching entitling the holder to emit one ton of SO₂. The remaining credits are sold by EPA auctioneers at the Chicago Board of Trade each March. The daily trade of the credits is then turned over to specialized brokers and trading firms. However, anyone can buy credits, including private investors and environmental organizations. At first, environmental groups were very skeptical of the market-based model. However, they now use it as a tool for environmental protection. For example, the environmental group Adirondack Council bought credits and passed them on to their donors and let them expire, thereby reducing the amount of SO₂ emitted.

The economy also profits under the market-based model. According to an estimate by environmental economist Dallas Burtraw of the research group Resources for the Future, the credit-trading regime has saved $800 million dollars in complying with the EPA’s standards. Additionally, there have been other benefits beyond the $800 million in savings. Many US utility operators have experiemented successfully with cleaner coal mixtures, which before had been dismissed as technically impossible.

The best proof of the success of the trading regime has been the drop in price of the credits: When the market was launched in the early 1990’s, the credits were valued at $1,000 or more. In the last two years, the value of a credit has dropped to between $100 and $200. While the SO₂ mitigation costs are still far more than other industrialized nations (like Germany), environmental economists stress that this does not argue against the trading regime.

"European politicans should remake their mitigation programs based on the US model," says Reimund Black, an environmental economist at the Technical University of Berlin.

A trading regime is now being put in place to mitigate the greenhouse gas carbon dioxide (CO₂). In 1997, the industrialized nations attend the United Nations climate change conference in Kyoto and pledged to reduce their CO₂ emissions to 1990 levels by 2012. Without a global CO₂ emissions trading regime similar to that of the US SO₂ model, Dr. Black warns that reduction targets can never attained because other methods are simply too expensive for countries in the European Community.

The UN climate conference has adopted the an emissions trading model in principle but, so far, disagreement over the final structure of this model prevails. The EU is already thinking about commerical restrictions, even before a ton of carbon is traded. This position is also supported by the Ministry of the Environment. The Ministry has declared that Germany should meet at least 50% of its emissions reduction in-country, before allowing companies to trade credits internationally.

Politicans should also avoid another defect in the American SO₂ model: free assignment of credits to companies. Economic models show that it is cheaper overall to auction all credits, allowing tax credits to flow back to the private sector. Had a full-auction model been in place, the total SO₂ mitigation costs would have been reduced by a third, according to environmental economist Dallas Burtraw. He believes that this decision is of historical importance.