Trading Programs2001 676. Trading ProgramsCrocker and Dales generally are credited with first proposing that marketableemission permits be used as an incentive mechanism for achieving environmentalgoals.89 The basic approach outlined by Crocker and Dales and later refined byDewees and Harrison is that the environmental authority can issue a fixed number ofmarketable permits to release emissions.90 Through trading, low-cost sources will sellsome of their permits and abate more than they would under a traditional regulatoryapproach, while high-cost sources will buy permits and abate less. The end result,according to the academic design, is the same amount of pollution reduction thatwould be achieved through traditional regulatory approaches, but it is achieved atlower cost.EPA first applied the concept of marketable emission permits in the mid-1970s as ameans for new sources of emissions to locate in non-attainment areas withoutcausing air quality to worsen. New sources and existing sources that wanted toexpand their facilities were required to offset their emissions by acquiring emissionreduction credits from existing sources. This important but modest beginning wasbased on an interpretation of the Clean Air Act, rather than on a specific statutoryauthority. EPA’s Offset Policy was included in the 1977 amendments to the CleanAir Act statute. In 1980, then-Administrator Hawkins signed a memo that allowedemission averaging between can-coating lines.91On August 7, 1980, EPA promulgated New Source Review (NSR) and Prevention ofSignificant Deterioration (PSD) rules that allowed netting, a means for sources toavoid PSD and NSR requirements for emission increases due to facility expansion, ifemissions were decreased contemporaneously elsewhere at the facility.92 Under thePSD mandate, this rule included facilities within a plant as a source of emissions aswell as an entire plant as a source of emissions, in what was termed a “dual-sourcedefinition.” Chevron and others challenged this rule, claiming it made modernizationtoo difficult. Eventually the U.S. Supreme Court agreed that states did not need toinclude the dual-source definition in their non-attainment rules. This opened the doorto many of the emission trading programs that exist today.The 1990 Clean Air Act Amendments authorized a variety of emission tradingsystems. While similar statutory authority to establish effluent permit trading systemsdoes not exist, EPA believes that the Clean Water Act allows effluent trading.Programs of this sort have been operational for several years without legalcontroversy. Pollution permit trading systems now come in a wide variety of forms,and they apply to a large and growing number of sources of pollution that affect thequality of air, water, and land.Insofar as trading between economic entities is concerned, two main forms of tradingsystems are observed: (1) uncapped emission (or effluent) reductions credit (ERC)systems, and (2) capped allowance systems (also referred to as cap-and-tradesystems). In the case of uncapped systems, pollution limits are rate-based (e.g.,grams per mile for motor vehicles), and sources earn credits by releasing lesspollution than their legal limit or other defined baseline. Under these systems,The U. S. Experience with Economic Incentives for Protecting the Environment68 Januaryemissions can increase with economic growth. By contrast, with capped systems, total emissionsare limited by an overall ceiling that is designed to achieve health or environmental goals, andallowances are allocated to sources in quantities consistent with this ceiling. The formula formaking such allocations will vary from one situation to the next.A number of the programs described in this chapter involve the right to average emissioncharacteristics of a slate of similar products that are manufactured by one economic entity.Emission averaging is an important mechanism for improving the cost effectiveness ofenvironmental regulation. It can be characterized as intra-firm trading across the product lineswhere it is allowed.Trading systems, properly designed and applied in appropriate circumstances, can cutcompliance costs, encourage technological development, and create incentives for achievingenvironmental benefits beyond minimum requirements. For trading systems to function well, anumber of requirements must be satisfied. There should be several potential participants in tradesif a functioning market is to be created. Exactly how small a universe of potential participantsthere can be and still have a functioning market is difficult to say, but simulation experimentssuggest that 8−10 participants is a reasonable estimate.93 If sources are dispersed geographically,trading ratios other than one-to-one might have to be imposed to account for wind direction orthe distance between sources to ensure no degradation in environmental quality.Some pollutants are seasonal in their impact, implying that trades might be allowed only during aportion of the year. Trading might be limited because of a desire to avoid “hot spots” wherepollution concentrations increase. Trading requires that pollution control agencies have theability to monitor emissions (or measure a surrogate to those emissions) reasonably well. Theneed to ensure accountability of trades must not pose unacceptably high transaction costs. Thecommodity to be traded needs to be defined. In general, a well-defined commodity requires abaseline from which to calculate the emission reduction credits (or allowances) that may betraded. Establishing baselines is likely to require good historic data on emissions, input use, etc.In the case of allowance systems, the political will must exist to achieve an allocation ofallowances among competing interests.Cap-and-trade systems to date have allocated most or all of the allowable emissions under thecap to existing sources, providing allowance set-asides for new sources or using auctions as asafeguard to ensure access to allowances. Initially, environmentalists opposed marketable permittrading because the existence of trading was evidence that sources could make greater reductionsin pollution than were being achieved. In addition, there has been a lingering concern that tradingcould result in localized “hot spots” that had undesirably high levels of pollution. With thesuccess of the Regional Clean Air Incentives Market (RECLAIM) and the Acid Rain Programdescribed later in this chapter,