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309 How Environmental Laws Work: An Analysis of the Utility Sector's Response to Regulation of Nitrogen Oxides and Sulfur Dioxide Under the Clean Air Act Published at 14 Tulane Environmental Law Journal 309 ( Summer 2001)

Byron Swift Environmental Law Institute*

I. INTRODUCTION.............................................................................. 312 A. Methodology......................................................................... 313 B. Background of Title IV.......................................................... 314 II. REGULATORY PROGRAM FOR SULFUR DIOXIDE ( SO2) ................... 315 A. Background and History of SO2 Regulation: Traditional Rate Based Standards........................................ 316 B. Title IV.................................................................................. 319 C. Industry Response................................................................. 322 1. Price Signals, Coupled with the Flexibility of Title IV, Drove Major Shifts in Businesses' Compliance Strategy.................................................... 323 2. Over Compliance and Banking.................................... 325 3. Autarkic Compliance ................................................... 327 4. Strategies for Compliance ............................................ 328 5. The Scrubbing Story: Fewer Scrubbers than Expected but Lower Costs Due to Economics, Innovation, and Regulatory Design.............................. 330 6. The Low Sulfur Coal Story   Regulatory Design and Economic Choices................................................. 335 7. Retirement.................................................................... 339 8. Substitution Units......................................................... 340 * The Environmental Law Institute gratefully acknowledges the support of the Andrew W. Mellon Foundation for this study. The research and analysis for this study benefited considerably from the assistance of LeRoy Paddock, together with Susan Bass, Linda Breggin, Shi ling Hsu, Gary Ganoung, Beverly Grossman, Kelly Mott, Jay Pendergrass, and Brian Rohan. ELI also gratefully acknowledges the assistance of the EPA's Clean Air Markets Division, Denny Ellerman of MIT, and Dallas Burtraw of Resources for the Future, the individuals who provided comments on this Article, and the many individuals, firms, and organizations interviewed during the research. The author can be reached by e mail at swift@ eli. org. 310 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 9. Trading......................................................................... 341 10. Phased Structure Caused Problems.............................. 349 11. Environmental Effects or " Hot Spots" from Trading......................................................................... 350 III. REGULATORY PROGRAMS FOR NOX............................................... 351 A. Background .......................................................................... 353 B. Title IV NOX Standard and Its Legislative History................ 354 C. Results of Title IV.................................................................. 357 1. Initial Litigation and Delay .......................................... 357 2. Implementation............................................................ 358 D. Business Behavior and Title IV............................................. 359 1. Rate Standards Led to One Time Compliance Using the Expected Technology................................... 360 2. In Making Pollutant Reductions, Firms Sought First to Optimize Their Process Efficiency, as Regulations Were Sufficiently Flexible to Create Benefits Through Doing So ......................................... 360 3. Firms Heavily Used Flexibility Mechanisms with Low Transaction Costs, Such as Averaging ................. 361 4. Businesses Faced with Rate Standards Can Be Expected to Over Comply by 10% .............................. 365 5. Innovation under Title IV's Moderate Rate Standards Was Limited in Scope and Extent................ 366 E. Other NOX Regulation in the 1990s...................................... 370 1. OTC Cap and Trade in 1999 Forced Further Reductions at Existing Plants....................................... 370 2. New Source Standards ................................................. 374 3. Technology Based Rate Standards for NOX in the 1990s Created an Uneven Regulatory Framework and Varied Economic Signals for Most Business Units............................................................................. 375 IV. GENERAL FINDINGS....................................................................... 376 A. Environmental Standards Have Been Essential to Drive Businesses to Reduce NOX and SO2 Emissions..................... 377 B. It Has Proven Difficult to Set Standards That Properly Align Private with Social Costs, and Both NOX and SO2 Standards Were in Retrospect Too Lenient............................ 378 C. Standards Based on Rates or an Old Source/ New Source Distinction May Create Conflict Rather Than Alignment Between Regulatory and Economic Drivers for Environmental Quality.................................................... 380 2001] HOW ENVIRONMENTAL LAWS WORK 311 D. Different Regulatory Designs Greatly Affect the Cost of Compliance for Achieving Equivalent Environmental Results .................................................................................. 381 E. Rate Standards Were Inflexible, Limiting Businesses' Ability to Develop and Implement Compliance Methods and Technologies .................................................................. 383 1. Emissions Rate Standards Limited Technology Choice .......................................................................... 384 2. Emissions Rate Standards Did Not Force a Move Toward Cleaner Technologies...................................... 387 3. Rate Standards Promote One Time Compliance Without Incentives for Further Progress ...................... 387 4. Rate Standards Created High Transaction Costs.......... 388 5. The Design of Rate Based Standards Can Be Marginally Improved ................................................... 388 F. Emissions Cap and Allowance Trading Programs Allow Greater Integration of Environmental Issues into Business Decision Making Processes, Providing Greater Flexibility and Lowering Costs Without Sacrificing Environmental Integrity...................................... 391 G. Innovation, Investment, and Cleaner Production ................. 392 1. Cap and Trade Programs Promote Broader Technology Use and Innovation................................... 393 2. Rate Based Systems Were Unfriendly to Innovation.................................................................... 394 3. While Innovation Can Be Expected to Occur Broadly, It Is Not Guaranteed for Any Specific Technology................................................................... 394 4. Traditional Regulatory Approaches Have Discouraged and Distorted Private Investment in Research and Development, and Capital Markets for Innovation............................................................... 395 H. Imposing Stricter Standards on New Sources Has Proven Ineffective in the Power Sector, and Has Led to Neither Cheaper Compliance Nor Better Environmental Results.......................................................... 396 1. New Source Standards Have Not Effectively Reduced Ambient Pollution Levels.............................. 397 2. New Source Standards Force Only Limited Kinds of Innovation................................................................ 397 312 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 3. NSR Rate Standards Create Few Net Benefits When Combined with Offsets or in Conjunction with an Emissions Cap................................................. 398 I. Transaction Costs in Cap and Trade and Rate Based Programs.............................................................................. 399 1. Transaction Costs in Establishing Legislation.............. 399 2. Transaction Costs in Establishing Regulations............. 400 3. Transaction Costs in Implementing the Programs........ 402 4. Transaction Costs in Incrementally Lowering Standards...................................................................... 403 J. Monitoring and Compliance................................................. 404 1. Strict Monitoring and High Penalties........................... 404 2. Design of Cap and Trade Programs............................. 404 3. Inclusiveness of Cap and Trade Programs................... 405 K. Over Compliance and Other Conservative Compliance Strategies by Firms ............................................................... 405 L. Flexibility Mechanisms with Low Transaction Costs Were Widely Used ................................................................. 406 M. Retirement and/ or Switching to Cleaner Power Sources...... 407 V. CONCLUSION................................................................................. 408 A. Stringency............................................................................. 408 B. Regulatory Design................................................................ 408 I. INTRODUCTION Many people have voiced concerns about our environmental regulatory system. Businesses express concern about the cost and complexity of regulation and slow governmental approvals. These concerns have added to industry resistance to efforts to tighten environmental standards or to address new problems such as global climate change. Environmental advocates are concerned about the effectiveness of regulations, their enforcement, and the need to tighten standards to increase social benefits. Policy analysts have drawn attention to the lack of common sense results and the inflexibility in many current regulatory systems, together with the lack of appropriate incentives for continuous improvement and innovation. This study is designed to examine the actual performance of environmental regulations and the compliance behavior of regulated businesses in a real world setting. It focuses on business compliance with regulatory standards for nitrogen oxides ( NOX) and sulfur dioxide ( SO2) in the electric power industry from 1995 through 1999. The selected time period permits evaluation of Phase I of Title IV of the 2001] HOW ENVIRONMENTAL LAWS WORK 313 federal Clean Air Act ( CAA), enacted in 1990 to regulate utility emissions of SO2 and NOX. This allows comparison of the two contrasting regulatory approaches Title IV imposed on electricitygenerating facilities: an emissions cap and allowance trading program for SO2, the most ambitious such program operating in the United States, and a more traditional technology based emission rate standard to control NOX emissions. The study also compares these standards to the new source standards for NOX and SO2 in effect during the 1995 1999 period, providing findings about business behavior in the face of varied regulatory standards.

A. Methodology A principal methodological approach of the study was the analysis of applicable environmental laws and polices, together with the extensive data compiled by governmental and private sources on the power generation industry. Particular use was made of the emissions and generation data compiled by the United States Environmental Protection Agency ( EPA) and the Department of Energy's Energy Information Administration ( EIA), 1 together with private sources such as the Center for Energy and Environmental Policy Research of the Massachusetts Institute of Technology ( MIT) and Resources for the Future. A second major methodological approach of the study was to conduct confidential interviews with representatives of power generating firms, federal and state regulators, public interest and citizen organizations, and technology manufacturers and consulting organizations providing equipment and advice to the electricity generating industry. This included detailed, often on site interviews with environmental program managers for most of the electricity generating firms affected under Phase I. 2 1. Prominent among these are the annual publications EPA, PUB. NO. EPA 430/ R 00 007, ACID RAIN PROGRAM: 1999 COMPLIANCE REPORT ( 2000), available at http:// www. epa. gov/ airmarkets/ cmprpt/ arp99 ( last updated Dec. 11, 2000) [ hereinafter EPA 1999 COMPLIANCE REPORT]; EPA, ACID RAIN PROGRAM: 1999 EMISSIONS SCORECARD ( 2000), available at http:// www. epa. gov/ airmarkets/ emissions/ score99 ( last updated Dec. 11, 2000) [ hereinafter EPA 1999 EMISSIONS SCORECARD]; U. S. ENERGY INFORMATION ADMINISTRATION ( EIA), U. S. DEP'T OF ENERGY, PUB. NO. DOE/ EIA 0383, ANNUAL ENERGY OUTLOOK 2001: WITH PROJECTIONS TO 2020 ( 2000), available at http:// www. eia. doe. gov/ oiaf/ aeo/ index. html ( last modified Jan. 30, 2001) [ hereinafter DOE ANNUAL ENERGY OUTLOOK]. 2. The interviews were confidential, and covered a wide range of topics about the effect of the regulations and firms' compliance strategies and behavior. 314 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 B. Background of Title IV Acid precipitation, which forms as a result of SO2 emissions and to a lesser extent NOX emissions, emerged as a significant environmental and political issue in the late 1970s. The problem was caused primarily by electricity generating plants in the east central part of the United States, extending from Missouri east to West Virginia and south to Georgia, which burned the high sulfur coal from this region. 3 The issue pitted these midwestern states and coal interests against environmentalists and the downwind northeastern states, and the acrimonious debate produced a ten year stalemate in Congress during the 1980s. 4 Title IV of the Clean Air Act Amendments of 1990, which enacted the Acid Rain Program to address both SO2 and NOX emissions, ultimately broke this stalemate. 5 Title IV's emissions cap and allowance trading system for SO2 was designed to reduce 1980 SO2 emission levels by 10 million tons, while promising lower costs than typically associated with traditional ratebased standards. 6 The law also imposed rate based standards designed to lower NOX emissions by about 2 million tons from baseline levels. 7 Both programs required significant reductions from the larger, dirtier utility units during Phase I, which lasted from 1995 until 1999.8 Phase 3. Acid precipitation occurs when sulfur dioxide and nitrogen oxides react in the upper atmosphere with water, oxygen, and other chemicals to form sulfuric acid and nitric acid. These acids adhere to rain drops or snow, damaging forests and acidifying lakes and limiting their ability to support aquatic life. Acid precipitation damage has been most pronounced in the northern tier and northeastern United States and Canada because the forests and lakes in these areas are more sensitive to acidic deposition. NATIONAL ACID PRECIPITATION ASSESSMENT PROGRAM, 1990 INTEGRATED ASSESSMENT REPORT ( 1991) [ hereinafter NAPAP INTEGRATED ASSESSMENT]; JAMES L. REGENS & ROBERT RYCROFT, THE ACID RAIN CONTROVERSY 35 58 ( 1989). 4. See generally RICHARD COHEN, WASHINGTON AT WORK, BACK ROOMS AND CLEAN AIR ( 1990) ( discussing congressional debates); BRUCE A. ACKERMAN & WILLIAM T. HASSLER, CLEAN COAL AND DIRTY AIR ( 1981) ( discussing competing interests regarding coal industry, environmentalists, CAA regulation, and various states). 5. Clean Air Act Amendments of 1990, Pub. L. No. 101 549, 104 Stat. 2399 ( 1990) ( codified at 42 U. S. C. § § 7401 7700 ( 1994)). 6. Ian M. Torrens et al., The 1990 Clean Air Act Amendments: Overview, Utility Industry Responses, and Strategic Implications, 17 ANN. REV. ENERGY & ENV'T 211, 213 ( 1992). Today, it is understood that the reductions required by Title IV benefit not only acid deposition, but also human health in reducing the formation of fine particulates and of urban ozone. 7. 42 U. S. C. § 4651( b) ( 1994). Because the standards were rate based, they never achieved the reduction from the 1980 baseline, but did slow the growth of NOX emissions to 3% between 1990 and 1999, compared to a 28% increase in plant utilization. EPA 1999 COMPLIANCE REPORT, supra note 1, at 2. 8. Title IV only covers electric generation units that sell electricity, loosely termed " utility units," although in today's deregulated environment, independent power providers may sell power without being a regulated utility. See 42 U. S. C. § 7651a( 17) ( 1994). Title IV excludes from its coverage industrial producers of electricity, even though in 1990 they emitted 3.6 million 2001] HOW ENVIRONMENTAL LAWS WORK 315 II commenced in 2000, and imposed stricter standards on virtually all utility units. 9 II. REGULATORY PROGRAM FOR SULFUR DIOXIDE ( SO2)

The centerpiece of Title IV was the emissions cap and allowance trading program for SO2, designed to reduce utility emissions by 10 million tons, or roughly 50% from 1980 levels. The program's record of over achieving this goal at very low compliance cost has prompted many to regard it as one of the most successful environmental regulatory programs. 10 The emissions cap sets a mass performance standard very unlike traditional rate standards. The cap is the most important element of Title IV because it establishes the program's environmental integrity and much of its economic efficiency by allowing regulated firms to choose any effective compliance method, leading to significant cost savings. 11 The emissions trading system also helped to lower compliance costs by allowing firms to reduce emissions at the generating units where their costs were lowest, and resulted in establishing a market price per ton of emission reductions. The combination of a cap and trade system makes every ton of reductions count and exerts continuous economic pressure on firms to improve performance, transforming business compliance behavior as compared to a traditional rate based approach. 12 Overall, this unique tons of SO2 compared to utility emissions of 15.9 million, and 3.0 million tons of NOX compared to utility emissions of 6.7 million. EPA, NATIONAL AIR POLLUTANT EMISSION TRENDS 1900 1998, PUB. NO. EPA 454/ R 00 002, at 3 10, 3 12 ( Mar. 2000), available at http:// www. epa. gov/ ttnchie1/ trends/ index. html [ hereinafter EPA EMISSIONS TRENDS]. Note that industrial sources may voluntarily opt into the SO2 program. 42 U. S. C. § 7651i( a) ( 1994). 9. Phase I of the program includes only larger units with emissions greater than 2.5 pounds per million Btu of fuel burned ( lb/ mmBtu) during the baseline period of 1985 1987 ( known as " Table A" units, as they are listed in Table A in the statute), together with any substitution or compensating units that were voluntarily entered into Phase I. See 42 U. S. C. § 7651c ( 1994). The 265 units included in Phase I of the SO2 program as of January 1, 1995, also are affected by the Phase I NOX program. See id. § 7651f. All utility units larger than 25 MW in size are included in Phase II of the program, which began in 2000. See id. § § 7651d( a), 7651f( a). 10. See generally EMISSIONS TRADING ( Richard F. Kosobud et al. eds., 2000) ( discussing economic, environmental, and regulatory issues surrounding emissions trading); A. DENNY ELLERMAN ET AL., MARKETS FOR CLEAN AIR: THE U. S. ACID RAIN PROGRAM ( 2000) ( evaluating the impact of Title IV on SO2 emissions). 11. 42 U. S. C. § 7651a c ( 1994). 12. Emission rate systems, especially if differentiated by technologies, exert few incentives to use cleaner base technologies, and promote an " equal effort" approach based on reasonable or best efforts. They also create no incentives to go beyond the standard. In contrast, emissions cap and allowance trading approaches, together with other potential market mechanisms, create an equal " cost per ton" approach that allows greater flexibility in compliance 316 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 regulatory design resulted in major emissions reductions, industry compliance costs below the lowest predictions, significant and unexpected innovation, relatively little litigation during program implementation, very low ongoing transaction costs, and 100% compliance. The environmental effects of the sulfur reductions have also been significant. Compliance with Title IV has already reduced acid deposition in northeastern states. 13 The EPA has also estimated the health benefits from reduced SO2 emissions at over $ 10 billion. 14 A. Background and History of SO2 Regulation: Traditional Rate Based Standards Prior to Title IV, existing power plants were primarily affected by state based legislation aimed at attaining national ambient environmental standards. 15 The federal Clean Air Act of 1970 established the first national ambient air standards for SO2, designed to protect health and welfare, 16 and required states to develop " state implementation plans"

choices and exerts continuous pressure on businesses to reduce tons of pollution. These issues are discussed infra Part V. 13. James A. Lynch et al., Changes in Sulfate Deposition in Eastern USA Following Implementation of Phase I of Title IV of the Clean Air Act Amendments of 1990, 34 ATMOSPHERIC ENV'T 1665 ( 2000) ( finding a 25% reduction by 1998). 14. EPA, PUB. NO. EPA 430/ R 95 010, HUMAN HEALTH BENEFITS FROM SULFATE REDUCTIONS UNDER TITLE IV OF THE 1990 CLEAN AIR ACT AMENDMENTS 6 4 ( 1995) ( calculating annual benefits for sulfate aerosol reductions at $ 10 billion in Phase I, rising to $ 40 billion by 2010, with 88% of benefits from reduced premature mortality). The EPA also estimates the benefits of additional NOX reductions at $ 1262 to $ 4786 per ton in 1999. EPA, PUB. NO. EPA 452/ R 98 003B, 2 REGULATORY IMPACT ANALYSIS FOR THE NO X SIP CALL, FIP, AND SECTION 126 PETITIONS ES 6 ( 1998) [ hereinafter EPA 1998 RIA]; see generally ENVTL. LAW INST., CLEANER POWER: THE BENEFITS AND COSTS OF MOVING AWAY FROM COAL TO NATURAL GAS POWER GENERATION ( Nov. 2000) ( calculating NOX, SO2 and CO2 benefits from reduced coal generation) [ hereinafter ELI CLEANER POWER]; CLEAN AIR TASK FORCE, DEATH, DISEASE & DIRTY POWER: MORTALITY AND HEALTH DAMAGE DUE TO AIR POLLUTION FROM POWER PLANTS 4 5 ( 2000) [ hereinafter CLEAN AIR TASK FORCE] ( calculating annual benefits of bringing power plants into compliance with modern pollution standards for SO2 and NOX at over $ 100 billion). 15. National legislation affecting SO2 dates back to the Clean Air Act of 1963, which restricted interstate air pollution. Clean Air Act of 1963, Pub. L. No. 88 206, 77 Stat. 392 ( 1963). This law failed to have great effect, as its cumbersome procedures required intergovernmental conferences to address specific instances of interstate pollution, as well as multiple requests for remedial action. Several cases did, however, result in reductions of SO2 and particulate deposition. See SENATE COMM. ON PUBLIC WORKS, 93D CONG., 2D SESS., A LEGISLATIVE HISTORY OF THE CLEAN AIR ACT AMENDMENTS OF 1970, at 1346 ( COMM. PRINT 1974). The Air Quality Act of 1967 later initiated a system for air quality planning based on ambient air quality standards to supplement these abatement procedures, a precursor to the 1970 legislation. See Air Quality Act of 1967, Pub. L. No. 90 148, 81 Stat. 485 ( 1967); Vickie L. Patton, The New Air Quality Standards, Regional Haze, and Interstate Air Pollution Transport, 28 ENVTL. L. REP. 10,155 ( 1998). 16. Clean Air Act, 40 C. F. R. 50.2( b) ( 2000). 2001] HOW ENVIRONMENTAL LAWS WORK 317 ( SIPs) to achieve these standards. 17 The primary standard for SO2 was set at 0.030 parts per million ( ppm), to be achieved on a calendar year basis, and the secondary standard was 0.5 ppm, set on a three hour basis. 18 An unintended consequence of these new ambient standards was the dispersion of SO2 through tall stacks. The EPA permitted over a dozen states to adopt SIPs allowing sources to meet the new standard by building tall stacks to disperse the SO2 instead of reducing emissions. 19 This practice injected SO2 into the higher atmosphere where it remained longer, facilitating the chemical reactions that produce sulfuric acid and aggravating acid precipitation. In the 1977 CAA Amendments Congress subsequently prohibited the use of tall stacks to achieve ambient standards. 20 It is important to note that these ambient standards still exist and protect against plants emitting SO2 at levels that would exceed local health based limits. In contrast to the lenient standards and relative lack of regulation of existing plants, the CAA established stringent standards for new sources or major modifications of existing sources, based on " new source performance standards" ( NSPS). 21 The first NSPS established in 1971 limited emission rates to 1.2 pounds of SO2 per million BTU of fuel burned ( lb/ mmBtu) for coal fired plants. 22 To meet this standard, new sources either had to use scrubbers to reduce emissions or use so called " compliance coal" with a sulfur content equivalent to the NSPS rate. The effect on the industry was dramatic because emission rates from existing sources were far higher. Because of the disparity between standards for existing and new plants, electric utilities began to focus their research and operational efforts on extending the operating life of the older, " grandfathered" facilities. 23 In the Clean Air Act Amendments of 1977, Congress created the New Source Review process and a stricter new source performance 17. 42 U. S. C. § 7410 ( 1994). 18. Clean Air Act, 40 C. F. R. § § 50.4, 50.5 ( 2000). See National Ambient Air Quality Standards for Sulfur Oxides ( Sulfur Dioxide)   Final Decision, 66 Fed. Reg. 1665 01 ( May 22, 1996). 19. See Patton, supra note 15, at 10,162; Richard L. Revesz, Federalism and Interstate Environmental Externalities, 144 U. PA. L. REV. 2341, 2351 52 ( 1996); see generally REGENS & RYCROFT, supra note 3 ( discussing history of efforts to control acid rain). 20. The 1977 Amendments added section 123 to the Act, which states that the " control of any air pollutant under an applicable implementation plan under this title shall not be affected in any manner by   ( 1) so much of the stack height of any source as exceeds good engineering practice . . . or ( 2) any other dispersion technique." 42 U. S. C. § 7423 ( 1994). 21. Id. § 7411. 22. Clean Air Act, 40 C. F. R. § 60.43 ( 2000) ( applying the standard to plants built between 1971 and 1978). 23. See infra Part III. D. 3. a. 318 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 standard that retained the former 1.2 lb/ mmBtu standard but also required new sources to reduce potential stack SO2 emissions by 70% or 90%, depending on the coal quality. 24 This standard required utilities to install scrubbers at all new generating units, removing much of the incentive to use low sulfur coal and favoring powerful eastern highsulfur coal interests. 25 By thus increasing the cost of new coal fired plants, the scrubbing requirement added incentives to extend the life of the older, dirtier plants. Both the ambient and new source SO2 standards were based principally on human health concerns, and proved inadequate to address the broader regional effects of acid deposition on ecosystems. By the late 1970s, Canada, several states, and national and state environmental organizations were raising serious concerns about acid precipitation. In 1980, Congress created the National Acid Precipitation Assessment Program to address disagreements over the cause of acid precipitation. 26 Throughout the 1980s, legislators introduced bills in Congress to reduce acid precipitation. 27 These typically focused on requiring the older, dirtier coal plants to meet the 1.2 lb/ mmBtu standard used for new sources since 1970, or to require scrubbing, with annual costs estimated at $ 4 to $ 7 billion. 28 Eastern coal interests and electric utilities blocked 24. 42 U. S. C. § 7411; Clean Air Act, 40 C. F. R. § 60.43a ( 2000). 25. In Sierra Club v. Costle, the court held that a utility could not use low sulfur coal to create equivalent reductions. 657 F. 2d 298, 320 21 ( D. C. Cir. 1981). It interpreted the rate based standard and held that "[ i] n no instance, however, can a plant reduce emissions less than 70% of potential uncontrolled emissions . . . . There is no dispute that the 70% floor in the standard necessarily means that, given the present state of pollution control technology, utilities will have to employ some form of flue gas desulfurization (` FGD' or ` scrubbing') technology." Id. at 316 & n. 38. Later, in Wisconsin Electric Power v. Reilly, the court held that use of low sulfur coal was also not permissible to avoid the threshold for imposition of strict New Source Performance Standards. 893 F. 2d 901, 919 ( 7th Cir. 1990). 26. 42 U. S. C. § § 8901 8912 ( 1994). 27. See generally COHEN, supra note 4 ( discussing congressional debates). 28. For instance, the Mitchell Compromise negotiated between Senator Mitchell, then Chairman of the Environment Subcommittee of the Senate Environment and Public Works Committee, and Majority Leader Senator Byrd, would have initially required scrubbing at 33 MW of " cost effective" plants, and required all utility coal fired plants not already meeting a 1.2 lb/ mmBtu emissions rate standard to meet a 1.0 lb/ mmBtu standard beginning in 2003. The annualized costs of fully implementing this were estimated at $ 4.4 to $ 6.1 billion. The Waxman Sikorski bill of the 98th Congress, co sponsored by over 80 House members, would have mandated scrubbing on the 50 largest utility plants with an estimated cost of as much as $ 7 billion annually. Paul R. Portney, Policy Watch: Economics and the Clean Air Act, 4 J. ECON. PERSP. 173, 175 ( 1990); see also H. R. 3400, 98th Cong. ( 2d Sess. 1984). See generally Dallas Burtraw, Appraisal of the SO2 Cap and Trade Market, in EMISSIONS TRADING 133 ( Richard F. Kosobud et al. eds., 2000) ( discussing costs and benefits of alternative regulatory methods). 2001] HOW ENVIRONMENTAL LAWS WORK 319 these efforts, arguing that they were too costly and would cause dramatic increases in electricity rates in many states. 29 In mid 1989, the Bush Administration broke the deadlock on acid precipitation with a proposal to cap emissions at a level 10 million tons below 1980 levels and to allow emissions trading under the cap. 30 This proposal, which became Title IV, was designed to achieve significant emissions reductions at substantially lower cost than earlier proposals.

B. Title IV Title IV was passed in 1990 to substantially reduce the SO2 emissions of electric utilities, which were then responsible for 70% of national emissions. 31 Title IV is unlike traditional regulations that impose source specific rate limits, and instead implements an industrywide mass standard   a permanent cap on utility SO2 emissions at 8.95 million tons per year, or roughly half their 1980 baseline emissions. 32 Phase I of the program began in 1995, and required the 263 dirtiest coalfired electricity generating units ( referred to as " Table A" units) to reduce their SO2 emissions to a base level of 5.7 million tons per year. 33 Phase II commenced in 2000, and requires all generating units larger than 25 megawatts to reduce their emissions to reach the final cap amount of 8.95 million tons. 34 29. Paul L. Joskow & Richard Schmalensee, The Political Economy of Market Based Environmental Policy: The U. S. Acid Rain Program, 41 J. L. & ECON. 37, 47 ( Apr. 1998); Arnold W. Reitze, Jr., The Legislative History of U. S. Air Pollution Control, 36 HOUS. L. REV. 679, 715 ( 1999). 30. The Bush Administration bill as originally presented on June 15, 1989, would have created a two pronged regulatory approach: power generation units that emitted over 1.2 lb/ mmBtu of SO2 in the baseline year ( 1985) would be subject to an emissions cap of 5.1 million tons, combined with an allowance trading system; those emitting less than 1.2 lb/ mmBtu would be required to maintain that emissions rate. The latter group, known as " the class of ' 85," came to perceive inclusion in the allowance system as preferable, and the debate began to center on how many allowances to provide to these " clean" utilities and to various sub groups within this group. The overall choice of a 10 million ton reduction was slightly in excess of the estimated reductions required by other bills recently proposed in Congress, and was based in part on a perceived " knee" in the cost of compliance curve at the 10 million ton reduction level. See, e. g., Nancy Kete, The Politics of Markets: The Acid Rain Control Policy in the 1990 Clean Air Act Amendments 182 3, 251 2 ( 1993) ( unpublished Ph. D. dissertation, Johns Hopkins University) ( on file with author) ( outlining costs of four bills as presented to the Bush Administration). 31. EPA EMISSIONS TRENDS, supra note 8, § 2.2, at 3 4. 32. 42 U. S. C. § 7651c ( 1994); see also Torrens et al., supra note 6, at 213. 33. 42 U. S. C. § 7651c. The level of the Phase I cap was reached by multiplying an emissions rate of 2.5 lb/ mmBtu SO2 ( about double the Phase II standard) times utilization in the baseline years. Id.; see also ELLERMAN ET AL., supra note 10, at 39 41 ( detailing precise Phase I allocation rules). 34. The level of the Phase II cap is reached by multiplying an emissions rate of 1.2 lb/ mmBtu SO2 times baseline utilization. The 1.2 lb/ mmBtu emission rate has historical 320 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 To implement the cap, the law assigned allowances, each equivalent to one ton of SO2 emissions, to each affected generating unit based on its historic base period ( 1985 1987) generation rates, but scaled down so that the aggregate emissions equaled the target emissions cap. 35 Title IV therefore effectively implements a new source standard of zero because any new generating source must purchase all its needed allowances from other sources, and total emissions do not grow. 36 In addition to these baseline allowance allocations, Title IV provided almost 4 million bonus allowances over the first years of the program, primarily to encourage the use of scrubbers; 37 together with a small number for renewable energy and small diesel refineries producing desulfurized fuel. 38 Both the annual allowances and the bonus allowances were allocated without charge to existing sources. Finally, to help establish a market and to counter fears of allowance hoarding, the law requires the EPA to hold back and auction roughly 3% of the allowances allocated to units each year, and to make available a limited amount of allowances at $ 1500 through a Direct Sales Reserve. 39 In another departure from traditional regulation, Title IV allows individual sources to trade their unused allowances to other sources, or bank them for future use. 40 The design of Title IV therefore creates several compliance options for a generating source:

significance, as it is the rate standard which has been required for new coal fired power plants since 1970. 35. Congress was trying to achieve a reduction of 10 million tons from 1980 emissions, but the individual source information for 1980 was poor, so Title IV established the baseline period based on emissions from 1985 through 1987, proportionately reduced to equal estimated 1980 emissions. 42 U. S. C. § 7651a( 4) ( 1994). 36. See 42 U. S. C. § 7651b( e) ( 1994). 37. By far the largest quantity of bonus allowances was the 3.5 million extension allowances, allocated primarily ( 2.1 million) to units that installed scrubbers. The origin of these 3.5 million bonus allowances was a shift forward of one year in the effective date of the Act, in moving from the Senate bill to the Administration bill. During Phase I, this achieved an added 3.5 million ton reduction, redistributed as bonus allowances to firms choosing to install scrubbers, which was in the interest of states with high sulfur coal deposits. 42 U. S. C. § 7651c( d) ( 1994); Torrens et al., supra note 6, at 215. A similar advance of one year for Phase II led to the allocation of an additional 530,000 allowances for the years 2000 through 2009. Id. at 213 n. 1. 38. Although 300,000 bonus allowances were authorized to reward efforts to develop alternative energy sources, only 30,377 were allocated during Phase I. 42 U. S. C. § 7651c( g) ( 1994). In addition, up to 35,000 allowances a year were authorized for small diesel refineries producing low sulfur fuel, of which 147,820 were allocated in Phase I. Id. § 7651i( h). Allocation data from EPA COMPLIANCE REPORTS. 39. 42 U. S. C. § 7651o( b)( d). The auction and Direct Sales Reserve provisions were added to Title IV to counter " fears that market imperfections, such as irrational hoarding of allowances by utilities or anti market behavior by state public utility regulators, might make it impossible for new entrants to acquire allowances necessary to construct and operate new generating capacity." ELLERMAN ET AL., supra note 10, at 169 & n. 5. 40. See id. § 7651b( b). 2001] HOW ENVIRONMENTAL LAWS WORK 321

emit at the unit's annual baseline tonnage limit;

emit below the limit and generate unused allowances that can be banked for later use, used by other units within the company, or sold or traded to other firms; or

emit above the limit and obtain allowances to cover the additional emissions. 41 In order to guard against the transfer of generation from Phase I units to noncovered Phase II units, Title IV required firms to maintain their average heat input from their baseline period, or suffer the loss of allowances. 42 However, another flexibility mechanism allowed them to designate non Table A units that would otherwise not be covered until Phase II as " substitution units" during Phase I. 43 Once a firm elected to do so, the EPA determined a baseline for the units and provided them with allowances just like Table A units, allowing firms to use the emissions reductions ( or exceedances) from these plants as part of their overall compliance strategy. 44 Finally, Title IV incorporates an extremely strict monitoring and compliance system. Continuous Emissions Monitoring Devices ( CEMS) must record data every fifteen minutes and regularly report consolidated data to the EPA, including data that indicates that the monitor is functioning properly. 45 The CEMS cost almost $ 1 million per stack. 46 At year end, following a two month period for " true up," each company must show that it has sufficient allowances to cover all emissions for that year. 47 If not, firms automatically receive a $ 2000 fine per ton of exceedances, and must restore each excess ton plus a penalty ton that is 41. Such allowances can come from the allowance market or from other units owned by the company, whether generated contemporaneously or banked in previous years. Id. 42. See id. § § 7651c, 7651g( c)( 1); Clean Air Act, 40 C. F. R. § 72.43 ( 2000). 43. Id. § 7651c( b). 44. Id. § 7651c( b), ( c). 45. Clean Air Act, 40 C. F. R. § 75.1 ( 2000). This is more stringent than the new source provisions, which require only two data points per hour. Clean Air Act, 40 C. F. R. § 60.47a( g) ( 2000). It has been noted that predictive emissions monitors are far cheaper and may be as accurate as CEMS, since sulfur emissions can be accurately predicted from fuel sulfur content and boiler characteristics, but these are rarely allowed. C. Foster Knight, How Regulations Impact Innovative Environmental Technologies: A Recent Case Study, TOTAL QUALITY ENVTL. MGMT. 119 ( Spring 1995) ( discussing predictive emissions monitoring systems). 46. ELLERMAN ET AL., supra note 10, at 248 50. 47. At the end of the year, utilities are granted a sixty day " true up," or grace period, during which SO2 allowances may be purchased, if necessary, to cover each unit's emissions for the year. At the end of the grace period, the allowances that a unit holds in its compliance account must equal or exceed the annual SO2 emissions recorded by the unit's monitoring system. Any remaining allowances may be sold or banked for use in future years. Clean Air Act, 40 C. F. R. § 77.3 ( 2000). 322 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 deducted from the firm's allotment for the following year. 48 This system has resulted in 100% compliance over the five years of the Phase I program. 49 This cap and trade system is both more rigid and more flexible than traditional regulation. The emissions cap is more rigid because it creates zero growth of emissions, which benefits the environment. The monitoring rules and compliance system are also extremely strict, with severe and automatic penalties. However, the system provides great flexibility to firms in choosing compliance options. Due to the true performance standard established by the emissions cap, together with trading, a utility is free to choose among competing compliance approaches, including scrubbing, switching to lower sulfur coal, blending coals with different sulfur contents, and shifting load to units that emit less sulfur. In addition, government regulators are not involved in decisions about technology choice, as they are in application of technology based standards like BACT, RACT, and LAER. 50 The government role is that of strict compliance monitoring, not supervising the choice of technology, which greatly lowers transaction costs and allows firms to rapidly change their compliance approaches.

C. Industry Response The electric industry's response to Title IV can be characterized in three overlapping stages. In the earliest years of the program, firms significantly over invested in compliance, including constructing scrubbers for twenty seven Phase I units. 51 These actions were driven by predictions of relatively high allowance prices in the $ 300 to $ 1000 range, and uncertainty as to whether additional allowances would be available on the market. 52 In the second stage, firms began to recognize and react to the lower cost of compliance represented by lower allowance prices in the $ 150 range, which first became evident in the 48. 42 U. S. C. § 7651( j) ( 1994); Clean Air Act, 40 C. F. R. § 77.6 ( 2000). 49. EPA 1999 COMPLIANCE REPORT, supra note 1, at 2. 50. 42 U. S. C. § § 7479( 3), 7501( 3), 7502( c)( 1) ( 1994). 51. See infra note 91. 52. When the cap and trade system was first proposed in 1990, the EPA's marginal cost estimates for Phase I were between $ 290 and $ 410 per ton, and $ 580 to $ 815 for Phase II in constant 1995 dollars. ICF RESOURCES, INC., COMPARISON OF THE ECONOMIC IMPACTS OF THE ACID RAIN PROVISIONS OF THE SENATE BILL ( S. 1630) AND THE HOUSE BILL ( H. 1630) ( July 1990) [ hereinafter ICF RESOURCES]. The National Acid Precipitation Assessment Program ( NAPAP) estimated that only modest SO2 reductions could be made at under $ 200 per ton, and that the marginal cost of a 10 million ton reduction by 2000 would be $ 700 to $ 900 per ton. NAPAP INTEGRATED ASSESSMENT, supra note 3, at 411. 2001] HOW ENVIRONMENTAL LAWS WORK 323 period from 1992 to 1993.53 These price signals led some firms to cancel scrubber contracts, and led to a growing use of low sulfur coal to reach compliance. 54 In this stage, and continuing throughout Phase I, the trading provisions were used by many firms to bank allowances for future use and for intra firm averaging among different units, with only a handful of firms using inter firm trading as a compliance strategy. 55 A third stage became evident toward the end of Phase I, in which many firms increased their participation in the allowance market, trading directly with other firms and increasing trading for arbitrage or profitmaking purposes. 56 However, this third stage did not represent any change in compliance strategies. Virtually all firms continued essentially autarkic or self reliant compliance strategies throughout Phase I, emitting well below their limits and banking allowances for future use. 57 The following sections describe firms' observed compliance behavior, and assess how the legal provisions or other aspects of Title IV have acted to influence this behavior.

1. Price Signals, Coupled with the Flexibility of Title IV, Drove Major Shifts in Businesses' Compliance Strategy One of the most interesting aspects of the early years of Title IV was firms' relatively rapid response to price signals generated by the allowance market that reflected the underlying cost of compliance. Initial industry expectations in 1991 were for prices between $ 300 and $ 1000 per allowance. 58 In 1992 and 1993, the earliest signals began to reveal that prices would be substantially lower. The first trades took place in 1992 at $ 265 and $ 300,59 and the EPA's first auction of 53. ELLERMAN ET AL., supra note 10, at 231 35 ( discussing estimates of Phase I costs prior to implementation). 54. U. S. GENERAL ACCOUNTING OFFICE, PUB. NO. GAO/ RCED 95 30, AIR POLLUTION: ALLOWANCE TRADING OFFERS AN OPPORTUNITY TO REDUCE EMISSIONS AT LESS COST 29 ( 1994) [ hereinafter GAO 1994 TRADING]; Burtraw, supra note 28, at 133 67. 55. See Figure 2 3. See generally A. Denny Ellerman, From Autarkic to Market Based Compliance: Learning from Our Mistakes, in EMISSIONS TRADING ( Richard F. Kosobud et al., eds. 2000) ( discussing utility emphasis on self reliance and Phase I over compliance). 56. See id. at 12. 57. See Figures 2 3 A, B. 58. An industry poll showed widespread expectations of allowance prices on the order of $ 300 to $ 725 for Phase I and $ 500 to $ 1000 for Phase II in June July 1991, falling to $ 200 to $ 550 for Phase I and $ 300 to $ 700 for Phase II by October/ November 1991. Torrens et al., supra note 6, at 220. Similarly, the EPA and other economic studies predicted that allowances would cost $ 290 to $ 410 during Phase I, and $ 580 to $ 815 in Phase II. See ICF RESOURCES, supra note 52. See generally Burtraw, supra note 28, at 152 ( setting forth long run cost estimates). 59. The first trade was of 10,000 allowances at $ 265 per allowance from Wisconsin Power & Light Company to the Tennessee Valley Authority. Frank Edward Allen, Tennessee 324 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 allowances in March of 1993 revealed prices at $ 131.60 As shown below, private transactions continued for almost a year to be somewhat above the price set by the 1993 auction, but by mid 1994 they fell to the $ 150 level set by the EPA auction in March of 1994, and continued in the $ 100 range through Phase I, until they began to climb towards $ 200 as Phase II approached. 61 See Figure 2 1: SO2 Allowance Prices62 Since allowance prices are closely tied to the cost of compliance, the low allowance prices reflect a very positive development: a low cost of compliance. 63 The major drivers of the lower costs in Phase I were innovation and investment relating to low sulfur coal, as well as increased scrubbing efficiency. 64 These responses were prompted in large part by the design of Title IV, although unrelated market forces, such as increased rail competition, also contributed. 65 The ability of firms to shift compliance strategies in response to the changing costs of different compliance options is directly related to the cap and trade standard. Title IV allowed firms to respond to the unexpectedly low price of low sulfur coals; several firms cancelled scrubber contracts and many switched to low sulfur coal. Altogether, scrubbers were built for only twenty seven Phase I units, significantly fewer than were anticipated at the time the 1990 CAA Amendments were adopted. 66 Title IV is therefore unlike the previous rate based NSPS standards that limited compliance technologies to scrubbing or the use of Valley Authority Is Buying Pollution Rights From Wisconsin Power, WALL ST. J., May 11, 1992, at A12. The second was a trade of 25,000 allowances from ALCOA to Ohio Edison for $ 300 per allowance. Joan E. Rigdon, Alcoa Unit Arranges $ 7.5 Million Sale of Pollution Allowances to Ohio Edison, WALL ST. J., July 1, 1992, at A6. 60. See Ellerman, supra note 55, fig. 1, at 6. 61. EPA 1999 COMPLIANCE REPORT, supra note 1, at 10. 62. EPA, PUB. NO. EPA 430/ R 00 0007, ACID RAIN PROGRAM: 1999 COMPLIANCE REPORT ( 2000). 63. Researchers, however, have pointed out that allowance prices may be lower than expected because they may reflect the marginal cost of compliance, and be less than the average cost due to the " lumpy" nature of certain investments in compliance technologies, such as scrubbers. See ELLERMAN ET AL., supra note 10, at 297 302; Dallas Burtraw & Byron Swift, A New Standard of Performance: An Analysis of the Clean Air Act's Acid Rain Program, 26 ENVTL. L. REP. 10,411 ( 1996). 64. See infra Part II. C. 5. a d. 65. Richard Schmalensee et al., An Interim Evaluation of Sulfur Dioxide Emissions Trading, 12 J. ECON. PERSP. 53, 57 ( 1998). 66. GAO 1994 TRADING, supra note 54, at 29; Burtraw, supra note 28, at 133 67; see also infra Part II. C. 5. 2001] HOW ENVIRONMENTAL LAWS WORK 325 " compliance coal." 67 It also differs markedly from traditional regulation by not requiring regulatory approval of changes in compliance choices, thus avoiding delay and transaction costs.

2. Over Compliance and Banking Title IV required firms to reduce emissions at Phase I units to a base level of approximately 6.7 million tons per year ( including both Table A and substitution units), 68 but the addition of bonus allowances distributed primarily in the first years of the program meant that the annual cap was between 8.7 and 7 million tons during Phase I, as shown in Figure 2 2.

See Figure 2 2: Phase I Sulfur Dioxide Emissions and Allowance Cap ( 1990 1999) 69 Utilities responded to the Title IV program by over complying and reducing SO2 emissions to 5.2 million tons, or approximately 30% below the cap. 70 This over compliance in part reflects a conservative business tendency to leave a margin of safety when complying with environmental regulations. However, two aspects of Title IV provided firms additional impetus to over comply. The first was the significant allocation of almost 4 million bonus allowances in Phase I, mostly for construction of scrubbers as a concession to coal mining interests. 71 Second, the ability to bank allowances under Title IV added value to early reductions because allowances would become more valuable in Phase II when allocations to Table A units would be reduced and all other 67. The design of Title IV prompted both innovation and investment in low sulfur coal, as firms actively began to experiment with fuel blending as a compliance strategy. See infra Parts II. C. 4, II. C. 6. a; see also ELLERMAN ET AL., supra note 10, at 244. Previous industry experience in reducing SO2 was under the New Source Performance Standards ( NSPS), which were rate standards and strongly limited compliance options. See supra text accompanying notes 21 25. 68. EPA 1999 COMPLIANCE REPORT, supra note 1, at 7, exh. 3. Approximately 5.7 million were allocated to Table A units, and 1 million per year to substitution units. 69. EPA, PUB. NO. EPA 430/ R 00 0007, ACID RAIN PROGRAM: 1999 COMPLIANCE REPORT ( 2000), at 7, 9. The 1990 emissions level of 9,720,466 tons is the average of the 1995 1999 units' emissions in 1990, and was derived from data in EPA, ACID RAIN PROGRAM: 1999 EMISSIONS SCORECARD ( 2000). 70. Id. at 7, 9. If the 4 million tons of bonus allowances are not counted, the overcompliance falls to 22% below the cap amount. See ENVIRONMENTAL DEFENSE, FROM OBSTACLE TO OPPORTUNITY: HOW ACID RAIN EMISSIONS TRADING IS DELIVERING CLEANER AIR 22 ( 2000). 71. See supra note 37. Interviews with government regulators and utility representatives indicate that the bonus allowances motivated the construction of an additional five to six scrubbers, generating additional reductions. 326 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 units would enter the program. 72 Together these factors created significant motivation towards over compliance in Phase I. 73 The net result in Phase I was that 38.1 million allowances were issued over all five years and net emissions were only 26.5 million tons. This created a bank of 11.6 million allowances saved for use in Phase II that is not expected to be depleted until 2010.74 Overall, a principal effect of banking may simply be to smooth the transition between Phases I and II, as it promotes a more gradual decline in emissions. The banking behavior also has minor positive environmental significance because it achieved early reductions during Phase I, although the saved tons may be expected to be emitted in later years. 75 Banking may be considered a form of trading, as it shifts the use of allowances from one year to another. If so, the extensive banking behavior becomes the principal use of Title IV's trading mechanisms. Overall, 14,031,943 tons of emission reductions were created by units that emitted below their allowance allocations. Of this amount, 10,518,211, or fully 75%, were banked for later use, and only 3,541,045 were " traded" in the more traditional sense to offset emissions of other units during Phase I. 76 72. 42 U. S. C. § 7651d ( 1994). 73. Analysis by Resources for the Future shows that banking helped to drive overinvestment in scrubbers. Dallas Burtraw & Erin Mansur, The Effects of Trading and Banking in the SO2 Allowance Market, DISCUSSION PAPER NO. 99 25, at 19, at http:// www. rff. org/ environment/ air. htm ( Mar. 1999). In theory, allowing for banking should decrease costs. However, we find that the opportunity for banking actually led compliance costs to be higher by $ 651 million in 1995 and $ 339 million in 2005 in our model. Banking encouraged the construction of scrubbers that appear ex post to be cost inefficient. Given changes in fuel markets subsequent to the planning and construction of these facilities, we calculate that none of the 21 scrubbers that were built in Phase I would have been built if there had not been banking. Id. 74. The 11.6 million ton bank includes the net 10.5 million allowances created by overcompliance at utility units during Phase I, plus other allowance pools not directly allocated to those units, i. e., the 750,000 auctioned allowances, 339,705 allowances to industrial opt in sources and the 147,820 allowances issued to small diesel refineries. These figures are derived from ELI analysis of EPA COMPLIANCE REPORTS, 1995 1999. 75. Since acid deposition creates cumulative impacts, early reductions are beneficial as they may prevent threshold effects for acid deposition that harm ecosystems. One analysis shows banking may also slightly improve health effects over time, primarily by displacing emissions out of highly populated areas in the northeast, but that this effect may be countered by future population growth. Burtraw & Mansur, supra note 73, at 15. 76. See Figure 2 5. Figures derived through ELI analysis of EPA COMPLIANCE REPORTS. 2001] HOW ENVIRONMENTAL LAWS WORK 327 3. Autarkic Compliance Compliance responses in Phase I revealed a strong tendency for firms to adopt an autarkic or " comply on your own" strategy. Most of the fifty one affected firms made extensive use of the flexibility mechanisms to achieve emission reductions within their own firm, but as shown in Figures 2 3, A and B, only three firms ( Illinois Power, Tampa Electric, and Duquesne Power) used inter firm trading as a compliance option over the full period of Phase I. All other firms achieved compliance through actions taken within the firms themselves.

See Figure 2 3A: SO2 Allowances and Emissions of Top 10 Phase I Utilities by Total Allowances Allocated ( 1995 1999) and Figure 2 3B: SO2 Allowances and Emissions, Phase I Utilities ( except 10 largest) ( 1995 1999) 77 This finding of minimal inter firm allowance trading is significant because most economic analyses reveal substantial differences in compliance costs among the Phase I units. Those differences should have driven greater use of the inter firm trading option. 78 The discussion in Part II( C)( 9) provides some reasons why firms did not use inter firm trading to the full extent that it may have been economically justified. Another aspect of autarkic compliance is the unequal burden placed on smaller firms with few units. When firms primarily use the trading provisions for intra firm averaging, large firms are able to lower their cost of compliance due to the variability among their own multiple units and may be little affected by the lack of inter firm trading. On the other hand, absent the ability to trade with other firms, a firm with only one or two units would be limited to compliance options that could achieve the needed reductions at those particular units. Indeed, a few of these smaller firms chose to install scrubbers, a relatively expensive compliance option for a small plant. 79 77. Figures derived from analysis of EPA COMPLIANCE REPORTS, 1995 1999. See also figure 2 5. Data shows the sum of all emissions and allowance allocations to Phase I affected units for each firm in the years 1995 1999. 78. GAO 1994 TRADING, supra note 54, at 72 73; Ellerman, supra note 55, at 190 91; Douglas R. Bohi & Dallas Burtraw, SO2 Allowance Trading: How Do Expectations and Experience Measure Up?, 10: 7 ELEC. J. 67 ( 1997) ( noting that many utilities have failed to take advantage of allowance trading as a method of reducing compliance costs). 79. These firms included small municipal utilities for the City of Owensboro, and Atlantic City. See Figure 2 5. See generally Todd J. Zywicki, Environmental Externalities and Political Externalities: The Economy of Environmental Regulation and Reform, 75 TULANE L. REV. 845, 864 ( 1999) ( finding that the fixed cost of scrubber installation falls harder on small businesses). 328 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 4. Strategies for Compliance As noted above, Title IV provides firms with a very wide scope of compliance options that include: 1. scrubbing; 2. fuel switching to lower sulfur coals; 3. shifting to natural gas or renewable energy; 4. optimization, or increasing the efficiency of the unit; 5. load shifting to lower emitting units; 6. use of substitution provisions; 7. allowance trading; 8. allowance banking; 9. demand side management; 80 and 10. retirement. 81 The emissions cap ( as opposed to the trading provisions) is the primary aspect of Title IV that allows firms the flexibility to choose among the first four compliance options. Traditional emissions rate standards would be more restrictive because they tend to reward technologies that reduce end of pipe emission rates, which may not allow firms to achieve pollutant reductions through cleaner processes, increased efficiency, or reduced demand. 82 The greater flexibility afforded by the emissions cap approach is supplemented by the trading and substitution mechanisms in Title IV that allow firms added flexibility in the locus of emissions reductions. The trading provisions allow intra firm averaging, trading with other firms, and banking allowances, and the substitution provisions allow for greater inclusiveness of units. The table below shows that firms achieved the major share of SO2 reductions by two methods. Scrubbing, an end of pipe control 80. Demand side measures are those taken to improve the efficiency of consumer power use, or to reduce consumption. Clean Air Act, 40 C. F. R. § 72.2 ( 2000). Note that while demandside management is a compliance mechanism under a cap and trade approach, the phased nature of Title IV required firms in Phase I to not reduce their overall utilization. Therefore, special rules were needed in Phase I to encourage demand side management. See, e. g., id. § § 72.43, 73.80. 81. Again, as with demand side management, the retirement of inefficient or obsolete units is a compliance mechanism generally under a cap and trade approach, but the phased nature of Title IV required firms in Phase I to not reduce utilization. 42 U. S. C. § 7651g( c)( 1) ( 1994). 82. Rate standards limit or restrict compliance technologies. In the SO2 context, the New Source Performance Standard adopted in 1977 only allowed scrubbing, and the 1971 NSPS standard limited compliance choice to scrubbing or a particular quality of coal. In the NOX context, standards such as BACT are interpreted by some states to only recognize reductions made through end of pipe control equipment, not through process change. See infra Part IV. E. 1. Rate standards thus often do not recognize or reward reductions made upstream, such as those made through the use of cleaner processes or fuels. 2001] HOW ENVIRONMENTAL LAWS WORK 329 technology that reduces SO2 to a solid waste, 83 contributed 35% of the total emission reductions made during Phase I ( not counting bonus allowances). Fuel switching by firms that blended or switched to lowsulfur or medium sulfur coal contributed 59% of reductions. Retiring units contributed another 6% of reductions although their output was generally made up at other units.

Figure 2 4. Source of Reduction for Plants that Reduced Emissions Below Allocations ( Total Reductions Made in Phase I, 1995 1999) 84 units Reductions with Bonus % Reductions w/ o Bonus %

scrubbing total 26 5,856,376 42 3,665,433 32 switching total 126 5,526,657 39 5,178,540 45 Table A Units retired/ not util. 7 283,905 2 283,905 2 scrubbed 16 292,469 2 292,469 3 unscrubbed 113 1,712,075 12 1,712,075 15 Substitution Units retired/ not util. 44 360,461 3 360,461 3 Total 14,031,943 100 11,492,883 100 Figure 2 5 reveals individual firms' compliance strategies. The first column shows firms' net allowance savings or withdrawals during Phase I. The second column shows the allowance savings made by unscrubbed Table A firms that emitted below their allowance allocation. The third shows the allowance withdrawals used by units that emitted above their allocations. Subsequent columns show the reductions achieved through scrubbed, retired, or substitution units. Bonus allowances allocated to firms are shown for information purposes, but these allowances are also included in the other columns since they formed part of firms' compliance strategies.

See Figure 2 5. Compliance Methods of Fifty One Companies in Phase I ( 1995 1999) 85 Several compliance strategies are evident: ( a) Sixteen utilities scrubbed at one plant and used the excess allowances for all or a substantial part of their allowance needs at their other units. Firms such as American Electric Power, TVA, and Allegheny Power scrubbed a single large plant to create over a million excess allowances in each case.

83. See REGENS & RYCROFT, supra note 3, at 59 74. 84. Data derived from analysis of EPA COMPLIANCE REPORTS, 1995 1999. Note that only plants that reduced emissions below allocations are included. 85. Data derived from analysis of EPA COMPLIANCE REPORTS, 1995 1999. 330 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 ( b) Thirty four firms adopted a primary strategy of switching to lower sulfur coals at some units to create excess allowances for all or a substantial part of their needs at their other units. The large Southern Company achieved net reductions at all of its forty nine units primarily by switching to lower sulfur coal. ( c) Only one firm, Illinois Power, purchased allowances as its principal compliance strategy.

5. The Scrubbing Story: Fewer Scrubbers than Expected but Lower Costs Due to Economics, Innovation, and Regulatory Design Scrubbing, or flue gas desulfurization, 86 was the principal compliance strategy for sixteen utilities, and scrubbed plants achieved 35% of all emissions reductions. 87 Scrubbing was clearly the central compliance strategy of major firms such as American Electric Power, the TVA, and Allegheny Power. These firms' scrubbing strategies not only offset excess emissions at other units, but allowed each firm to build up a banked supply of over 1 million allowances for Phase II. 88 In addition to these larger firms, some small firms, such as municipally owned entities, chose scrubbing despite the relatively high per ton compliance costs to install scrubbers at smaller units. These firms did so because it was an available compliance option that allowed each firm to comply on its own. 89 Contrary to initial expectations, scrubbing turned out to be the more expensive of the two principal compliance methods, and the actual number of scrubbers built was substantially less than expected, as firms turned to low sulfur coals as a cheaper compliance option. A 1994 Government Accounting Office report found that scrubber vendors expected to complete thirty five or forty contracts in Phase I, though some vendors claim that they expected a need for as much as 100,000 86. Scrubbing essentially replicates the chemical reaction that gives rise to acid precipitation, but is contained within the scrubbing vessel. This technology sprays limestone or another calcium source into the fuel chamber, causing a chemical reaction with the flue gas that turns the SO2 gas into a solid. The resulting slugs are then disposed of in landfills or, if calcium sulfite is used, employed in the production of wallboard. Id. 87. Phase I scrubbers cost $ 249 per kilowatt to install, or $ 150 million for a 600 MW plant. See Figure 2 7. They also use about 1.5% of the electric power generated by the plant to run, consume significant lime or limestone, and generate solid wastes that over the lifetime of a 300 MW plant would fill 1000 acres, unless alternative uses of the wastes can be found, such as for gypsum or landfill. Interviews with scrubber manufacturers. 88. Each of these companies generated over a million allowances at a single scrubbed plant, Cumberland ( TVA), Harrison ( Allegheny Power), and Gavin ( AEP). See Figure 2 11. 89. Interviews with smaller firms show that most never seriously considered allowance purchases for compliance. 2001] HOW ENVIRONMENTAL LAWS WORK 331 MW of installed or retrofit scrubber capacity. 90 Ultimately, only twentyseven scrubbers were installed for Table A plants, with a capacity of 16,167 MW. 91 Most utilities that installed scrubbers did so in part due to the need for early implementation of compliance options. A retrofit scrubber requires from eighteen to thirty months of advance planning, so commitments to scrubbing vendors had to be made as early as 1992, when estimates of the cost of compliance and of allowances still ranged from $ 300 to $ 700.92 Had these early projections of compliance costs proven to be accurate, scrubbing, especially at larger plants, would have been a cost effective compliance strategy. 93 However, economic analysis shows that in retrospect, few or none of these scrubbers would now be considered to have been an economic investment. 94 The bonus allowance provisions in Title IV also contributed to the early over investment in scrubbers. As a concession to high sulfur coal mining interests, Congress allocated about 2.1 million of the 3.5 million extension allowances awarded during Phase I to utilities that committed to install scrubbers. 95 These bonus allowances provided subsidies regarded as worth $ 200 to $ 400 million based on the value of 90. GAO 1994 TRADING, supra note 54, at 29. An MIT Center for Energy and Environmental Policy Research ( MIT/ CEEPR) survey of respondents who represented about half of the retrofitted scrubbing capacity also identified 3600 MW where scrubbing was the initial option but not the last. A. D. ELLERMAN ET AL., EMISSIONS TRADING UNDER THE U. S. ACID RAIN PROGRAM: EVALUATION OF COMPLIANCE COSTS AND ALLOWANCE MARKET PERFORMANCE 50 ( M. I. T. Center for Energy and Envtl. Policy Research, 1997); cf. ICF RESOURCES, supra note 52 ( predicting lower need for scrubbed capacity). 91. The scrubbers for these twenty seven units were constructed in the early to mid 1990s in response to Title IV. In addition, a scrubber was installed at one Table A plant in 1985, which was therefore part of its baseline and not a compliance strategy. Another Table A unit, Big Bend Unit 1, installed a scrubber in December 1999, which was the last month of Phase I, and relevant only for Phase II compliance. In addition to the Table A units, substitution units had installed fifteen pre 1990 NSPS scrubbers, with a capacity of 6056 MW, making a grand total of 21,223 MW scrubbed capacity for units in Phase I for all five years. However, the reductions at substitution units made before 1990 do not count as Phase I reductions, but instead are part of their baseline emissions. See Clean Air Act, 40 C. F. R. § 72.41( c)( 3) ( 2000). 92. See Torrens et al., supra note 6, tbl. 1, at 220. In a survey conducted by the MIT/ CEEPR, 75% of respondents, representing about half of the retrofitted scrubbing capacity, " indicated that expectations of allowance prices of $ 300 to $ 400 were ` very important' in decisions to scrub." ELLERMAN ET AL., supra note 90, at 50. The long lead time to install a retrofit scrubber was needed so the equipment could be installed during planned outages in 1994 or 1995. 93. Economic estimations are that few scrubbers would have been built during Phase I had firms been able to accurately predict the lower costs of switching. See Burtraw, supra note 28. 94. Burtraw & Mansur, supra note 73. 95. These 3.5 million allowances represent the savings made by moving up the effective date of the legislation one year, from 1996 to 1995. 332 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 allowances, and were a significant factor that motivated several utilities to install Phase I scrubbers at an estimated five or six units. 96 See Figure 2 6. Scrubbers Installed by Year and Type97 One of the significant stories of Phase I was the declining cost of scrubbing over the course of Phase I. ICF Resources projected in 1990 that scrubber costs for Phase I units would amount to $ 455 per ton of SO2 removed. 98 Actual costs calculated by MIT were $ 282 per ton, caused not by a decline capital costs, but major reductions in operating costs, as shown in Figure 2 7. By 2000, scrubbing costs had declined yet again, this time due to a precipitous drop in capital costs to the $ 100/ kW level, less than half the $ 249/ kW cost in 1995.99 Figure 2 7. Phase I Scrubber Cost Components ( in 1994 dollars) 100 Predicted 1995 ( ICF Resources, 1990) Actual 1995 ( MIT, 2000) Initial Capital cost ($/ KW) $ 249 $ 249 Fixed O& M ($/ KW yr) $ 6.55 $ 2.00 Variable O& M ( per kWh) 1.81 mills 1.26 mills Removal efficiency 90% 95% Utilization 65% 82% Cost per ton SO2: $ 455 $ 282 Capital charge (@ 11.33%) $ 285 $ 206 96. See Interviews with state regulatory officials and utility companies. States such as Illinois also attempted to protect their high sulfur coal mining industries by providing subsidies for scrubber installation. Even these incentives were insufficient to tilt the balance in favor of scrubbing. One utility spent $ 35 million to begin construction of a scrubber, received approval for a subsidy from the state for the scrubber, but opted instead to achieve compliance by first purchasing allowances in Phase I, and subsequently by switching to low sulfur coal in Phase II, thus foregoing a substantial subsidy for the scrubber installation. See American Bar Association, New Strategies for New Market: The Electric Industry's Response to the Environmental Protection Agency's Sulfur Dioxide Emission Allowance Trading Program, 47 ADMIN. L. REV. 469, 480 81 ( 1995) ( describing Illinois Power's decision to cancel " its plan to install scrubbers" in favor of purchasing allowances to comply with Phase I). 97. U. S. ENERGY INFORMATION AGENCY, PUB. NO. EIA 0348( 99) 12. FLUE GAS DESULFURIZATION ( FGD) CAPACITY IN OPERATION AT U. S. ELECTRIC UTILITY PLANTS AS OF DECEMBER 1999, 2 ELEC. POWER ANNUAL, tbl. 30 ( October 2000). The type of scrubber was determined through interviews with plant managers and scrubber manufacturers, and also by reference to data compiled by MIT's Center for Energy and Environmental Policy Research. 98. See Figure 2 7. 99. See Interviews with scrubber manufacturers. 100. ICF RESOURCES, INC. COMPARISON OF THE ECONOMIC IMPACTS OF THE ACID RAIN PROVISIONS OF THE SENATE BILL ( S. 1630) AND THE HOUSE BILL ( H. 1630[ sic]) ( July 1990); A. D. ELLERMAN ET AL., MARKETS FOR CLEAN AIR: THE U. S. ACID RAIN PROGRAM, tbl. 9.3, 240 ( 2000). 2001] HOW ENVIRONMENTAL LAWS WORK 333 Fixed Overhead and Maintenance $ 66 $ 15 Variable Overhead and Maintenance $ 104 $ 65 These major cost reductions were due to several factors: technological innovation in scrubber design, economic factors that led firms to increase utilization at scrubbed plants in Phase I, and Title IV's flexible design that allowed more efficient scrubbers to be built. The innovation and rapid decline in scrubber costs during Phase I stand in marked contrast to the previous two decades, during which scrubbing vendors enjoyed a monopoly in SO2 compliance technology for new firms. During that time relatively little innovation in scrubber design had taken place. 101 a. Increased Scrubber Utilization One factor that led to decreased per ton costs of scrubbing was the unexpectedly high utilization rate of scrubbed units during Phase I, which spread the capital costs over a larger number of tons. The increased utilization can be explained by the relatively low variable costs of scrubbing, at about $ 65 per ton of SO2, once the significant capital investment is made. 102 Operating an existing scrubber was therefore profitable as long as the variable cost was lower than the price of allowances. This cost savings created an impetus for firms to shift power generation, or " load," away from Phase I unscrubbed units to scrubbed units. 103 b. Innovation in Scrubber Design Design improvements also lowered scrubbing costs. Interviews with scrubber manufacturers revealed that significant innovation in scrubbers has occurred since the first Phase I scrubbers were installed in 101. ELLERMAN ET AL., supra note 10, at 241 (" A recent study of the advances in scrubber technology in the United States through 1992 found ` no significant progress . . . in abatement technology' and attributes this result to the ` small incentives for innovation [ associated with] the form of regulation typically used in the U. S.'"); see also Allen Bellas, Empirical Evidence of Advances in Scrubber Technology, 20 RESOURCES & ENERGY ECON. 327 ( 1998); Paul A Ireland et al., A Review of Phase I Retrofit FGD Cost Experience   New Benchmarks for the Future, Presentation at AMWA Mega Symposium sponsored by EPRI DOE EPA ( 1995) ( notes on file with author). 102. See Figure 2 7. 103. ELLERMAN ET AL., supra note 10, at 235 42. 334 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 1995.104 The major advance that led to price reductions was eliminating redundancy. Modern scrubbers typically have a single vessel that serves multiple units, greatly reducing costs. Redundancy has been reduced in other components as well. Another advance has been higher speed flue gas streams that increase the rate at which the reaction between flue gas and the reagent slurry occurs. 105 Other advances include using less expensive ceramic materials in scrubbing vessels and sourcing materials worldwide. In addition to these design improvements, innovation has taken place in waste disposal practices. Since the solid wastes from a scrubber may cover 1000 acres over the life of a large plant, waste disposal is a significant part of scrubbing cost. 106 Utilities have worked to enhance cost effective ways to recover saleable, commercial quality gypsum from scrubbing waste by using a different reagent, or by further processing. 107 c. Title IV's Design A third factor in reducing scrubbing expense is that Title IV's design allowed more efficient scrubbers to be built. Until 1992, most utilities installed scrubbers to meet New Source Performance Standards, although a few utilities had installed scrubbers to meet state SO2 emission or ambient standards. 108 Under NSPS, sources had to achieve a 90% or 70% reduction on a continuous basis. 109 NSPS scrubbers therefore had to be very reliable to ensure strict compliance with this rate limit, as any deviation would lead to a violation and potentially require shutting down the plant while the scrubber was repaired. As a consequence, the scrubber built for NSPS required significant redundancy and typically an entire backup scrubber module in case the 104. In one case, scrubbers being built at two units of the Mount Storm plant today will cost 30% to 40% less than the scrubber built at an identical unit of that plant in 1995. See Interviews with industry representatives; Pollution Engineering Online, Marshley Wins $ 88 Million Scrubber Contract, at http:// www. pollutionengineering. com ( Apr. 1999). 105. This has made it possible to achieve the same amount of SO2 emissions reduction with a smaller scrubbing vessel, thereby lowering capital costs and maintenance costs by 15% to 20%. 106. See Interviews with scrubber manufacturers. 107. An increase in the demand for gypsum has helped fuel research and development in refining this process, with the result that by product gypsum production has become highly economical for some utilities. Gypsum companies are now building facilities close to some generating units. The use of gypsum obtained from scrubbers increased from 1.5 million tons to 2.5 million tons between 1996 and 1998. R. F. BALAZIK, U. S. GEOLOGICAL SURVEY, MINERALS INFORMATION   1998: ANNUAL REVIEW FOR GYPSUM 35.1 ( 1999). 108. See Interviews with electric utilities; ELLERMAN ET AL., supra note 10, at 235 42. 109. See supra note 25. 2001] HOW ENVIRONMENTAL LAWS WORK 335 first one failed, causing costs to be far higher than needed to reduce sulfur emissions efficiently. Title IV adopted a mass limit with an annual averaging period, allowing a utility to average its emissions over a year and even to purchase allowances if needed to compensate for scrubber down time. As a result, scrubbers built to comply with Title IV do not have to be over built, nor include backup modules, significantly lowering their capital and operating costs. 110 Another aspect of Title IV's design that promoted innovation was its flexibility, which introduced competition into the SO2 reduction field. For the first time scrubbers had to compete with other compliance methods, thus spurring innovation. A second factor of Title IV's design is that every ton of reductions counts, creating incentives for businesses to raise scrubber efficiencies. The NSPS rate standard, on the other hand, created no incentives for achieving removal efficiency greater than the established rate limits. 111 6. The Low Sulfur Coal Story   Regulatory Design and Economic Choices The widespread use of low sulfur coal has been a major compliance strategy during Phase I, accounting for 59% of actual reductions. 112 Firms such as the Southern Company switched to lower sulfur coals as the centerpiece of their compliance strategies, characterized by the company as " BUBA," or " Bank, Use and Buy Allowances." All fortynine of Southern's units emitted below their allowance allocation, allowing the company to build a 1 million ton bank of allowances for Phase II. 113 Many other firms were also able to switch to low sulfur coal at relatively low cost, although geographic location in relation to lowsulfur coal fields, and the availability of low cost transportation from these fields, were important factors. 114 110. See Figure 2 7. 111. Some firms reported that some public utility commissions prohibited overcompliance with the 90% reduction new source standard for scrubbing, as any overcompliance was not in accordance with a " prudent investment" policy. This represents an extreme example of the limitations caused by rate based standards. 112. See Figure 2 4. 113. Gary R. Hart, Southern Company's BUBA Strategy in the SO2 Allowance Market, in EMISSIONS TRADING 204, 205 ( Richard F. Kosobud ed., 2000) (" Our plan was to procure a substantial supply of this low sulfur coal for our affected units during Phase I while at the same time paying little or no premium for this 1% coal [ emitting SO2 at 1.67 lb/ mmBtu] as opposed to a coal that emitted the 2.5 lb/ mmBtu rate."). 114. See Jeffrey M. Hirsch, Emission Allowance Trading Under the Clean Air Act: A Model for Future Environmental Regulations?, 7 N. Y. U. ENVTL. L. J. 352, 381 82 ( 1999). 336 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 The use of low sulfur coal was catalyzed by the flexibility afforded by Title IV, which unlike any of the NSPS standards did not place constraints on the use of low sulfur coal for compliance. 115 This led to experimentation and innovation in fuel blending techniques that facilitated greater use of low sulfur western coals, and provided incentives to use eastern low and medium sulfur coals, as described below. These innovations, together with investment prompted by Title IV, lowered the expected cost premium for low sulfur coals and increased their use. 116 a. Low Sulfur Western Coal Coal from the Powder River Basin ( PRB) in Wyoming and Montana has a very low sulfur content at or below 0.6 lb/ mmBtu. 117 The market for western coal was growing even before Title IV was enacted because of its low cost to mine, lower shipping prices produced by rail deregulation, and state acid precipitation regulatory programs in states such as Minnesota and Wisconsin. 118 Following the enactment of Title IV several utilities, especially those within 1000 miles of the PRB, moved rapidly to adapt their coal handling and milling equipment to accommodate PRB coal. 119 Use of PRB coal has now penetrated east to West Virginia and south to Georgia. 120 Despite its low sulfur content, the use of PRB coal presents problems: it is subbituminous, and has both higher ash content and lower heat value than harder eastern bituminous coals, which can cause derating ( or loss of generating capacity) and interfere with boiler operation. 121 Prior to the enactment of Title IV, many utilities believed that western coals would not perform well in their generating units, especially the large cyclone boilers in the midwest built to handle eastern coals. 122 Available options therefore were believed to be scrubbing or switching to relatively expensive eastern low sulfur coals.

115. 42 U. S. C. § 7651b ( 1994). 116. See ELLERMAN ET AL., supra note 10, at 82 89; infra text accompanying note 131. 117. EIA, COAL INDUSTRY ANNUAL, PUB. NO. DOE/ EIA 0584( 98) ( 1999). 118. Utility emissions of SO2 had already begun to fall before Phase I, with 1993 levels 7% below 1985 levels. EPA 1999 EMISSIONS SCORECARD, supra note 1. 119. See ELLERMAN ET AL., supra note 10, at 82 88. "[ T] he consequence of competition and productivity improvements has been the halving of the rail rate for long distance shipments of coal out of the PRB." Id. 120. See Interviews with utility companies. 121. See ELLERMAN ET AL., supra note 10, at 244. 122. See Interviews with utility companies; Burtraw & Swift, supra note 63. 2001] HOW ENVIRONMENTAL LAWS WORK 337 In response to the impetus provided by Title IV's design, which credits any emission reductions, utilities began experimenting with blending inexpensive low sulfur PRB coal with traditionally highersulfur midwestern coal to reduce total SO2 emissions. 123 Early on, typical blends were 40% low sulfur PRB coal and 60% higher sulfur bituminous coal, a combination firms believed would prevent or minimize the operational and derating problems. Experimentation allowed utilities to steadily increase the percentage of PRB coal through reengineering their plants. 124 Today, blends of up to 80% PRB coal are not uncommon, and a number of plants have been modified in ways that permit using 100% PRB coal. 125 PRB related innovation is closely tied to Title IV's mass standard because firms initially did not think they could blend PRB coal to reach rate values such as 1.2 lb/ mmBtu. 126 Because, unlike a rate standard, Title IV rewarded any reduction, such as moving from high emissions to medium emissions, firms began to experiment with blending PRB, with the positive results outlined above.

b. Low and Medium Sulfur Eastern Coals As Phase I continued, eastern low and medium sulfur coals also began to compete with western coal for new market share. The greater distance from western coal fields and the operating issues with PRB coal increased the attractiveness of Appalachian low sulfur coal, with sulfur content at about 1.2 lb/ mmBtu. A study by MIT of the early years of Phase I showed this coal was able to capture a significant part of the market, accounting for 44% of SO2 reductions from fuel switching, with the medium sulfur coal accounting for another 35% of reductions from fuel switching. 127 123. ELLERMAN ET AL., supra note 10, at 250. 124. Id. at 244. "[ I] n what must be considered a triumph of tinkering and continuous tinkering, it was found that subbituminous coal could be blended with the local bituminous coal up to a point without incurring significant derating." Id. 125. See Interviews with utility firm representatives. See also ELLERMAN ET AL., supra note 10, at 129 ( noting that PRB coal accounts for about 15% of the SO2 emissions reductions from fuel switching under Title IV and 10% of the overall SO2 emissions reductions under Title IV). 126. The rate value of 1.2 lb/ mmBtu has significance as it is the rate standard new plants have to achieve under NSPS, and is the rate standard on which the Phase II cap was established. Most units would need to reach such a rate level by Phase II. 127. ELLERMAN ET AL., supra note 10, at 128 29. 338 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 c. Economic Considerations in Switching to Low Sulfur Coals In considering switching from higher sulfur to low sulfur coals, firms considered three primary cost elements: mine mouth cost, transportation cost, and the premium paid for the lower sulfur content of the coal. 128 All three costs can vary considerably between coals. 129 For example, PRB coal from large open pit mines costs only $ 0.20 per mmBtu to mine, or one quarter of the cost of mining eastern coals, but transportation costs are higher due to the greater distance to eastern generating units. 130 A major element affecting Title IV implementation has been the lower than expected sulfur premium, which has led to greater use of lowsulfur coal. One factor contributing to the lower price was rail deregulation in the 1980s, which lowered shipping cost and made PRB coal more competitive. 131 Title IV itself promoted major investment by utilities. One study identified $ 12 billion in added investment associated with Title IV by mid 1995: $ 6 billion for development of low sulfur coal fields, $ 3 billion for scrubbers and modifications, $ 2 billion in coalrelated rail investment, and over $ 1 billion in allowance purchases. 132 This spurred rail industry innovations in the design of cars and infrastructure, 133 and some utilities also invested in transportation infrastructure, including barges and rail cars, to ensure access to PRB coal at competitive prices. 134 These investments in assets and infrastructure addressed bottlenecks and barriers to the use of low sulfur coal, and contributed to the observed reduction in compliance cost. The second factor leading to greater than expected use of low sulfur coal was the lower than expected capital cost of retrofitting boilers so they could use low sulfur coal, which included the cost of boiler modifications, coal handling equipment, and particulate controls. 135 Here, there is an important distinction between eastern and western coals. Most boilers built for the bituminous coal prevalent in the eastern part of the country can switch to low sulfur bituminous coal at low 128. See Ireland, supra note 101. 129. ELLERMAN ET AL., supra note 10, at 129 30. 130. Id. 131. See id. at 128 30; EIA, THE EFFECTS OF TITLE IV OF THE CLEAN AIR ACT AMENDMENTS OF 1990 ON ELECTRIC UTILITIES: AN UPDATE, PUB. NO. DOE/ EIA 0528( 97), at 23 25 ( 1997). 132. Clean Air Capital Markets, Research ( 1995) ( unpublished data, Washington, D. C.) ( on file with author). 133. Burtraw & Swift, supra note 63, at 10,419. 134. See Interviews with utility representatives. 135. Id. 2001] HOW ENVIRONMENTAL LAWS WORK 339 capital expense, around $ 5 to $ 10 per kW of capacity for most units. 136 It costs more to retrofit these boilers to burn sub bituminous coals from the western United States, which have higher ash and moisture content, and hence different combustion characteristics. The magnitude of this expenditure depends on the plant, but typically is in the range of $ 50 to $ 75 per kW. 137 Although significant, these costs are far less than the $ 249/ kW in capital costs to install scrubbers. A third factor related to the use of low sulfur coal was the concern about the use of PRB coal potentially resulting in derating and operational problems. These concerns failed to materialize.

d. Effect of Title IV on Coal Pricing Title IV significantly changed coal prices. Prior to Title IV, the principle added value was for coal with a sulfur content of 1.2 pounds or less of sulfur per million Btu of heat content. Often referred to as " compliance coal," it allowed firms built between 1971 and 1978 to meet the New Source Performance Standard in effect at that time, or similar state standards. 138 The sulfur content of coal made little difference to other plants: plants built before 1971 were essentially unregulated, and plants subject to the new source standard imposed after 1978 were required to scrub, making them apt to buy the cheapest coal regardless of its sulfur content. 139 Title IV dramatically changed this situation by making any reduction in SO2 valuable. This introduced more price competition among fuels and created a uniform gradient in the price of coals based on sulfur content.

7. Retirement Normally, retirement of a unit would be an effective compliance strategy under a cap and trade program, as it would result in allowance savings. However, the phased nature of Title IV required that firms 136. See Ireland et al., supra note 101; see also ELLERMAN ET AL., supra note 10, at 224 ( switching to PRB cost $ 15 to $ 75 per kW; switching to other bituminous coals cost $ 0 to $ 15 per kW). 137. See Ireland et al., supra note 101; see also ELLERMAN ET AL., supra note 10, at 224. Added particulate controls were also needed because western coal is " dustier" than most eastern coal, increasing explosion danger as well. 138. Clean Air Act, 40 C. F. R. § 60.43 ( 2000); see also supra text accompanying note 22. 139. See supra text accompanying note 25. If a utility had to install a scrubber in order to meet ambient air quality standards or if a plant subject to NSPS opted for the 90% removal standard, the principle consideration in the choice of coal was price, not sulfur content, since there was no regulatory or economic advantage to using lower sulfur coal. Many of the utilities in the central part of the country chose to use lower priced high sulfur coal mined in the region. See Interviews with utility representatives. 340 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 maintain their baseline utilization during Phase I, although they could average the utilization of all their units. 140 For the most part, this precluded retirement as an independent compliance strategy in Phase I, since the reduced utilization would need to be made up at other units. Overall, only seven Table A units ( 1343 MW) in the midwest with short remaining lives were shut down, with lost generation made up at other units. 141 Approximately forty substitution units, or more than 3000 MW, also were retired, reducing the emissions of these units by 383,587 tons, but again with offsetting generation at other units. 142 8. Substitution Units Firms made significant use of substitution units, confirming their readiness to make use of a flexibility mechanism with low transaction costs. Almost three quarters of all firms, thirty six in all, designated substitution units, and substitution was a significant method of compliance for a dozen firms. 143 Overall, 195 units were included as substitution units for at least one year, and net reductions from substitution units were 2,365,005 tons, about 20% of the total reductions achieved during Phase I. 144 The substitution provisions were intended to allow greater flexibility in meeting the reduction requirements, as firms found it cheaper to achieve the needed reductions at another of their units rather than the ones designated under Table A. For example, it might make more economic sense to scrub a newer Phase II unit, or switch to lowsulfur coal at a Phase II unit that was located nearer to a transportation route such as a river or railway. However, analysis conducted at MIT shows that allowing firms to voluntarily choose which units to include led in part to " gaming," with firms choosing to include units that would have decreased their emissions anyway. 145 Again, this is a problem with the phased structure of Title IV, and will not be an issue once all firms are included in Phase II.

140. 42 U. S. C. § 7651g( c)( 1) ( 1994). 141. Four of the units were Wisconsin Electric Power's old North Oak Creek plant, and the lost utilization was made up at the South Oak Creek plant owned by the same utility. The other retired units were Avon Lake 11 in Ohio, Breed 1 in Indiana and Des Moines 11 in Iowa. EPA 1999 COMPLIANCE REPORT, supra note 1, app. B 4. See generally Ireland et al., supra note 101 ( citing POWER ENGINEERING UPDATE, Mar. 1993). 142. EPA 1999 COMPLIANCE REPORT, supra note 1, app. B 4. 143. Eleven companies with three or more units achieved roughly half or more of their compliance through substitution units. In addition, two smaller firms participated in Phase I only because their units were chosen as substitution units. See Figure 2 5. 144. See id. 145. ELLERMAN ET AL., supra note 10, at 197 220. 2001] HOW ENVIRONMENTAL LAWS WORK 341 The use of the substitution provision could have been even greater had not the environmental community and certain elements of the industry litigated in response to initial rules promulgated by the EPA that would have allowed firms to count the reductions made at substitution units that installed scrubbers between 1985 and 1990.146 Although advocates of this approach argued that the scrubbers were installed in anticipation of the legislation, and thus that their reductions should be counted, the plaintiffs argued against retroactively counting any reductions achieved before 1990. The EPA settled the case by agreeing with the plaintiffs, and providing that baseline emissions would be the lower of 1985 or 1990 levels. 147 These events left a searing memory in many of the firms interviewed, who view the lesson learned as " early compliers lose." They also partly attribute industry's reluctance to voluntarily reduce CO2 emissions before passage of final legislation to these earlier events. 148 9. Trading The trading mechanisms under Title IV represent the most significant use of emissions trading in our environmental laws, and so have received a great deal of attention. Although not as critical as the emissions cap, trading is an important element of Title IV, as it contributed to cost reductions by allowing firms to bank allowances, shift load between their units as a compliance strategy, and to benefit from inter firm trading. Allowance trading climbed steadily throughout Phase I as firms became more accustomed to its use, and as movement toward a deregulated energy policy placed greater emphasis on marketing and trading in general. EPA data from the Allowance Tracking System shows that at least 81.5 million allowances were traded during Phase I. 149 However, most of these consisted simply of internal reallocation within a firm, and the extent of trading is better reflected in the 30.8 million allowances traded between economically unrelated entities, as shown in Figure 2 8.150 146. See Acid Rain Program: Permits, 59 Fed. Reg. 60,218 ( Nov. 22, 1994). 147. See Clean Air Act, 40 C. F. R. § 72.41( c)( 3) ( 2000). 148. See Interviews with utility representatives. 149. EPA 1999 COMPLIANCE REPORT, supra note 1, at 10 11. These figures include trades of both Phase I and Phase II allowances, which are not reported separately by the EPA. 150. EPA 1999 COMPLIANCE REPORT, supra note 1, at 11. 342 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 See Figure 2 8. Allowance Transactions Between Unrelated Entities ( 1995 2000) 151 The experience of Phase I reveals a number of interesting contrasts and findings regarding trading. One was its increased importance and use for arbitrage and profit making purposes, contrasting with firms' conservative use of trading for compliance. Aside from banking, only 3.5 million of the traded allowances, or 13% of total emissions, were used for compliance purposes during Phase I. 152 Most of these were used internally by firms to average the emissions of their own units, and interfirm trading for compliance comprised only 577,583 allowances, or 2% of total emissions. 153 Another was that early fears about market power in trading, or the creation of emissions hot spots, never materialized. Finally, the effect of trading in creating a price for a ton of emissions reduction allowed the greater integration of an environmental parameter into the economic decision making of firms. Before examining the use of trading in Phase I, it is important to note the relationship of trading to the emissions cap. The cap is arguably the more important element of Title IV, as it creates the environmental integrity and much of the economic efficiency in the program. The cap also creates the context in which trading can take place through allowances, which combine far greater opportunity for trading, lower transaction costs, and greater environmental integrity than the previous forms of credit trading. This commodity like nature of allowances allows trades to be made without government presence, and creates some of the important environmental and economic benefits of allowance trading.

a. Establishment of the Trading System The growth of trading has been influenced by the annual EPA auction of allowances and the role of an independent community of allowance brokers who facilitate allowance transactions. The initial 1993 1994 period of trading was marked by relatively little trading and uncertainty in the market. 154 Roughly 50% of allowance transactions were made through the official EPA auctions, which provided an early 151. Id. 152. 3.5 million was the total number of allowances needed by individual units to cover emissions that exceeded their allowance allocations. See Figure 2 5. 153. Only three firms emitted more allowances than they were allocated, requiring their use of 577,583 allowances. See Figure 2 5. A slightly higher number is reached if one adds the 130,789 allowances used by other firms that exceeded their allowance allocation for only one or two years. See infra note 171. 154. EPA 1999 COMPLIANCE REPORT, supra note 1, at 11. 2001] HOW ENVIRONMENTAL LAWS WORK 343 signal of the unexpectedly low price of compliance. Allowance prices, however, varied between the auction and private deals, indicating an immature market. 155 Confirming firms' lack of familiarity with the market, most trades were made through brokers, and different brokers charged commissions of $ 3.50 to $ 10 per allowance in this period. 156 Today, about 6 to 10 million allowances are traded annually between separate entities, largely through private transactions. Only 2% of transactions take place through the EPA auction. 157 However, the EPA helps establish a secure market through its Allowance Tracking System, which records allowance transactions, typically within twenty four hours. 158 Prices are transparently quoted in several privately maintained indexes, and the consistency of prices is high. 159 One aspect of firms' increased familiarity with trading is the decreased fraction of trades made through brokers today. Direct trades made by utilities have climbed from a negligible amount in 1994 1997 to an amount equal to the total made through brokers. This trend is also reflected in the commission charged by brokers, which has steadily declined to $ 1 per ton in 1995, $ 0.50 per ton in 1997, and $ 0.20 per ton in 1999.160 One of the early concerns during the creation of Title IV was that allowances simply would not be available, due to hoarding or other market power problems. This concern led to inclusion of the provisions for an allowance auction and a guaranteed reserve of allowances priced at $ 1500.161 However, there has been widespread liquidity throughout Phase I, assisted by the independent community of emissions brokers. 162 155. Ellerman, supra note 55, fig. 1, at 6. 156. See Interviews with emissions brokers. One firm charged $ 10 per allowance in this early period, and sold a significant share of the early allowances, but provided considerable technical and strategic advice along with the allowance sale. 157. Only 150,000 allowances are traded in the EPA auction, which was about 2% of the 10 million allowances traded in 1999. See Figure 2 8. 158. Clean Air Act, 40 C. F. R. § 73.30 ( 2000). See Joseph A. Kruger et al., A Tale of Two Revolutions: Administration of the SO2 Trading Program, in EMISSIONS TRADING 115, 121 ( Richard F. Kosobud ed., 2000) ( noting that the " EPA processes about 90% of allowance transactions within 24 hours of receipt, using just two Acid Rain staff."). 159. EPA 1999 COMPLIANCE REPORT, supra note 1, at 10 ( showing allowance price indexes of Fieldston Publications and Cantor Fitzgerald). 160. Carlton J. Bartels, Turning Gas into Cash, ENVTL. FIN. 32 ( Nov. 1999); ELLERMAN ET AL., supra note 10, at 167 n. 4. 161. Each year approximately 3% of allowances are withheld from units to be auctioned, and a limited reserve of allowances are guaranteed to be available at a price of $ 1500, to ensure the availability of at least a small number of allowances. 42 U. S. C. § 7651o ( 1994); see also ELLERMAN ET AL., supra note 10, at 169 n. 5. 162. See Interviews with emissions brokers; see also Bartels, supra note 160. 344 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 b. Use of Trading Allowance trading encouraged utilities to seek out " least cost" compliance options among their plants in order to minimize the cost of compliance. Such strategies can be clearly seen in firms' decisions to install scrubbers on the largest plants, where the cost per ton of emission reductions would be the lowest; or to switch those plants closest to existing rail or water transportation to low sulfur coal, thereby minimizing the cost of the transported coal. 163 The benefits of trading have the potential to be significant, as most studies have shown great variability in the cost per ton of emissions reductions at various plants. 164 The extent of trading depends greatly on the definition of trading. As shown in Figure 2 8, over 30 million allowances were traded between discrete entities, but in contrast only 3.5 million allowances were used for compliance purposes by units to emit above their allowance allocation. 165 Almost all of this use was for averaging, or trading between units owned by the same firm, and only 708,372 allowances were used over all of Phase I to allow firms to exceed their allowance allocation in any one year. 166 The use of the trading provisions at the unit level is shown by Figure 2 9, which compares actual emissions of the 372 units in the program all five years with their allowance allocations. The figure shows that a majority, or 244 units, emitted lower than their allocated level and banked allowances, while 128 units emitted over their allocated level and used excess allowances generated by other units for compliance.

See Figure 2 9: Difference Between SO2 Emissions and Allowances, Phase I Units ( 1995 1999) 167 c. Compliance Trading Notwithstanding the greatly increased use of trading, firms' use of trading for compliance purposes was relatively unchanged throughout Phase I, and remained conservative. Firms made major use of only two potential compliance uses of trading, those of banking and intrafirm 163. See Interviews with utility representatives; see also ELLERMAN ET AL., supra note 10, at 129 36. 164. GAO 1994 TRADING, supra note 54. 165. See Figure 2 5 ( showing that only 3,541,045 allowances were used by units to emit over their allowance allocations). 166. See infra note 171. 167. Data derived from analysis of EPA COMPLIANCE REPORTS, 1995 1999. 2001] HOW ENVIRONMENTAL LAWS WORK 345 averaging, and made less use of interfirm trading than may have been dictated by purely economic factors.

i. Banking The most extensive use of the trading provisions in Title IV was inter temporal trading or banking, described earlier. Banking, or saving allowances, accounted for almost 75%, or 10,518,211, of the 14,031,943 allowances created by the 244 units that emitted below their allowance allocations. 168 ii. Averaging Firms made considerable use of the opportunity to trade allowances between different units for the purpose of intra firm averaging. Almost 60%, or thirty of the fifty one firms, used averaging to achieve compliance over the five years of the program, and even more used averaging to allow a unit to emit over its allowance total for at least one year. 169 For instance, all of the forty nine units owned by the Southern Company emitted below their allocations over the five year period, but a few required allowances to meet their compliance obligations in one or more years. 170 iii. Inter firm Trading for Compliance Inter firm trading of allowances for compliance purposes totaled only 708,372 allowances during Phase I, or less than 3% of total emissions. 171 Despite the growing level of trading, only one utility, Illinois Power, relied extensively on allowances to meet its compliance obligations in Phase I, emitting 44% over its allocation. 172 Only two 168. See Figure 2 4. 169. See Figure 2 5 ( showing ELI analysis of unit data in EPA 1999 COMPLIANCE REPORT, supra note 1). 170. Id. 171. The total use of allowances by firms to emit more than their allowances in any one year was: Illinois Power, 503,208; Tampa Electric, 60,138; Duquesne 14,237, and all others 130,789. Id. These 708,372 allowances used by firms to cover their allowance deficit during Phase I is 2.6% of Phase I's 26.5 million tons of total emissions. Data from ELI analysis of EPA COMPLIANCE REPORTS 1995 1999. 172. This situation occurred primarily due to political, and not economic, considerations concerning the 1900 MW Baldwin Plant, responsible for most of Illinois Power's emissions. The Baldwin plant burned local high sulfur coal, with emissions over 5 lb/ mmBtu. There was political opposition from coal miners and the legislature to closing these mines and allowing the plant to switch to low sulfur coal. Illinois Power initially started to build a scrubber at Baldwin, although according to some sources this was simply to appease the local legislature and in state coal miners. Ultimately, Illinois Power stopped building the scrubber, and instead used allowances for compliance throughout Phase I. See Interviews with government regulators and 346 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 other firms made net allowance purchases during Phase I: Tampa Electric emitted 14% over its allocation, and Duquesne Power emitted 4% over. 173 An additional twelve firms used inter firm trading to emit more than their allowances in a given year, but in all cases only did so for one or two years, and emitted below their allocation for Phase I as a whole. 174 In large part, the limited interutility trading reveals a bias towards autarkic behavior by firms in their environmental strategies. However, several specific problems discouraged such trading. The most important involved state public utility regulations, which typically required that gains or losses generated by trading be refunded to ratepayers as an element of fuel cost. 175 A second disincentive is the tax treatment of allowances. The Internal Revenue Service considers allowances to have a zero cost basis, since they are allocated for free. 176 This imposes a large tax on the first seller of an allowance, creating a significant disincentive. Discussions with several utilities showed that this was a serious constraint for some firms, but not for others that had offsetting tax credits or other special situations that avoided tax consequences. 177 Thirdly, public opposition to trading in the early years of the program led some utilities, such as TVA, to limit buying or selling allowances for compliance. 178 environmental groups. Illinois Power has now achieved a 90% reduction in SO2 at Baldwin by shifting to low sulfur coal at the advent of Phase II. ST. LOUIS POST DISPATCH, Nov. 13, 1998. 173. The excess emissions were: Illinois Power, 503,208; Tampa Electric, 60,138; Duquesne 14,237. See Figure 2 5. 174. See supra note 171. 175. ELLERMAN ET AL., supra note 10, at 193 ("[ A] cross all states issuing regulations, public utility commission regulations on allowance trading activity largely require that 100% of both expense and revenues be returned to the ratepayers."). See generally Elizabeth M. Bailey, Allowance Trading Activity and State Regulatory Rulings: Evidence from the U. S. Acid Rain Program, at web. mit. edu/ afs/ Athena. mit. edu/ org/ c/ ceepr/ www/ workingpapers. htm ( Mar. 1998) ( analyzing public utility trading in response to state regulation). 176. See Gary Hart, Roadblocks to an Optimal Trading System, ENVTL. FIN. 26, 26 ( May 2000), available at http:// www. emissions. org/ publications/ member_ articles/ index. html. " The potential tax policy consequences coupled with the direct refunding of the remaining proceeds to customers . . . . have led many utilities to hold, or bank, allowances for future compliance and not participate fully in the allowance market." Id. 177. Id.; see also Interviews with utility representatives. One practice of utilities was to make a six month loan of allowances to brokers or other utilities to trade, which is tax free. The allowances would be repaid by the broker with interest in an additional amount of allowances, such as 5%. See Hart, supra note 176, at 26. Although this was a way of making profits from allowances holdings, it has little relevance to compliance. 178. TVA's board of directors adopted a no trading policy after negative publicity on its participation in one of the very first SO2 allowance trades in 1992. See Matthew L. Wald, Utility Is Selling the Right to Pollute, N. Y. TIMES, May 12, 1992, at A1 ( criticizing the firm's participation in the allowance trade). 2001] HOW ENVIRONMENTAL LAWS WORK 347 d. New Paradigm of Trading and Arbitrage Trading Trading of energy related commodities such as power, fuels, and emissions has been at the center of the revolution in the power sector as many states have initiated deregulation to a market based system for the generation and marketing of power. 179 In this new, competitive era, firms' use of trading has also evolved, with many firms commencing to trade for arbitrage or profit making purposes as well as compliance. 180 The increased emphasis on marketing and trading in many firms has led to a major realignment in which the generation division within a firm may no longer dictate terms to the traders, but vice versa. 181 Arbitrage trading by some firms has become significant, with allowances regarded as an asset that can lead to profits through trading, especially if combined with fuel and energy trading. 182 This new attitude toward trading has been assisted by practices such as six month tax free loans of allowances between utilities and brokers that the broker uses for trading, and then repays to the utility with additional allowances as interest. 183 Such arbitrage trading is neutral in terms of the environment, and helps to explain the difference between the 30.8 million allowances traded between distinct entities in Phase I, and the only 3.5 million traded for actual compliance purposes. The enormous importance of trading to some firms is reflected in the placement of emissions trading authority in the corporate structure. The allowance trading function was traditionally located in the company's environmental department, after which it was shifted in some firms to the fuel purchasing department where allowances are bought and sold along with other commodities like coal. Today, many electricity generating companies have established a division or separate corporate entity for trading energy related commodities. 184 Some smaller firms with particularly active programs may generate as much gross revenue from such trading as they do selling electricity. 185 179. See Energy Survey, THE ECONOMIST, Feb. 10, 2001, at 11. 180. See Interviews with emissions brokers and utility representatives. 181. See Vito Stagliano & Sarah Emerson, Energy Trading: The Market's Response to Deregulation, RESOURCES 127 ( Spring 1997); see also Interviews with utility representatives. 182. See Interviews with utility representatives. 183. Id.; see also ELLERMAN ET AL., supra note 10, at 178 ( discussing allowance swapping). 184. See Interviews with utility representatives 185. See Interviews with emission trading representatives of utility companies. Cinergy, a larger firm, reported revenues of $ 640 million from its trading subsidiary, about 11% of its total 1998 revenues. CINERGY CORP., 1998 FINANCIAL REPORT & 1999 PROXY STATEMENT C 20, C 26 ( 1999). 348 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 e. Trading Helped to Integrate Environmental and Economic Issues A potentially profound influence of trading on compliance behavior is its effect in establishing a market price for a ton of reductions. This has allowed a greater integration of environmental and certain economic aspects of the industry and, some claim, allowed far greater integration of environmental considerations into overall business decisionmaking 186 The most evident example of this integration is that allowance prices are today fully integrated into the price of coal: the sulfur premium for coal tracks the allowance price, and coal suppliers now bundle allowances with their coal. 187 This integrates the environmental effects of coal into its price, and hence into all firm decisions about fuel cost and efficiency. It also creates an even cline in the sulfur premium that contributes to a competitive coal market. A second example is that allowance prices are regularly updated in the dispatch models that dictate which of a firm's plants will operate at any time. 188 Again, this fully integrates an environmental parameter into one of a firm's key ongoing economic decisions. Neither of these integrations would be possible under rate standards, and both show how cap and trade systems continue to exert dynamic effects on a continuing basis long after the effective date of the regulations. Some argue further that creating a price for pollution causes a revolution in compliance behavior because it broadly moves consideration of pollution effects into mainstream company decisions. 189 By allowing companies to profit from trading allowances, they argue that firms begin to view environmental compliance as another arena for competition, lowering resistance to regulation by firms that perceive they may out compete other firms in this arena. Achieving these positive effects is assisted if the company's accounts reflect the market value of 186. See Interviews with emission trading representatives of utility companies and indepen dent emissions brokers. 187. The allowance system allows coal suppliers to " bundle" allowances with their coal to meet emissions limits or utilities' demands. The opportunity to profit through arbitrage trading if coal prices are out of line with allowance prices ensures a relatively high degree of consistency between allowance prices and the sulfur premium. Coal suppliers have opened accounts in the EPA's Allowance Tracking System and trade allowances to bundle them with coal supplies. These practices tie in the price of coal with other compliance strategies, and so achieve economic efficiency and least cost compliance. See ELLERMAN ET AL., supra note 10, at 255 57. 188. See Interviews with environmental compliance representatives of power generation firms. Many update allowance prices on a monthly basis. 189. The discussion in the following paragraphs is derived from confidential interviews with industry sources. 2001] HOW ENVIRONMENTAL LAWS WORK 349 allowances, instead of carrying them at zero basis if they are allocated for free. Once the cost of allowances is reflected in the accounts, the pollution consequences of actions may affect all economic decisions made by a firm. One regulatory factor that appears to be critical in achieving this integration is the ability to freely trade allowances with minimal transaction costs or delay. This creates a market price through a competitive and transparent trading market that is national in scope with no restrictions or limits on trades. Because of the cap and trade system, this can be done while maintaining very high environmental integrity. 190 10. Phased Structure Caused Problems Title IV created a two phased structure that regulated only certain generating units in Phase I. However, because of the interconnected nature of the electricity grid, this created the potential for these units to transfer generation and therefore emissions to other units not included in Phase I. 191 Title IV's rules partially prevent this practice by requiring firms to utilize their Phase I plants at least to the level at which they were operated during the baseline period. 192 However, they did not prevent firms from meeting the increased demand for energy that occurred during Phase I by increasing the use of Phase II generating units proportionally more than Phase I units. The MIT Center for Energy and Environmental Policy Research analyzed utilization levels in the years 1995 1997, and concluded that firms did indeed shift some utilization due to growth from Phase I to Phase II units, leading to greater SO2 emissions over time. 193 These actions actually reduced Phase I emissions by a total of 427,590 tons, as 190. The cap assures environmental quality, while the strict monitoring and penalty provisions assure the integrity of trading. The allowance method, unlike credit trades, also means that no government pre approvals are needed that would slow trades and add significant transaction costs. 191. While Phase I achieved early reductions, it created a problem due to the interconnectedness of all electricity generating firms. Firms could potentially reduce emissions at Phase I units simply by generating more electricity at other units that would not be covered until Phase II. See BRIAN MCLEAN, EPA, PUB. NO. EPA 95 RA12004, LESSONS LEARNED IMPLEMENTING TITLE IV OF THE CLEAN AIR ACT 7 ( 1995). Further, as described infra in Part II. C. 8, the substitution provisions also likely resulted in excess Phase I emissions. 192. See 42 U. S. C. § 7651g( c)( 1) ( 1994); Clean Air Act, 40 C. F. R. § 72.2 ( 2000). 193. Susanne Schennach, The Effect of Title IV on SO2 Emission and Heat Input, in MARKETS FOR CLEAN AIR: THE U. S. ACID RAIN PROGRAM 323 ( Ellerman et al. eds., 2000); ELLERMAN ET AL., supra note 90, at 50; E mail from A. Denny Ellerman, Executive Director, MIT Center for Energy and Environmental Policy Research, to Byron Swift, Environmental Law Institute ( Dec. 29, 1999) ( on file with author) ( calculating that 7% of heat input was transferred from Phase I unscrubbed units to Phase II units, and the emissions transferred to Phase II less the emissions reductions in Phase I). 350 TULANE ENVIRONMENTAL LAW JOURNAL [ Vol. 14 the Phase II units were generally cleaner. 194 However, it allowed the Phase I units to bank an additional 1,159,995 allowances, potentially creating a net difference of 732,404 additional tons of emissions over time. 195 These problems indicate that phasing of power plants in a regulatory system is difficult at best, and if done again, more sophisticated rules need to be developed.

11. Environmental Effects or " Hot Spots" from Trading Concern has been expressed that Title IV's allowance trading system could result in " hot spots," or areas of localized high pollution levels, by allowing heavily emitting units simply to buy allowances instead of reducing emissions. 196 The results of Phase I reveal that allowance trading had a relatively small effect in shifting emissions, with a slight tendency towards cooling hot spots, not creating them. 197 Since local pollutant levels depend primarily on the overall stringency of regulation, together with economic factors such as plant siting, size, and utilization, it appears that rate based systems may allow greater hot spots than cap and trade systems. Before examining the results of trading in Phase I, it is important to note that Title IV requires reductions in addition to the existing ambient standards for SO2 that are designed to protect public health in the vicinity of a plant. 198 As noted before, many plants met these ambient standards through tall stacks and not emissions reduction, but these ambient standards still exist and serve as a check against SO2 trading ever causing significant hot spots. 199 Phase I data indicates there has been relatively little shifting of emissions due to trading. First, as shown in the figure below, emissions were fairly evenly below authorized allocations in virtually all states.

See Figure 2 10: SO2 Allowances Allocated and Emissions by State ( 1995 1999) 200 A second indication of the lack of effect of trading in causing hot spots during Phase I is an EPA analysis of the origin of all allowances 194. See supra note 193. 195. Id. 196. Byron Swift, Allowance Trading and SO2 Hot Spots   Good News from the Acid Rain Program, 31 ENV'T REP. 954 ( May 12, 2000), available at http:// www. epa. gov/ airmarkets/ articles/ so2trading hotspots_ charts. pdf. 197. Id. 198. See 42 U. S. C. § 7651 ( 1994). 199. See supra text accompanying notes 17 20. 200. Data derived from analysis of EPA COMPLIANCE REPORTS, 1995 1999. 2001] HOW ENVIRONMENTAL LAWS WORK 351 actually used at units to offset emissions in the years 1995 1998.201 This study revealed that 81% of allowances actually used originated in the same state as the source, and that net inter regional trading only constituted 3% of all allowances used. 202 A third way to look at the effects of trading is to review the reductions made at individual plants during Phase I. The data confirms a general prediction made about cap and trade programs that they will tend to create incentives for the dirtiest plants to clean up the most, as the per ton cost of emissions reductions should be lowest where the capital costs of control are spread over the largest number of tons. Figure 2 11 reveals that the largest emitters have reduced emissions the most, with the result of cooling hot spots rather than creating them.

See Figure 2 11: Allowances vs. Emissions of the Twenty Largest Phase I Plants203 Overall, it appears that localized levels of pollution are determined overwhelmingly by economic factors, notably plant location, size, and utilization. To the extent that regulation has any effect on localized levels of pollution, it is the overall stringency of the regulation that matters, not whether it is achieved by a rate or cap and trade system.