1 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite VIII. Model NOx and SO2 Cap and Trade Programs A. What Is the Overall Structure of the Model NOx and SO2 Cap and Trade Programs?

The EPA is finalizing model rules for the CAIR annual NOx, CAIR ozone season NOx, and SO2 trading programs that States can use to meet the emission reduction requirements in the CAIR. These rules are designed to be referenced by States in State rulemaking. State use of the model cap and trade rules helps to ensure consistency between the State programs, which is necessary for the market aspects of the regional trading program to function properly. It also allows the CAIR Program to build on the successful Acid Rain Program. Consistency in the CAIR requirements from Stateto State benefits the affected sources, as well as EPA,

which administers the program on behalf of States.

This section focuses on the structure which maintains the existing NOx SIP Call rules ( in part 96, subparts A through J) while adding parallel rules for the CAIR annual NOx ( in subparts AA through II), CAIR SO2 ( in subparts AAA through III), and the CAIR ozone season NOx ( in subparts AAAA through IIII) of the model rules. Commenters generally supported the proposed structure of the model rules, as well as the use of the cap and trade approach, which are 2 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite maintained in the final rules. Later sections of today's rule discuss specific aspects of the model rules that have been modified or maintained in response to comment.

The EPA designed the model rules to parallel the NOx SIP Call model trading rules ( part 96) and to coordinate with the Acid Rain Program. Mirroring the structure of existing part 96 in the final CAIR NOx and SO2 model rules will ease the transition to the CAIR rules as many States and sources are already familiar with the layout of the NOx SIP Call rule. In addition, because the EPA proposed new CAIR model trading rules   separate from the existing NOx SIP Call model rule in part 96   States can continue to reference part 96 ( subparts A through J) through 2008. The CAIR ozone season NOx cap and trade program that the EPA has included in today's final rule is intended for use by CAIR ozone affected sources as well as those subject to the NOx SIP Call in 2009 and beyond. Those States that wish to use an EPA administered, ozone season cap and trade program to achieve the reductions mandated by the CAIR or the NOx SIP Call, must use the CAIR ozone season NOx model rule ( subparts AAAA through IIII) in 2009 and beyond.

The model rules rely on the detailed unit level emissions monitoring and reporting procedures of part 75 and 3 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite consistent allowance management practices. ( Note that full CAIR related SIP requirements, i. e., part 51, are discussed in section VII of today's preamble.) Additionally, section IX. B of today's preamble discusses the final revisions to parts 72 through 77 in order to, among other things,

facilitate the interaction of the title IV Acid Rain Program's SO2 cap and trade provisions and those of the CAIR SO2 trading program.

Road Map of Model Cap and Trade Rules The following is a brief " road map" to the final CAIR NOx and SO2 cap and trade programs. Please refer to the detailed discussions of the CAIR programmatic elements throughout today's rule for further information on each aspect.

State Participation

States have flexibility to achieve emissions reductions however they chose, including developing and implementing their own trading program.

States may elect to participate in an EPA managed cap and trade program. To participate, a State must adopt the model cap and trade rules finalized in this section of today's rule with flexibility to modify sections regarding NOx allocations and whether to include 4 1 Rhode Island ( RI) is the only State currently participating in the NOx SIP Call cap and trade program that is not affected by today's ozone finding. As is explained in section IX, RI may join the CAIR ozone season trading program as a means of satisfying its NOx SIP Call requirements.

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite individual unit opt in provisions.

States may participate in EPA managed cap and trade programs for either the annual NOx, the ozone season NOx, the SO2, or any combination. The State can only choose to participate in the EPA administered, CAIR cap and trade program( s) that is( are) relevant to thier finding( s).

The annual NOx model rule is to be used by only those States that are affected by the CAIR PM2.5 finding.

The ozone season NOx model rule is designed to be used by those States that are affected by the CAIR ozone finding as well as take the place of the NOx SIP Call requirements1. The CAIR ozone season NOx program will be the only ozone season NOx program that EPA will administer. Because the EPA will no longer run a NOx SIP Call trading program, States may include their NOx SIP Call sources if they adopt the EPA administered CAIR ozone season NOx program.

The SO2 model rule is designed to satisfy the ongoing 5 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite statutory requirements of the title IV Acid Rain SO2 cap and trade program   with simultaneous compliance with title IV and the CAIR   for sources in the CAIR region that are affected by both the Acid Rain Program and the CAIR.

Trading Sources

States must achieve all of the mandated emission reductions from EGUs to participate in EPA managed cap and trade programs. States may include other NOx SIP Call trading sources in the ozone season CAIR NOx cap and trade program and still participate in EPA managed cap and trade programs.

States may participate in EPA managed cap and trade programs whether or not they adopt the optional individual opt in provisions of the model rule.

However, if the State chooses to allow individual sources to opt in, the opt in requirements must reflect the requirements of the model rule.

Emission Allowances

The CAIR annual NOx cap and trade program will rely upon CAIR annual NOx allowances allocated by the States. The NOx SIP Call allowances and CAIR ozoneseason NOx allowances cannot be used for compliance 6 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite with the annual CAIR reduction requirement. ( Note that allowances from the Compliance Supplement Pool ( CSP)

will be CAIR annual NOx allowances.)

The CAIR ozone season NOx cap and trade program will rely upon CAIR ozone season NOx allowances allocated by the States. In addition, pre 2009 NOx SIP Call allowances can be banked into the program and used by CAIR affected sources for compliance with the CAIR ozone season NOx program. The NOx SIP Call allowances of vintages 2009 and later can not be used for compliance with any EPA administered cap and trade programs.

The CAIR SO2 cap and trade program will rely upon title IV SO2 allowances but may also include additional CAIR SO2 allowances, should a State not require all of their SO2 emissions reductions from EGUs in their budget demonstration. Pre 2010 title IV SO2 allowances can be used for compliance with the CAIR.

Sulfur dioxide reductions are achieved by requiring sources to retire more than one allowance for each ton of SO2 emissions. The emission value of an SO2 allowance is independent of the year in which it is used, but is based upon it's vintage ( i. e., the year in 7 2 The 200,000 total includes the share of the CSP that DE and NJ would receive if the EPA finalizes a parallel rule finding that they are significant contributors for PM2.5.

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite which the allowance is issued). Sulfur dioxide allowances of vintage 2009 and earlier offset one ton of SO2 emissions. Vintages 2010 through 2014 offset 0.5 tons of emissions. And, vintages 2015 and beyond offset 0.35 tons of emissions.

Allocation of Allowances to Sources

For SO2 allowances, sources have already received allowances through title IV.

NOx allowances ( for both the annual and ozone season programs) will be allocated based upon the State's chosen allocation methodology. The EPA's model NOx rules have provided an example allocation, complete with regulatory text, that may be used by State's or replaced by text that implements a States alternative allocation methodology.

Compliance Supplement Pool ( CSP)

Each State will have a share of the CSP that is comprised of 200,0002 CAIR annual NOx allowances of vintage year 2009. The State may distribute the CSP allowances based upon the criteria, found in the SIP Approvability section of today's rule, for early 8 3 Compliance with the title IV Acid Rain Program will be determined separately from CAIR compliance.

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite reductions and need.

Emission Monitoring and Reporting by Sources

Sources monitor and report their emissions using part 75. This includes individual sources that opt in to the program.

Source information management, emissions data reporting, and allowance trading is done through online systems similar to those currently used for the Acid Rain SO2 and NOx SIP Call Programs.

Emission monitoring and reporting for both the CAIR annual and ozone season NOx cap and trade programs will use part 75.

Compliance and Penalties

Compliance for the annual and ozone season NOx cap and trade programs, as well as the SO2 program, will be determined separately. 3

For the NOx and SO2 cap and trade programs, any source found to have excess emissions must: ( 1) surrender allowances sufficient to offset the excess emissions;

and, ( 2) surrender allowances from the next control period equal to three times the excess emissions. 9 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite Comments Regarding the Use of a Cap and Trade Approach and the Proposed Structure Commenters overwhelmingly supported the use of a cap and trade approach and the overall framework of the model rules to achieve the mandated emissions reductions. Some supported the use of cap and trade for achieving regional emissions reductions but noted the need to have additional measures that ensure that emission reductions take place in nonattainment areas. This is in line with the EPA's strategy of reducing transported SO2 and NOx through a regionwide cap and trade approach and encouraging States to take complementary measures to address their particular,

persistent nonattainment issues. ( Note that comments on specific mechanisms within the cap and trade program are discussed in the topic specific sections that follow.)

B. What Is the Process for States to Adopt the Model Cap and Trade Programs and How Will It Interact with Existing Programs?

1. Adopting the Model Cap and Trade Programs States may choose to participate in the EPAadministered cap and trade programs, which are a fully approvable control strategy for achieving all of the 10 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite emissions reductions required under today's rulemaking in a highly cost effective manner. States may simply reference the model rules in their State rules and, thereby, comply with the requirements for statewide budget demonstrations detailed in section VII. B of today's preamble. Affected States for both PM2.5 and ozone can adopt the annual NOx and SO2 cap and trade programs in part 96, subparts AA through II, part 96 subparts AAA through III, and AAAA through IIII.

States with ozone season only CAIR requirements ( i. e.,

Arkansas, Connecticut, Delaware, Massachusetts, and New Jersey) can adopt the ozone season CAIR NOx program ( subparts AAAA through IIII). Part 96 subparts AA through II and AAA through III can be used by States that are affected for only PM2.5 ( i. e., Georgia, Minnesota, and Texas). States that elect to achieve the required reductions by regulating other sources or using other approaches will follow alternate State requirements, also described in section VII. B of today's preamble.

As proposed, the EPA is requiring States that wish to participate in the EPA managed cap and trade program to use the model rule to ensure that all participating sources,

regardless of which State in the CAIR region they are located, are subject to the same trading and allowance 11 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite holding requirements. Further, requiring States to use the complete model rule provides for accurate, certain, and consistent quantification of emissions. Because emissions quantification is the basis for applying the emissions authorization provided by each allowance and emissions authorizations ( in the form of allowances) are the valuable commodity traded in the market, the emissions quantification requirements of the model rule are necessary to maintain the integrity of the cap and trade approach of the program and therefore, to ensure that the environmental goals of the program are met.

For States Electing to Participate in the EPA Administered Ozone Season CAIR NOx Cap and Trade Program States that wish to achieve their CAIR ozone season requirements through an EPA administered ozone season NOx cap and trade program will adopt the CAIR model rule in subparts AAAA through IIII. ( Note that the EPA administered annual NOx CAIR cap and trade program is independent of ozone season CAIR NOx model rule.) Because the EPA will no longer administer the trading program for the NOx SIP Call,

States that wish to continue to meet their NOx SIP Call obligations through an EPA administered cap and trade program will also adopt the CAIR ozone season model rule. 12 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite NOx SIP Call States will " sun set" their NOx SIP Call rules for sources that will move into the CAIR NOx ozone season program. Part 96, sections A  J ( i. e., the NOx SIP Call trading rule) will continue to be available for the NOx SIP Call and will not be removed for the CAIR. The CAIR model rules specifically address how NOx SIP Call allowances carry forward into the CAIR NOx ozone season program. ( Section IX. A provides additional discussion of interactions between the CAIR and the NOx SIP Call).

For States Electing to Participate in the EPA Administered Annual NOx Cap and Trade Program States that are PM2.5 affected and wish to participate in an EPA administered annual NOx cap and trade program will adopt the CAIR model rule in subparts AA through II. States may participate by either adopting the model rule provisions by reference or codifying the model rule in their State regulations.

For States Electing to Participate in the EPA Administered SO2 Cap and Trade Program States may simply adopt new provisions, whether by incorporating by reference the CAIR SO2 cap and Trade rule ( part 96, subparts AAA through III) or codifying the provisions of the CAIR SO2 cap and trade rules, in order to 13 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite participate in the EPA administered SO2 cap and trade program. The CAIR SO2 model rule works in conjunction with the Acid Rain Program provisions, which are implemented at the Federal level and will stay in place. Today's action also finalizes some revisions to the Acid Rain Program ( i. e., parts 72, 73, 74, 75, and 78). ( Section IX. B of today's preamble provides additional discussion of interactions between the CAIR and the Acid Rain Program and changes to the Acid Rain Program).

Comments Regarding the Process for Adopting the Model Rules Commenters supported the EPA's proposed process and emphasized the importance of workable model rules, because States with limited resources are likely to incorporate them by reference or heavily rely on them as the basis for State rules.

2. Flexibility in Adopting Model Cap and Trade Rules It is important to have consistency on a State to State basis with the basic requirements of the cap and trade approach when implementing a multi State cap and trade program. Such consistency ensures the: preservation of the integrity of the cap and trade approach so that the required emissions reductions are achieved; smooth and efficient operation of the trading market and infrastructure across 14 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite the multi State CAIR region so that compliance and administrative costs are minimized; and equitable treatment of owners and operators of regulated sources. However, the EPA believes that some limited differences are possible without jeopardizing the environmental and other goals of the program. Therefore, the final rule allows States to modify the model rule language to best suit their unique circumstances in a few, specific areas.

First, States have the flexibility to include, as full trading partners, all trading sources affected by the NOx SIP Call in the ozone season CAIR NOx cap and trade program.

This is an outgrowth of the development of the CAIR ozoneseason NOx program, which will be the only ozone season NOx cap and trade program administered by the EPA.

In addition, States may develop their own NOx allocations methodologies, provided allocation information is submitted to the EPA in the required timeframe. ( Section VIII. D of today's preamble discusses unit level allocations and the related comments in greater detail. This includes a discussion of the provisions establishing the advance notice States must provide for unit by unit allocations).

Lastly, States using the model cap and trade rules may elect to include provisions that allow individual units to 15 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite " opt in" to the cap and trade programs. States that wish to include this mechanism must adopt provisions discussed in section VIII. G of today's rulemaking. Adopting the individual unit opt in provisions, which would allow non

EGUs that meet the opt in requirements to enter into the EPA managed cap and trade programs, does not preclude a State from participating in the EPA administered cap and trade programs.

C. What Sources Are Affected under the Model Cap and Trade Rules?

In the January 2004 NPR, the EPA proposed a method for developing budgets that assumed reductions only from EGUs.

Electric Generating Units were defined as: fossil fuelfired non cogeneration EGUs serving a generator with a nameplate capacity of greater than 25 MWe; and fossil fuelfired cogeneration EGUs meeting certain criteria ( referred to as the " 1/ 3 potential electric output capacity criteria"). In the SNPR, we proposed model cap and trade rules that applied to the same categories of sources. We are finalizing the nameplate capacity cut off that we proposed in the NPR for developing budgets and that we proposed in the SNPR for the applicability of the model trading rules. We are also finalizing the " fossil fuel 16 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite fired" definition and the 1/ 3 electric output capacity criteria that were proposed. The actual rule language in the SNPR describing the sources to which the model rules apply is being slightly revised to be clearer in response to some comments that the proposed language was not clear.

1. 25 MW Cut Off The EPA is retaining the 25 MW cut off for EGUs for budget and model rule purposes. The EPA believes it is reasonable to assume no further control of air emissions from smaller EGUs. Available air emissions data indicate that the collective emissions from small EGUs are relatively small and that further regulating their emissions would be burdensome, to both the regulated community and regulators,

given the relatively large number of such units. For example, NOx and SO2 emissions from EGUs of 25 MW or less in the CAIR region represent approximately one percent and two percent of total NOx and SO2 emissions from EGUs,

respectively. There are over 4000 EGUs of 25 MW or less in the CAIR region. Consequently, EPA believes that administrative actions to control this large group with small emissions would be inordinate and thus does not believe these small units should be included. This approach of using a 25 MW cut off for EGUs is consistent with 17 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite existing SO2 and NOx cap and trade programs such as the NOx SIP Call ( where existing and new EGUs at or under this cutoff are, for similar reasons, not required to be included)

and the Acid Rain Program ( where this cut off is applied to existing units and to new units combusting clean fuel).

Also, EPA's New Source Performance Standards use an applicability threshold of approximately 25 MW under subpart Da.

One commenter suggested a plant wide cut off of 250 MW.

This commenter suggested that including units between 25 and 250 MW would cause these units to shutdown but failed to provide any analysis to support its claim. Such a cut off would be inconsistent with other existing SO2 and NOx cap and trade programs as noted above. The EPA estimates that approximately 1/ 3 of the SO2 reductions, and 30 percent of the NOx reductions, required under today's rule come from plants between 25 MW and 250 MW. Our modeling shows that some units below 250 MW will put on controls as part of our highly cost effective set of control actions. The units also have the option to coal switch, alter dispatch, and/ or purchase allowances.

Another commenter suggested that, in lieu of the language proposed in the SNPR, the EPA adopt a definition 18 4 For example, certain cogeneration units and new units 25 MW or less that burn only clean fuel are exempt from the Acid Rain Program.

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite for EGU that, according to the commenter, is the Acid Rain Program's definition of affected utility. The commenter stated that the Acid Rain definition of EGU is " all fossil fuel fired units with a nameplate capacity greater than 25 MW supplying more than 1/ 3 of potential electrical output to the grid." However, the commenter misstated the Acid Rain definition and confused the Acid Rain applicability provisions concerning utility units in general with those provisions concerning cogeneration units in particular. The Acid Rain Program covers, with certain exceptions, 4 all existing fossil fuel fired units greater than 25 MW that produce any electricity for sale; and new fossil fuel fired units that produce any electricity for sale. The language referenced by the commenter concerning potential electrical output applies, in the Acid Rain Program, only to cogeneration units, not all fossil fuel fired units. For non cogeneration units, there is no exemption from Acid Rain Program requirements based on the unit selling a " small"

amount of electricity for sale. The provisions in the NPR and the SNPR concerning cogeneration units are discussed below. 19 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite 2. Definition of Fossil Fuel Fired The EPA is finalizing the proposed definition of fossil fuel fired, i. e., where any amount of fossil fuel is used at any time. This is the same definition that is used in the Acid Rain Program. One commenter suggested that the proposed definition is too broad and that the EPA should use in the CAIR Program the same definition that is used in the NOx SIP Call, i. e., where a unit uses fossil fuel for at least 50 percent of its annual heat input during a specified period. The same commenter also proposed excluding large wood fired boilers and black liquor recovery furnaces. The commenter's definition would result in units already subject to the Acid Rain Program in a given State being excluded from the CAIR Program and the model cap and trade rules applicable in that State. Such exclusion would make it more difficult to coordinate the Acid Rain Program and the CAIR Program. Consequently, the EPA rejects the commenter's more restricted definition of fossil fuel fired.

The EPA recognizes that new ( i. e., post 1990) units that are 25 MW or less and burn other than clean fuels are subject to the Acid Rain Program but not to the CAIR Program. However, there are very few such units, and EPA has decided to exclude any units that are 25 MW or less on 20 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite other grounds discussed above.

3. Exemption for Cogeneration Units As proposed, EPA is finalizing an exemption from the model cap and trade programs for cogeneration units, i. e.,

units having equipment used to produce electricity and useful thermal energy for industrial, commercial, heating,

or cooling purposes through sequential use of energy and meeting certain operating and efficiency standards ( discussed below). The EPA is adopting the proposed definition of cogeneration unit and the proposed criteria for determining which cogeneration units qualify for the exemption from the model cap and trade programs.

The CAIR trading program has different applicability provisions for non cogeneration units and cogeneration units. If a unit initially qualifies as a cogeneration unit, and for the exemption from the trading program for certain cogeneration units, but subsequently loses its cogeneration unit status ( e. g., due to changes in operation), such unit loses the cogeneration unit exemption and becomes subject to the applicability criteria for noncogeneration units, regardless of any future changes in the unit or its operations. If, under the non cogeneration unit applicability criteria, the unit becomes subject to the 21 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite trading program, the unit will remain subject to the program in the future. Conversely if a unit initially does not qualify as a cogeneration unit, such unit becomes subject to the applicability criteria for non cogeneration units,

regardless of any future changes in the unit. If, under such criteria, the unit is subject to the trading program,

the unit will remain subject to the program in the future.

This approach to applicability means that units ( other than,

in some cases, opt in units) cannot go in and out of the trading program, which, if allowed, would make it difficult for the EPA, States, and owners or operators to determine which units should be complying with trading program requirements, and during what years, and would likely result in more non compliance problems.

a. Efficiency Standard for Cogeneration Units The EPA proposed operating and efficiency standards ( i. e., the useful thermal energy output of the unit must be no less than a certain percent of the total energy output and, in some cases, useful power must be no less than a certain percent of total energy input) in the SNPR that a unit must meet in order to qualify as a cogeneration unit.

If the unit qualifies as a cogeneration unit, then it may be eligible for exemption from the CAIR, depending upon whether 22 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite it meets additional operating criteria, discussed below. As discussed in the NPR, the EPA proposed the same operating and efficiency standards for all fossil fuel fired units ( regardless of whether they burn coal, oil, or gas). In addition, not applying the operating and efficiency standards to coal fired units would be counter productive to the EPA's efforts to reduce SO2 and NOx emissions under this proposed rule because of the relatively high SO2 and NOx emissions from coal fired units. In particular, without application of the efficiency standards to coal fired units,

highly inefficient coal fired units, which have particularly high emissions per MWhr generated, could be exempt from the CAIR Program. In addition, if coal fired units were not subject to the operating standard, the potential would exist for a coal fired unit to provide only a token amount of useful thermal energy and still qualify for a cogeneration unit exemption from the CAIR Program, despite having relatively high emissions.

One commenter suggested that the EPA should not use the efficiency standards for solid fuel fired cogeneration units, because it may require some coal fired cogeneration units that were exempt from the Acid Rain Program to purchase CAIR allowances. However, the EPA analysis 23 5 The range included solid fuel fired cogeneration units from 25 MW to 250 MW.

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite indicates that most existing solid fuel fired cogeneration units affected by this rule will meet the proposed standard.

See TSD entitled " Cogeneration Unit Efficiency Calculations"

in the docket. To the extent any solid fuel fired cogeneration units cannot meet the efficiency standard and become affected units under the CAIR, the EPA believes that,

considering their relatively high emissions of SO2 and NOx compared to oil and gas fired units, it is important to require these sources to meet the efficiency standards or be subject to the emission limits under the CAIR Program.

Another commenter suggested that the efficiency standards should not apply to solid fuel fired cogeneration units because solid fuel fired unit efficiency is based on HHV ( higher heating value) while gas, or oil fired unit efficiency is based on LHV ( lower heating value). The EPA analyzed a range5 of solid fuel fired cogeneration units and calculated their efficiencies to see if they would meet the minimum efficiency standard. All of the units selected satisfied the proposed efficiency standard. See TSD entitled " Cogeneration Unit Efficiency Calculations" in the docket. As a result, the EPA believes that most solid fuel 24 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite fired cogeneration units will meet the proposed efficiency standard. The efficiency standard the EPA is adopting is the Public Utility Regulatory Act ( PURPA) of thermal efficiency of 42.5 percent. See TSD entitled, " Cogeneration Unit Efficiency Calculations" for further discussion, is based on LHV. If the efficiency of a solid fuel fired unit is expressed in terms of HHV, it can easily be converted to LHV for purposes of determining whether it meets the efficiency standard. Therefore, the reason given by the commenter ( that solid fuel fired unit efficiency is expressed in terms of HHV) is not grounds for not applying an efficiency standard to these units. One commenter supported applying the same efficiency standard to solid fuel fired units as the EPA proposed. The EPA is finalizing its proposed cogeneration unit definition, which applies the same operating and efficiency standards to all units regardless of the type of fossil fuel burned.

b. One third Potential Electric Output Capacity The EPA is finalizing the 1/ 3 potential electric output capacity criteria in the NPR and SNPR. Under the proposals,

the following cogeneration units are EGUs: any cogeneration unit serving a generator with a nameplate capacity of greater than 25 MW and supplying more than 1/ 3 potential 25 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite electric output capacity and more than 219,000 MW hrs annually to any utility power distribution system for sale.

These criteria are similar to those used in the Acid Rain Program to determine whether a cogeneration unit is a utility unit and the NOx SIP Call to determine whether a cogeneration unit is an EGU or a non EGU. The primary difference between the proposed criteria and the 1/ 3 potential electric criteria for the Acid Rain and NOx SIP Call Programs is that these programs applied the criteria to the initial operation of the unit and then to 3 year rolling average periods while the proposed CAIR criteria are applied to each individual year starting with the commencement of operation. The EPA believes that using an individual year approach would streamline the application and administration of this exemption. No adverse comments were received on using an individual year approach as opposed to a 3 year rolling average. In addition, the criteria under the Acid Rain Program and the NOx SIP Call are applied somewhat differently to units commencing construction on or before November 15, 1990 and units commencing construction after November 15, 1990. Several commenters suggested exempting all cogeneration units under the PURPA instead of using the proposed criteria and cite the high efficiency of 26 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite cogeneration as a reason for a complete exemption. The EPA believes it is important to include in the CAIR Program all units, including cogeneration units, that are substantially in the business of selling electricity. The proposed 1/ 3 potential electric output criteria described above are intended to do that.

Inclusion of all units substantially in the electricity sales business minimizes the potential for shifting utilization, and emissions, from regulated to unregulated units in that business and thereby freeing up allowances,

with the result that total emissions from generation of electricity for sale exceed the CAIR emissions caps. The fact that units in the electricity sales business are generally interconnected through their access to the grid significantly increases the potential for utilization shifting.

One commenter suggested that the 1/ 3 of potential electric output capacity criteria be applied on an annual basis. The EPA agrees that the criteria should be applied annually. The proposed and final model cap and trade rules adopt that approach.

c. Clarifying " For Sale"

Several commenters requested the EPA confirm that, for 27 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite purposes of applying the 1/ 3 potential electric output criteria, simultaneous purchases and sales of electricity are to be measured on a " net" basis, as is done in the Acid Rain Program. At least one commenter suggested that the net approach also be applied to purchase and sales that are not simultaneous. For purposes of applying the 1/ 3 potential electric output criteria in the CAIR Program and the model cap and trade rules, EPA confirms that the only electricity that counts as a sale is electricity produced by a unit that actually flows to a utility power distribution system from the unit. Electricity that is produced by the unit and used on site by the electricity consuming component of the facility will not count, including cogenerated electricity that is simultaneously purchased by the utility and sold back to such facility under purchase and sale agreements under the PURPA. However, electric purchases and sales that are not simultaneous will not be netted; the 1/ 3 potential electric output criteria will be applied on a gross basis,

except for simultaneous purchase and sales. This is consistent with the approach taken in the Acid Rain Program.

d. Multiple Cogeneration Units Some commenters suggested aggregating multiple cogeneration units that are connected to a utility 28 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite distribution system through a single point when applying the 1/ 3 potential electric output capacity criteria. These commenters suggested that it is not feasible to determine which unit is producing the electricity exported to the outside grid. The EPA proposed to determine whether a unit is affected by the CAIR on an individual unit basis. This unit based approach is consistent with both the Acid Rain Program and the NOx SIP Call. The EPA considers this approach to be feasible based on experience from these existing programs, including for sources with multiple cogeneration units. The EPA is unaware of any instances of cogeneration unit owners being unable to determine how to apply the 1/ 3 potential electric output capacity criteria where there are multiple cogeneration units at a source.

In a case where there are multiple cogeneration units with only one connection to a utility power distribution system, the electricity supplied to the utility distribution system can be apportioned among the units in order to apply the 1/ 3 potential electric output capacity criteria. A reasonable basis for such apportionment must be developed based on the particular circumstances. The most accurate way of apportioning the electricity supplied to the utility power distribution system seems to be apportionment based on 29 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite the amount of electricity produced by each unit during the relevant period of time.

Exemption for Independent Power Production ( IPP) Facilities:

Some commenters stated that certain IPP facilities are exempt from the Acid Rain Program and that they should also be exempt from the CAIR Program and model cap and trade rules. Under the Acid Rain Program, an IPP facility that has, as of November 15, 1990, a qualifying power purchase commitment ( including a sales price) to sell at least 15 percent of planned net output capacity and has installed net output capacity not exceeding 130 percent of planned net output capacity is exempt. However, if the power purchase commitment changes after November 15, 1990 in a way that allows the cost of compliance with the Acid Rain Program to be shifted to the purchaser, then the IPP facility loses the exemption. For example, expiration or termination of the power purchase commitment or modification so that the price is increased ( e. g., changed to a market price) results in loss of the exemption. The purpose of the exemption is to protect IPP facilities subject to contract prices that were set before passage of the CAA Amendments of 1990 ( including the Acid Rain Program in title IV) and that did not allow passthrough of the costs of Acid Rain Program compliance. 30 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite However, the EPA maintains that this exemption was aimed at easing the transition of such facilities into the Acid Rain Program and that there is no basis for maintaining this exemption for every subsequent cap and trade program. In addition, this exemption was not used in the NOx SIP Call.

D. How Are Emission Allowances Allocated to Sources?

It is important to have consistency on a State by State basis with the basic requirements of the cap and trade approach when implementing a multi State cap and trade program. This will ensure that: the integrity of the cap and trade approach is preserved so that the required emissions reductions are achieved; the compliance and administrative costs are minimized; and source owners and operators are equitably treated. However, the EPA believes that some limited differences, such as allowance allocation methodologies for NOx allowances, are possible without jeopardizing the environmental and other goals of the program.

1. Allocation of NOx and SO2 Allowances.

Each State participating in EPA administered cap and trade programs must develop a method for allocating ( i. e.,

distributing) an amount of allowances authorizing the emissions tonnage of the State's CAIR EGU budget. For NOx 31 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite allowances, each State has the flexibility to allocate its allowances however they choose, so long as certain timing requirements are met.

For SO2, as noted in the January 2004 proposal, States will have no discretion in their allocation approach since the CAIR SO2 cap and trade program uses title IV SO2 allowances, which have been already allocated in perpetuity to individual units by title IV of the CAA.

a. Required Aspects of a State NOx Allocation Approach.

While it is the EPA's intent to provide States with as much flexibility as possible in developing allocation approaches, there are some aspects of State allocations that must be consistent for all States. All State allocation systems are required to include specific provisions that establish when States notify the EPA and sources of the unit by unit allocations. These provisions establish a deadline for each State to submit to the EPA its unit by unit allocations for processing into the electronic allowance tracking system. Since the Administrator will then expeditiously record the submitted allowance allocations, sources will thereby be notified of, and have access to, allocations with a minimum lead time ( about 3 years) before the allowances can be used to meet the NOx 32 6 If the deadline for States to submit SIPs is September of 2006, then this would result in notification period of less than 3 years for the first year of CAIR.

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite emission limit.

Today's action finalizes the proposal to require States to submit unit by unit allocations of allowances for a given year no less than 3 years prior to January 1 of the allowance vintage year, which approach was supported by commenters. 6 Requiring States to submit allocations and thereby provide a minimum lead time before the allowances can be used to meet the NOx emission limit ensures that an affected source   regardless of the State in the CAIR region in which the unit is located   will have sufficient time to plan for compliance and implement their compliance planning.

Allocating allowances less than 3 years in advance of the compliance year may reduce a CAIR unit's ability to plan for and implement compliance and, consequently, increase compliance costs. For example, a shorter lead time would reduce the period for buying or selling allowances and could prevent sources from participating in allowance futures markets, a mechanism for hedging risk and lowering costs.

Further, requiring a uniform, minimum lead time for submission of allocations allows the EPA to perform its allocation recordation activities in a coordinated and 33 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite efficient manner in order to complete expeditiously the recordation for the entire CAIR region and thereby promote a fair and competitive allowance market across the region.

These minimum requirements apply to the NOx allocation approach and are not relevant for the SO2 cap and trade program, which relies on title IV allowances.

b. Flexibility and Options for a State NOx Allowance Allocations Approach.

Allowance allocation decisions in a cap and trade program raise essentially distributional issues, as economic forces are expected to result in economically efficient and environmentally similar outcomes regardless of the manner in which allowances are initially distributed. Consequently,

for CAIR NOx allowances, States are given latitude in developing their allocation approach. NOx allocation methodology elements for which States will have flexibility include:

The cost of the allowance distribution ( e. g., free distribution or auction);

The frequency of allocations ( e. g., permanent or periodically updated);

The basis for distributing the allowances ( e. g.,

heat input or power output); and, 34 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite

The use of allowance set asides and their size, if used ( e. g., new unit set asides or set asides for energy efficiency, for development of Integrated Gasification Combined Cycle ( IGCC) generation, for renewables, or for small units).

Some commenters have argued against giving States flexibility in determining NOx allocations, citing concerns about complexity of operating in different markets and about the robustness of the trading system. The EPA maintains that offering such flexibility, as it did in the NOx SIP Call, does not compromise the effectiveness of the trading program.

A number of commenters have argued against allowing ( or requiring) the use of allowance auctions, while others did not believe that the EPA should recommend auctions. For today's final action, while there are some clear potential benefits to using auctions for allocating allowances ( as noted in the SNPR), the EPA believes that the decision regarding utilizing auctions should ultimately be made by the States. Therefore, EPA is not requiring, restricting,

or barring State use of auctions for allocating allowances.

A number of commenters supported allowing the use of allowance set asides for various purposes. In today's final 35 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite action, the EPA is leaving the decision on using set asides up to the States, so that States may craft their allocation approach to meet their State specific policy goals.

i. Example Allowance Allocation Methodology In the SNPR, EPA included an example ( offered for informational guidance) of an allocation methodology that includes allowances for new generation and is administratively straightforward. In today's preamble, EPA is including in today's preamble, this " modified output"

example allocations approach, as was outlined in the SNPR.

The EPA maintains that the choice of allocation methodology does not impact the achievement of the specific environmental goals of the CAIR Program. This methodology is offered simply as an example, and individual States retain full latitude to make their own choices regarding what type of allocation method to adopt for NOx allowances and are not bound in any way to adopt the EPA's example.

This example method involves input based allocations for existing fossil units, with updating to take into account new generation on a modified output basis. It also utilizes a new source set aside for new units that have not yet established baseline data to be used for updating.

Providing allowances for new sources addresses a number of 36 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite commenter concerns about the negative effect of new units not having access to allowances.

Under the example method, allocations are made from the State's EGU NOx budget for the first five control periods ( 2009 through 2013) of the model cap and trade program for existing sources on the basis of historic baseline heat input. Commenters expressed some concern regarding the proposed January 1, 1998 cut off on line date for considering units as existing units. The cut off on line date was selected so that any unit meeting the cut off date would have at least 5 years of operating data, i. e., data for 1998 through 2002 ( which was the last year for which annual data was available). The EPA is still concerned with ensuring that particular units are not disadvantaged in their allocations by having insufficient operating data on which to base the allocations. The EPA believes that a 5 year window, starting from commencement of operation, gives units adequate time to collect sufficient data to provide a fair assessment of their operations. Annual operating data is now available for 2003. The EPA is finalizing January 1,

2001 as the cut off on line date for considering units as existing units since units meeting the cut off date will have at least 5 years of operating data ( i. e., data for 37 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite 2001 through 2005).

The allowances for 2014 and later will be allocated from the State's EGU NOx budget annually, 6 years in advance, taking into account output data from new units with established baselines ( modified by the heat input conversion factor to yield heat input numbers). As new units enter into service and establish a baseline, they are allocated allowances in proportion to their share of the total calculated heat input ( which is existing unit heat input plus new units' modified output). Allowances allocated to existing units slowly decline as their share of total calculated heat input decreases with the entry of new units.

After 5 years of operation, a new unit will have an adequate operating baseline of output data to be incorporated into the calculations for allocations to all affected units. The average of the highest 3 years from these 5 years will be multiplied by the heat input conversion factor to calculate the heat input value that will be used to determine the new unit's allocation from the pool of allowances for all sources.

Under the EPA example method, existing units as a group will not update their heat input. This will eliminate the potential for a generation subsidy ( and efficiency loss) as 38 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite well as any potential incentive for less efficient existing units to generate more. This methodology will also be easier to implement since it will not require the updating of existing units' baseline data. Retired units will continue to receive allowances indefinitely, thereby creating an incentive to retire less efficient units instead of continuing to operate them in order to maintain the allowances allocations.

Moreover, new units as a group will only update their heat input numbers once  for the initial 5 year baseline period after they start operating. This will eliminate any potential generation subsidy and be easier to implement,

since it will not require the collection and processing of data needed for regular updating.

The EPA believes that allocating to existing units based on a baseline of historic heat input data ( rather than output data) is desirable, because accurate protocols currently exist for monitoring this data and reporting it to the EPA, and several years of certified data are available for most of the affected sources. The EPA expects that any problems with standardizing and collecting output data, to the extent that they exist, can be resolved in time for their use for new unit calculations. Given that units keep 39 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite track of electricity output for commercial purposes, this is not likely to be a significant problem.

A number of commenters expressed support for the EPA's proposal in the SNPR that the heat input data for existing units be adjusted by multiplying it by different factors based on fuel type. Contrary to some commenters' claims,

determining allocations with fuel factors would not create disincentives for efficiency. With the use of a single baseline for existing units, neither adjusted input, nor input, nor output based allocations would provide additional incentives for energy efficiency. All sources have incentives to reduce emissions ( improving efficiency is a way of doing this) as a result of the cap and trade program,

not because of the choice of an allocation based on a single historic baseline.

The EPA acknowledges that since allowances have value,

different allocations of allowances clearly do impact the distribution of wealth among different generators. However,

in general, the economics of power generation dictate that generators selling power will seek to operate ( and burn fuel) to meet energy demand in a least cost manner. The cost of the power generated ( reflecting the bid price per megawatt hour) will include the cost of allowances to cover 40 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite emissions, whether the generator uses allowances that it already owns, or whether it needs to purchase additional allowances. With a liquid market for allowances,

allocations for existing sources ( whose baseline does not change) are a sunk benefit or sunk cost, not impacting the existing generator's behavior on the margin. Thus, the use of fuel factors in our allocating method would not be expected to result in changes in generators' choices for fuel efficiency.

In its example allocation approach, the EPA is including adjustments of heat input by fuel type based on average historic NOx emissions rates by three fuel types ( coal, natural gas, and oil) for the years 1999 2002. As noted in the SNPR, such calculations would lead to adjustment factors of 1.0 for coal, 0.4 for gas and 0.6 for oil. The factors would reflect the inherently different emissions rates of different fossil fired units ( and consequently also reflect the different burdens to control emissions.

However, allocating to new ( not existing) sources on the basis of input ( and particularly fuel adjusted heat input) would serve to subsidize less efficient new generation. For a given amount of generation, more 41 7 Energy Information Administration, " Annual Energy Outlook 2004, With Projections to 2025", January 2004. Assumptions for the NEMS model. http:// www. eia. doe. gov/ oiaf/ archive/ aeo04/ assumption/ tbl38. h tml Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite efficient units will have the lower fuel input or heat input. Allocating to new units based on heat input could encourage the building of less efficient units since they would get more allowances than an equivalent efficient,

lower heat input unit. The modified output approach, as described below, will encourage new, clean generation, and will not reward less efficient new coal units or less efficient new gas units.

Under the example method, allowances will be allocated to new units of each fuel type with an appropriate baseline on a " modified output" basis. The new unit's modified output will be calculated by multiplying its gross output by a heat rate conversion factor of 7,900 btu/ kWh for coal units and 6,675 btu/ kWh for oil and gas units. The 7,900 btu/ kWh value for the conversion factor for new coal units is an average of heat rates for new pulverized coal plants and new IGCC coal plants ( based upon assumptions in EIA's Annual Energy Outlook ( AEO) 20047). The 6,675 btu/ kWh value for the conversion factor for new gas units is an average of heat rates for new combined cycle gas units ( also based upon 42 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite assumptions in EIA's AEO 2004). A single conversion rate for each fuel type will create consistent and level incentives for efficient generation, rather than favoring new units with higher heat rates.

For new cogeneration units, their share of the allowances will be calculated by converting the available thermal output ( btu) of useable steam from a boiler or useable heat from a heat exchanger to an equivalent heat input by dividing the total thermal output ( btu) by a general boiler/ heat exchanger efficiency of 80 percent.

New combustion turbine cogeneration units will calculate their share of allowances by first converting the available thermal output of useable steam from a heat recovery steam generator ( HRSG) or useable heat from a heat exchanger to an equivalent heat input by dividing the total thermal output ( btu) by the general boiler/ heat exchanger efficiency of 80 percent. To this they will add the electrical generation from the combustion turbine, converted to an equivalent heat input by multiplying by the conversion factor of 3,413 btu/ kWh. This sum will yield the total equivalent heat input for the cogeneration unit.

Steam and heat output, like electrical output, is a useable form of energy that can be utilized to power other 43 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite processes. Because it would be nearly impossible to adequately define the efficiency in converting steam energy into the final product for all of the various processes,

this approach focuses on the efficiency of a cogeneration unit in capturing energy in the form of steam or heat from the fuel input.

Commenters expressed concern about a single conversion factor, arguing for different factors for different fuels and technologies. The EPA recognizes these concerns and agrees that different new fossil generation units have inherently different heat rates, largely dictated by the technology needed to burn different fuels. A single conversion rate for all units would provide new gas fired combined cycle units with relatively more allowances,

relative to their emissions, than it would for new coalfired units.

The EPA maintains that providing each new source an equal amount of allowances per MWh of output, given the fuel it is burning, is an equitable approach. Since electricity output is the ultimate product being produced by EGUs, a single conversion factor for each fuel, based on output,

ensures that all new sources burning a particular fuel will be treated equally. 44 8 Some commenters stated that, if allocations were provided for non emitting new generation, they also should be provided to all such generation, including nuclear units.

9 For instance, would the addition of a single new wind turbine at a wind farm constitute a " new unit"?

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite Some commenters support allocating allowances to all new generation, not just fossil fuel fired CAIR units. The EPA notes that including new non CAIR and non fossil units in the allowance distribution would raise issues, about which the EPA lacks sufficient information for resolution at this time for the EPA's example method. It would be necessary to clearly define what types of generating facilities that could participate and what would constitute " new" non fossil generation. 8 Commenters did not provide any analysis of the impact of possible definitions on generation mix, or electricity markets. Further, in order to include all generation, there would be a need to establish application and data collections procedures and determine appropriate size cut offs and boundaries of this generation  since in many such instances there is no clear analog to discrete fossil " units". 9 There also are associated issues about developing appropriate measurement and data reporting requirements for such sources.

Commenters supporting this approach did not address any of 45 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite these matters in any detail. However, the EPA encourages States that are interested in including such units in their updating allocations to consider potential solutions and include them in their SIPs. Under the example method, new units that have entered service, but have not yet started receiving allowances through the update, will receive allowances each year from a new source set aside. The new source allowances from the set aside will be distributed based on their actual emissions from the previous year.

Such an allocation approach will generally provide new units sufficient allowances to cover their emissions during the interim period before the units are allocated allowances on the same basis as existing units.

Today's example method includes a new source set aside equal to 5 percent of the State's emission budget for the years 2009 2013 and 3 percent of the State's emission budget for the subsequent years. In the SNPR, the EPA proposed a level 2 percent set aside for all years.

Commenters noted their concern that the amount of the set aside in the early years of the program should be higher to reflect the fact that the set aside will initially need to accommodate all new units entering into service from 1998 46 10 As noted earlier in this section, the EPA is now considering new units to be those that went online after January 1, 2001 rather than 1998.

Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite through 2010.10 In order to estimate the need for allocations for new units, the EPA looked at the NOx emissions from units that went online starting in 1999 as projected by the Integrated Planning Model ( IPM) runs modeling CAIR for the years 2010 and 2015. These IPM emissions projections indicated over 57,000 tons of NOx emissions in 2010 and about 74,000 tons of NOx emission by 2015 from new sources need to be covered under set asides throughout the CAIR region. The 2010 number represents almost 4 percent of the Phase I NOx regional cap, while the 2015 number represents about 6 percent of the Phase I regional cap. Consequently, today's example method includes a 5 percent set aside for the initial period ( 2009 2013).

It should be noted that by 2014, the set aside would need to cover new sources from the entire period 2004 2013.

The choice of a 3 percent new source set aside,

starting in 2014, reflects concerns that adequate allowances be provided for the 10 years of new units to be covered by the set aside in 2014 and subsequent years. ( The set aside in 2014, for example, would need to accommodate all units that went on line between 2004 and 2013). 47 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite Individual States using a version of the example method may want to adjust this initial 5 year set aside amount to a number higher or lower than 5 percent to the extent that they expect to have more or less new generation going online during the 2001 2013 period. They may also want to adjust the subsequent set aside amount to a number higher or lower than 3 percent to the extent that they expect more or less new generation going on line after 2004. States may also want to set this percentage a little higher than the expected need, since, in the event that the amount of the set aside exceeds the need for new unit allowances, the State may want to provide that any unused set aside allowances will be redistributed to existing units in proportion to their existing allocations.

For the example method, the EPA is finalizing the approach that new units will begin receiving allowances from the set aside for the control period immediately following the control period in which the new unit commences commercial operation, based on the unit's emissions for the preceding control period. Thus, a source will be required to hold allowances during its start up year, but will not receive an allocation for that year.

States will allocate allowances from the set aside to all new units in any given year as a group. If there are 48 11 With the alternate approach from the NOx SIP Call, States could distribute a new source set aside for a control period based on full utilization rates, at the end of the year the actual allowance allocation would be adjusted to account for actual unit utilization/ output, and excess allowances would be returned and redistributed, first taking into account new unit requests that were not able to be addressed. Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite more allowances requested than in the set aside, allowances will be distributed on a pro rata basis. Allowance allocations for a given new unit in following years will continue to be based on the prior year's emissions until the new unit establishes a baseline, is treated as an existing unit, and is allocated allowances through the State's updating process. This will enable new units to have a good sense of the amount of allowances they will likely receive

in proportion to their emissions for the previous year.

This methodology will not provide allowances to a unit in its first year of operation; however it is a methodology that is straightforward, reasonable to implement, and predictable.

In the SNPR, the example method from the NOx SIP Call model rule was proposed as an alternate approach. 11 However, the EPA has found this approach to be complicated for both the States and the EPA to implement. Additionally,

the NOx SIP Call approach would introduce a higher level of uncertainty for sources in the allocation process than 49 12 Auctions could provide States with a non distortionary source of revenue. Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite necessary.

While the EPA is offering an example allocation method with accompanying regulatory language, the EPA reiterates that it is giving States' flexibility in choosing their NOx allocations method so they may tailor it to their unique circumstances and interests. Several commenters, for instance, have noted their desire for full output based allocations ( in contrast to the hybrid approach in the example above). In the past, EPA had sponsored a work group to assist States wishing to adopt output based NOx allocations for the NOx SIP Call and believes it is a viable approach worth considering. Documents from meetings of this group and the resulting guidance report ( found at http:// www. epa. gov/ airmarkets/ fednox/ workgrp. html) together with additional resources such as the EPA sponsored report " Output Based Regulations: A Handbook for Air Regulators"

( found at http:// www. epa. gov/ cleanenergy/ pdf/ output_ rpt. pdf)

can help States, should they choose to adopt any outputbased elements in their allocation plans.

As an another alternative example, States could decide to include elements of auctions into their allowance allocation programs. 12 An example of an approach where CAIR 50 13 5 percent of the allowances would go to a new source setaside Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite NOx allowances could be distributed to sources through a combination of an auction and a free allocation is provided below.

During the first year of the trading program, 94 percent of the NOx allowances could, for example, be allocated to affected units with an auction held for the remaining 1 percent of the NOx allowances13. Each subsequent year, an additional 1 percent of the allowances ( for the first 20 years of the program), and then an additional 2.5 percent thereafter, could be auctioned until eventually all the allowances are auctioned. With such a system, for the first 20 years of the trading programs, the majority of allowances would be distributed for free via the allocation. Allowances allocated for these earlier years are generally more valuable than allowances allocated for later years because of the time value of money. Thus, most emitting units would receive relatively more allowances in the early years of the program, when they are facing the expenses of taking actions to control their emissions. Even though the proportion of allowances allocated to existing sources declines in the later years of the program, these sources receive for free a very significant share of the 51 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite total value of allowances ( because the discounted present value of allowances allocated in the early years of the program is greater than the discounted present value of the allowances auctioned later).

Auctions could be designed by the State to promote an efficient distribution of allowances and a competitive market. Allowances would be offered for sale before or during the year for which such allowances may be used to meet the requirement to hold allowances. States would decide on the frequency and timing of auctions. Each auction would be open to any person, who would submit bids according to auction procedures, a bidding schedule, a bidding means, and by fulfilling requirements for financial guarantees as specified by the State. Winning bids, and required payments, for allowances would be determined in accordance with the State program and ownership of allowances would be recorded in the EPA Allowance Tracking System after the required payment is received.

The auction could be a multiple round auction.

Interested bidders would submit before the auction, one or more initial bids to purchase a specified quantity of NOx allowances at a reserve price specified by the State,

specifying the appropriate account in the Allowance Tracking System in which such allowances would be recorded. Each bid 52 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite would be guaranteed by a certified check, a funds transfer,

or, in a form acceptable to the State, a letter of credit for such quantity multiplied by the reserve price. For each round of the auction, the State would announce current round reserve prices for NOx and determine whether the sum of the acceptable bids exceeds the quantity of such allowances,

available for auction. If the sum of the acceptable bids for NOx allowances exceeds the quantity of such allowances the State would increase the reserve price for the next round. After the auction, the State would publish the names of winning and losing bidders, their quantities awarded, and the final prices. The State would return payment to unsuccessful bidders and add any unsold allowances to the next relevant auction.

In summary, today's action provides, for States participating in the EPA administered CAIR NOx cap and trade program, the flexibility to determine their own methods for allocating NOx allowances to their sources. Specifically,

such States will have flexibility concerning the cost of the allowance distribution, the frequency of allocations, the basis for distributing the allowances, and the use and size of allowance set asides.

E. What Mechanisms Affect the Trading of Emission Allowances? 53 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite 1. Banking a. The CAIR NPR and SNPR Proposal for the Model Rules and Input from Commenters Banking is the retention of unused allowances from 1 calendar year for use in a later calendar year. Banking allows sources to make reductions beyond required levels and " bank" the unused allowances for use later. Generally speaking, banking has several advantages: it can encourage earlier or greater reductions than are required from sources, stimulate the market and encourage efficiency, and provide flexibility in achieving emissions reductions goals.

When sources reduce their SO2 and NOx emissions in the early phases, the cap and trade program creates an emissions " glide path" that provides earlier environmental benefits and lower cost of compliance. This " glide path" does allow emissions to exceed the cap and trade program budget   especially in the initial years after the adoption of a more stringent cap. The use of banked allowances from the Acid Rain and NOx SIP Call Programs in the CAIR NOx and SO2 cap and trade programs is discussed below in section VIII. F of this preamble.

The January 30, 2004 CAIR NPR and June 10, 2004 CAIR SNPR proposed that the CAIR NOx and SO2 cap and trade programs allow banking and the use of banked allowances 54 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite without restrictions. Allowing unrestricted banking and the use of banked allowances is consistent with the existing Acid Rain SO2 cap and trade program. The NOx SIP Call cap and trade program, however, has some restrictions on the use of banked allowances, a procedure called " flow control,"

described in detail in the June 10, 2004 CAIR SNPR.

Comments Regarding Unrestricted Banking after the Start of the CAIR NOx and SO2 Cap and Trade Programs Many commenters supported the EPA's proposal to allow unrestricted banking and the use of banked allowances for both SO2 and NOx, agreeing that flow control is a complex and confusing procedure with undemonstrated environmental benefit. Further, they agreed that banking with no restrictions on use will encourage early emissions reductions, stimulate the trading market, encourage efficient pollution control, and provide flexibility to affected sources in meeting environmental objectives.

Other commenters objected to the EPA's proposal to allow unrestricted use of banked allowances. All of these commenters supported some use of flow control in the CAIR cap and trade programs, most supporting its use for both SO2 and NOx.

Some commenters disagreed with the EPA's assessment that the use of flow control in the Ozone Transport 55 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite Commission ( OTC) cap and trade program was complicated to understand and implement and caused market complexity. One commenter further elaborated that flow control was accepted by industry. Another commenter claimed that the EPA has not analyzed the impact of the flow control mechanism.

Some commenters supportive of flow control stated that flow control was " successful" in the OTC and NOx SIP Call trading programs and " worked well" and " achieved the desired effect," without supporting those statements.

b. The Final CAIR Model Rules and Banking The EPA acknowledges that the OTC NOx cap and trade program has functioned for several years despite the complexity introduced by the flow control procedures.

Industry and other allowance traders have adapted to these complex procedures, yet there are ongoing questions from the regulated community about how the procedures actually work.

As an example, one commenter, while disagreeing with the EPA's assertion that flow control is overly complex, goes on to describe incorrectly the implementation of flow control.

The NOx SIP Call cap and trade program includes similar procedures but flow control was not triggered in the first 2 years of the program ( 2003 and 2004), so there is no experience to be drawn from that program.

The EPA maintains that the benefits of utilizing these 56 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite complex procedures is questionable. The EPA has analyzed the use of the flow control procedures in a paper released in March 2004, " Progressive Flow Control in the OTC NOx Budget Program: Issues to Consider at the Close of the 1999 to 2002 Period." The lessons learned from this analysis were as follows:

1) Flow control can create market pricing complexity and uncertainty. The need for implementation of flow control for a particular control period is not known more than a few months in advance, and the value of banked allowances varies from year to year, depending on whether flow control has been triggered for the particular year.

Therefore, when deciding how much to control, a source has some increased uncertainty about the value of any excess allowances it generates.

2) Flow control can have a bigger impact on small entities than on large entities. Large firms with multiple allowance accounts can shift banked allowances among those accounts to minimize the number of banked allowances surrendered at a discounted rate.

3) Flow control does not directly affect short term emissions, so it may not serve the environmental goals for which it was created.

Incorporating these lessons learned, the EPA is 57 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite finalizing the CAIR NOx and SO2 cap and trade programs with no flow control mechanism.

2. Interpollutant Trading Mechanisms a. The CAIR NPR Proposal for the Model Rules and Input from Commenters Mechanisms for interpollutant trading allow reduced emissions of one pollutant to be exchanged for increased emissions of another pollutant where both pollutants cause the same environmental problem ( e. g., are precursors of a third pollutant). Interpollutant trading mechanisms are typically based upon each precursor's contribution to a particular environmental problem and are often controversial and scientifically difficult to design because of the complexities of environmental chemistry. Determination of conversion factors ( i. e., transfer ratios that relate the impact of one pollutant to the impact of another pollutant)

can be dependent upon location, the presence of other pollutants that are necessary for chemical reactions, the time of emissions, and other considerations.

The January 30, 2004 CAIR NPR did not propose a specific interpollutant trading mechanism but rather took comment on interpollutant trading in general as well as the following specific issues:

( 1) What would be the exchange rate ( i. e., the transfer 58 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite ratio) for the two pollutants ( 2) How can the transfer ratio best achieve the goals of PM2.5 and ozone reductions in downwind States and,

( 3) How would the interpollutant trading accommodate the different geographic regions of the PM2.5 and ozone programs?

Comments Regarding the Potential Interpollutant Trading The EPA received several comments on interpollutant trading with the most commenters generally opposed to including provisions to allow for the interchangability of SO2 and NOx allowances.

Several commenters pointed out that the CAIR ozone attainment benefits result from the NOx emissions reductions, and contend that the EPA has not shown that SO2 emissions impact ozone. Therefore, the commmenters conclude that it would be inappropriate for SO2 allowances to be traded and used for compliance with the NOx cap. Some commenters supported the consideration or use of interpollutant trading if it was one directional, i. e., NOx allowances could be used for compliance with the SO2 allowance holding requirements, but not vice versa. This could result in fewer NOx emissions and more SO2 emissions.

Some commenters supported the consideration or use of interpollutant trading and emphasized the scientific 59 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite difficulty in developing accurate transfer ratios. Of these commenters, some added that interpollutant trading would be appropriate if the EPA conducted a thorough analysis of the potential impacts that interpollutant trading would have on:

nonattainment areas' ability to come into attainment; the allowance markets and prices; and the integrity of the NOx caps in light of the potentially large SO2 allowance bank that might be carried forward into the CAIR trading programs.

A few commenters noted that the EPA is directed by the CAA to study interpollutant trading and has approved SIPs that allow the trading of ozone precursors under specific circumstances.

b. Interpollutant Trading and the Final CAIR Model Rules Interpollutant trading can provide some additional compliance flexibility, and potentially lower compliance costs, if appropriately applied to multiple pollutants that have reasonably well known impacts on the same environmental problem. The EPA acknowledges that it has the authority to create interpollutant trading programs and has done so, in other regulatory contexts, in the past. However, for several reasons, the EPA determined that direct interpollutant trading is not appropriate in the CAIR.

The final CAIR includes separate annual SO2 and annual 60 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite NOx model rules to address PM2.5 precursor emissions, and an ozone season NOx model rule to address summertime ozone precursor emissions. The EPA believes it is not appropriate for the CAIR model rules to allow annual SO2 or NOx allowances to be used for compliance with ozone season NOx allowance holding requirements because this has the potential to adversely impact the ozone season emissions reductions and ozone air quality improvements from CAIR.

This is significant because the EPA, as required by the CAA,

has promulgated a national air quality standard for 8 hour ozone based on a determination that the standard is necessary to protect public health. Section 110( a) 2( D)

requires States to prohibit emissions in amounts that will significantly contribute to nonattainment in, or interfere with maintenance by, any other State with respect to any air quality standard, including ozone. In this rule, EPA has designed the annual ( SO2 and NOx) and ozone season ( NOx)

emission caps to achieve the emissions reductions necessary to address each State's significant contribution to downwind PM2.5 and ozone nonattainment, respectively, and to prevent interference with maintenance. If sources were permitted to use annual SO2 or annual NOx allowances for compliance with ozone season NOx allowance holding requirements ( i. e., the ozone season NOx cap), then there would be no assurance that 61 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite upwind States' ozone season NOx reduction obligations would be met, and CAIR's projected ozone improvements in downwind nonattainment areas could be significantly reduced. As a result, should interpollutant trading be permitted between the annual and ozone season programs, the EPA could not demonstrate that the use of a CAIR ozone season cap and trade program would result in the emissions reductions necessary to satisfy upwind States' obligations under section 110( a) 2( D) to reduce NOx for ozone purposes.

The EPA believes it is also inappropriate to use annual NOx allowances for compliance with the annual SO2 allowance holding requirements, and vice versa. The EPA agrees with commenters that emphasize that the chemical interactions for PM2.5 precursors are scientifically complex and must be accurately reflected in any transfer ratio in order to maintain the integrity of the market. For example, EPA analysis has shown ( see January 30, 2004 NPR) that PM2.5 precursors, such as NOx and SO2, may have non linear interactions in the formation of PM2.5. Any uniform,

interpollutant transfer ratio would have to be an average and would introduce significant variability concerning the impact of interpollutant trading on emissions and significant uncertainty concerning the achievement of the CAIR Program's emission reduction goals. The EPA did not 62 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite receive a response to the request in the January 30, 2004 NPR for information on an appropriate value for a potential transfer ratio. While the EPA did receive one comment that recommended the use of a trading ratio of two NOx allowances for one SO2 allowance, no comments presented supporting analysis that could be used to develop transfer ratios.

While many commenters supportive of allowing interpollutant trading in the CAIR claimed that it would provide additional compliance flexibility to sources, the EPA contends that use of the newly created CAIR trading markets is sufficiently flexible. Sources may develop integrated, multi pollutant control strategies and use the separate allowance markets to mitigate differences in control costs ( within the boundaries of emissions caps). In other words, a source can choose the level to which they can cost effectively control one pollutant and, if necessary,

buy or sell emission allowances of the other pollutant to compensate for any expensive or inexpensive control cost.

When markets are used to provide for trading of multiple pollutants, sources benefit from the additional compliance flexibility while the caps assure the achievement of the overarching environmental goals.

In the June 10, 2004 SNPR, the EPA solicited comment on how an interpollutant trading mechanism might accommodate 63 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite the slightly different geographic regions found to be significant contributors for PM2.5 and ozone under the CAIR.

No commenters provided supporting analysis or input on this issue.

In summary, the EPA received comments that generally opposed including a specific interpollutant trading mechanism. No commenters provided analysis to demonstrate the benefit of including a specific interpollutant trading mechanism nor was there analysis provided in response to the EPA's solicitation in the June 10, 2004 SNPR for input on:

transfer ratios, addressing two different environmental issues, and having slightly different annual NOx and ozone season NOx control regions. Furthermore, because the NOx and SO2 markets provide very flexible mechanisms for trading of the two pollutants, the EPA does not believe there is a compelling need to go further at this time. Therefore, EPA is not finalizing provisions in the CAIR model rules that specifically address interpollutant trades.

F. Are There Incentives for Early Reductions?

When sources reduce their SO2 and NOx emissions during the first phase of a multi phase cap and trade program, it creates the emissions " glide slope" of a cap and trade approach that provides early environmental benefit and 64 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite lowers the cost of compliance. Early reduction credits ( ERCs) can provide an incentive for sources to install and/ or operate controls before the implementation dates.

Allowing emission allowances from existing programs to be used for compliance in the new program is another mechanism to encourage early reductions prior to the start of a cap and trade program. This section discusses the potential use of mechanisms to provide incentives for early reductions in the CAIR.

1. Incentives for Early SO2 Reductions a. The CAIR NPR and SNPR Proposal for the Model Rules and Input from Commenters.

The January 30, 2004 CAIR NPR and June 10, 2004 CAIR SNPR acknowledge the benefit of early reductions and provide for the use of title IV SO2 allowances of vintage years 2009 and earlier to be used for compliance in the CAIR at a oneto one ratio. In other words, title IV allowances can be banked into the CAIR Program. This provides incentive for title IV sources to reduce their emissions in years 2009 and earlier because these allowances may be used for CAIR compliance without being discounted by the retirement ratios applied to the 2010 and later SO2 allowances. No other mechanism, such as SO2 ERCs were proposed by the EPA.

Comments Regarding the Incentives for Early SO2 Reductions 65 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite The EPA received comments on incentives for early SO2 reductions with the majority supporting the EPA proposal to encourage early emission reductions by allowing the CAIR sources to use 2009 and earlier vintage title IV SO2 allowances for CAIR compliance. Some supporters noted concerns in meeting the CAIR's stringent Phase I SO2 requirements as another reason to allow the banking of undiscounted title IV allowances into the CAIR.

Some commenters expressed concern that achieving the SO2 caps would be delayed if a large number of SO2 allowances were being banked into the CAIR. Based upon experience with implementing the Acid Rain Program, the EPA acknowledged in the SNPR that crediting early reductions does create a glide slope   where emissions are reduced below the baseline before the implementation date and " glide" down to the ultimate cap level sometime after the program begins. This gradual reduction in emissions is a key component to cap and trade programs having lower cost of compliance than command and control approaches. One commenter proposed that the EPA needs to assess the likelihood that allowing the banking of undiscounted title IV allowances would delay the attainment of the Phase I SO2 cap until Phase II. Because the EPA included this mechanism ( i. e., the use of 2009 and earlier vintage SO2 allowances 66 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite for compliance in the CAIR) in the policy case modeled as part of this rulemaking, EPA analysis includes the benefits and costs that would result from the level of SO2 reductions that would take place with banking of undiscounted title IV allowances.

One commenter advocated the use of SO2 ERCs. It was not clear whether these would be awarded in addition to banking title IV allowances into the CAIR or the ERC mechanism would take the place of banking SO2 allowances into the CAIR.

b. SO2 Early Reduction Incentives in the Final CAIR Model Rules.

The CAIR SO2 model rule allows CAIR sources to use title IV SO2 allowances of vintage 2009 and earlier for compliance with the CAIR at a one to one ratio. This approach was part of the CAIR policy case assumptions used in the rulemaking modeling and the EPA has shown that the SO2 cap and trade program, with this early incentive mechanism, will achieve the level of SO2 reductions needed to meet the CAIR goals. These reductions take place on a glide slope that includes early emissions reductions as well as some use of the SO2 allowance bank as sources gradually reduce emissions toward the cap levels.

The EPA did not include SO2 ERCs because the Acid Rain 67 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite Program cap and trade program, which affects a large segment of the CAIR source universe, makes it impossible to determine whether sources are reducing their SO2 emissions below levels required by existing ( i. e., the Acid Rain Program) programs. Furthermore, given that most sources with substantial emissions receive SO2 emission allowances under the Acid Rain Program, a significant number of SO2 allowances are expected to be banked into the CAIR. These banked allowances would be available to CAIR sources in the early years of the program and make ERCs largely unnecessary.

2. Incentives for Early NOx Reductions a. The CAIR NPR and SNPR Proposal for the Model Rules and Input from Commenters.

In the June 10, 2004 SNPR, the EPA proposed to provide incentives for early NOx reductions by allowing the use of NOx SIP Call allowances of vintage 2009 and earlier to be used for compliance in the CAIR. Further, the EPA did not propose, but solicited comment on the potential use of NOx ERCs to provide an additional incentive for sources to reduce NOx emissions prior to CAIR implementation. In addition to the general solicitation for comment on NOx ERCs, the EPA solicited input on the following specific approaches that could be utilized: ( 1) the EPA could 68 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite maintain the NOX SIP Call requirements and allow sources to use ERCs only for compliance with the annual limitation, to ensure that ozone season NOX limitations are met. Under this scenario, the additional States subject to the CAIR that have been found to significantly contribute to ozone nonattainment may also have to be included in the ozone season cap; ( 2) the EPA could limit the period of time during which ERCs could be created and banked; ( 3) the EPA could cap the amount of ERCs that can be created; and ( 4)

the EPA could apply a discount rate to ERCs.

Comments Regarding the Incentives for Early NOx Reductions The EPA did not receive comment on the proposed use of NOx SIP Call allowances of vintage years 2009 and earlier for compliance in the CAIR. In fact, several commenters characterized the CAIR proposal as not including any incentives for early NOx emissions reductions.

The EPA received several comments on the potential use of NOx ERCs with the majority in favor of some sort of ERC mechanism. Several commenters advocated the use of ERCs to mitigate concerns that they would not be able to meet the stringent Phase I CAIR reduction requirements. One commenter wanted early reductions to facilitate the ozone attainment in 2010 but believed 2010 attainment could only be helped if there were some restrictions on the number of 69 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite ERCs that could be created.

Some ERC supporters wanted credit for wintertime emissions reductions only, while a few believed that credit should be given for reductions at any time of year. One commenter advocated providing ERCs for wintertime reductions only as part of a broader proposal to create a bifurcated NOx trading system ( i. e., separate wintertime and summertime allowances and trading markets.)

Many of the commenters supporting the use of ERCs advocated that they be distributed from a pool of allowances similar to the CSP used in the NOx SIP Call. ( The NOx SIP Call CSP was a fixed pool of NOx allowances that were distributed on a first come first serve, prorated, or need basis, depending upon the State). Commenters noted that the CSP approach has already been part of a litigated rulemaking and provides the added benefit of limiting the total number of allowances that can be distributed for early reductions.

Other commenters proposed that should the final approach use a pool of allowances, this pool should not remove allowances from the existing State NOx budget. Another commenter suggested that allowances from a CSP could be distributed based upon a NOx emission rate, such as 0.25 lbs/ mmBtu.

Allowances could be distributed to any source emitting below the target emission rate. 70 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite Several commenters were concerned that too many NOx ERCs ( as well as NOx SIP Call allowances) could be introduced into the CAIR and the ability of the NOx cap and trade program to meet the annual and ozone season reduction goals could be compromised. Some commenters suggested that crediting early reductions at a discount ( e. g., two tons of NOx reductions earn 1 ERC) could mitigate this concern.

Other commenters noted that a CSP style mechanism also provides safeguards against an overabundance of ERCs.

Another commmenter noted that restrictions on the use of ERCs similar to the progressive flow control ( PFC) mechanism used in the NOx SIP Call   PFC restricts the use of banked NOx allowances for compliance in years where the NOx bank is greater than 10 percent of the allocations   could help to ease concerns of flooding the market with NOx ERCs.

One commenter believed that the EPA's projection that the potential pool of NOx ERCs could be as large as 3.7 million tons ( presented in the June 10, 2004 SNPR) is unrealistically high. The commenter contended that technical limitations of Selective Catalytic Reduction ( SCR)

operation would not permit facilities to simply run all of their SCRs year round. More specifically, the commenter believes the lower operating loads, typically of the wintertime dispatch, would not meet the minimum conditions 71 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite necessary for SCR operation ( i. e., at lower capacity the stack gas temperatures will not support the use of the catalyst). Fewer wintertime opportunities to operate the SCRs is believed by the commenter to result in a smaller projected ERC estimate. This was an estimate used for discussion purposes and was not directly used in the development of the CSP.

A few commenters advocated providing credits to any source that reduced emission rates below those used to determine the CAIR State budgets. One commenter suggested that the rates be based on those rates used to determine the NOx SIP Call caps.

A few commenters proposed that the EPA should develop a strategy for crediting NOx reductions from sources that have implemented control measures in response to State level regulations that are more stringent than the NOx SIP Call.

Another commenter advocated only providing ERCs in States subject to both the NOx SIP Call and the CAIR.

Some commenters did not support the use of NOx ERCs in any form. These commenters believe that the use of ERCs would delay attainment of the CAIR emission caps.

b. NOx Early Reduction Incentives in the Final CAIR Model Rules.

The CAIR ozone season NOx cap and trade rule will allow 72 14 The 200,000 ton pool includes the 1,503 tons that would be DE and NJ's share. Section V of today's action describes in detail the State by State apportionment of the total CSP. Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite the proposed use of NOx SIP Call allowances of vintage years 2008 and earlier for compliance in the CAIR. This mechanism would provide incentive for sources in NOx SIP Call States to reduce their ozone season NOx emissions and bank additional allowances into the CAIR. Because today's final ozone season cap and trade rule includes a mandatory ozoneseason NOx cap in 2009 ( this modification is discussed in section IV), the provisions to allow the banking of NOx SIP Call allowances into the CAIR are adjusted to reflect this implementation date.

The CAIR annual NOx cap and trade rule will provide additional incentives for early annual NOx reductions by creating a CSP for CAIR States from which they can distribute allowances for early, surplus NOx emissions reductions in the years 2007 and 2008. The earning of CAIR CSP allowances for NOx emission reductions does not begin until 2007 because this is the first year after the State SIP submittal deadlines. The CAIR CSP will provide a total of 200,00014 CAIR annual NOx allowances of vintage 2009 in addition to the annual CAIR NOx budgets.

The CAIR's CSP is patterned after the NOx SIP Call's 73 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite CSP, which is part of an established and extensively litigated rulemaking. Similarities include: limiting the total number of allowances that can be distributed; limiting the years in which CSP allowances can be earned; populating the CSP with allowances vintaged the first compliance year;

and using distribution criteria of early reductions and need.

The EPA will apportion the CSP to the States based upon their share of the final, regionwide NOx CAIR reductions.

Similar to the NOx SIP Call, States may distribute these CAIR NOx allowances to sources based upon either: ( 1) a demonstration by the source to the State of NOx emissions reductions in surplus of any existing NOx emission control requirements; or ( 2) a demonstration to the State that the facility has a " need" that would affect electricity grid reliability. Sources that wish to receive CAIR CSP allowances based upon a demonstration of surplus emissions reductions will be awarded one CAIR annual NOx allowance for every ton of NOx emissions reductions. ( Should a State receive more requests for allowances than their share of the CAIR CSP, the State would pro rate the allowance distribution.) Determination of surplus emissions must use emissions data measured using part 75 monitoring.

The EPA elected to include the CSP in response to 74 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite several comments noting the benefit of early NOx reductions and some commenters concerns in complying with the stringent Phase I CAIR NOx cap. While EPA analysis has shown that sources had sufficient time to install NOx emission controls, the EPA does believe that it would be appropriate to provide some mechanism to alleviate the concerns of some sources which may have unique issues with complying with the 2009 implementation deadline. In addition to mitigating some of the uncertainty regarding the EPA projections of resources to comply with CAIR, the CAIR CSP also effectively provides incentives for early, surplus NOx reductions.

The EPA agrees with the comments that advocate allowing sources to earn CAIR annual NOx allowances only for those reductions that are in surplus of the sources' existing NOx reduction requirements. By allowing sources in NOx SIP Call and non NOx SIP Call States to demonstrate that their yearround early reductions are truly " surplus" and, therefore,

deserving of CSP allowances, the EPA is responding to comments that the EPA should allow sources in non NOx SIP Call States to receive credit for early reductions. Some commenters advocated crediting sources in the ozone season NOx cap and trade program that emitted below the emission rate used to determine the ozone season budget. The EPA did not accept this recommendation because a source that is 75 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite allowed to bank NOx SIP Call allowances into the CAIR ozoneseason NOx program and receive early reduction credit from CAIR's CSP would be essentially " double counting" that emission reduction.

The EPA did not restrict the use of the NOx allowances awarded from the CSP because several aspects of the CSP already address concerns that too many total credits would be distributed and that they would flood the markets.

First, the CSP is a finite pool of NOx allowances. Second,

by requiring sources to reduce one ton of NOx emissions for every NOx allowance awarded from the CSP ensures that significant reductions are made prior to the CAIR implementation date.

G. Are There Individual Unit " Opt In" Provisions?

In the SNPR, EPA described a potential approach for allowing certain units to voluntarily participate in, or " opt in," to the CAIR. Originally, EPA proposed to have no opt in provision but included language in the SNPR on what a potential opt in provision may look like. This " potential"

opt in provision would have allowed non EGU boilers and turbines that exhaust to a stack or duct and monitor and report in accordance with part 75 to opt into the CAIR The opt in unit would have been required to opt in for both SO2 and NOx. The allocation method for opt ins assumed a 76 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite percentage SO2 reduction from a baseline and for NOx,

allocations were equal to a baseline heat input multiplied by a specified NOx emissions rate, the same NOx emissions rate EGUs were subject to in the assumed EGU budgets.

Allocations were updated annually and after opting in units would have had to stay in the CAIR for a minimum of 5 years.

The EPA received many comments in favor of and very few comments against including an opt in provision in the final rule. As a result, EPA is including an opt in provision in this final rule that is based on the approach described in the SNPR but includes several modifications and additions in response to comments as described below. In general, EPA believes there is value to including an opt in provision but believes that sources that opt in should be responsible for a certain level of reduction below its baseline because of the additional flexibility provided to that source by opting into a regional trading program and because of the possibility that participation in the CAIR may reduce or eliminate future potential required reductions. Therefore,

the following opt in approach has as its goals to provide more flexibility to the units opting in as well as to potentially provide more cost effective reductions for the affected EGUs but also to ensure a certain level of reduction from the units opting into the program. 77 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite 1. Applicability Some commenters suggested that the opt in provision not be limited to boilers and turbines but should be open to any unit. The EPA strongly believes that any unit participating in an emissions trading program be subject to accurate and reliable monitoring and reporting requirements. This is the purpose of part 75. The EPA has developed criteria for boilers and turbines to satisfy the requirements of part 75 but has not developed criteria for all non boilers and turbines and, therefore, cannot be confident their emissions can be monitored with the high degree of accuracy and reliability required by a cap and trade program. Continuous Emissions Monitoring Systems or " CEMS" are typically what is required by EPA to participate in a cap and trade program.

In response to comments received suggesting that non boilers and turbines be allowed to opt in, EPA is expanding applicability of the opt in provision to include,

in addition to boilers and turbines, other fossil fuel fired combustion devices that vent all emissions through a stack and meet monitoring, recordkeeping, and recording requirements of part 75.

2. Allowing Single Pollutant Some commenters suggested that sources should be allowed to opt in for only one pollutant instead of 78 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite requiring the source to opt in for both SO2 and NOx as EPA proposed. These commenters argued that some sources may only emit significant amounts of one of the two regulated pollutants and that it would not make sense to require reductions in both pollutants from such a source. The EPA agrees with this comment and will allow units to opt in for one pollutant, i. e., NOx, SO2, or both. Another commenter suggested that EPA allow non EGUs subject to the NOx SIP Call to opt into the CAIR for NOx only without requiring any reductions in SO2. This commenter argued that these non EGUs could simply turn on their SCRs during the non ozone season and easily achieve significant NOx reductions. The EPA agrees that the relatively small number of non EGUs subject to the NOx SIP Call that have SCRs could achieve significant NOx reductions by operating their SCRs during the non ozone season. As stated above, EPA is allowing sources to opt in for one pollutant and thus non

EGUs subject to the NOx SIP call may opt in for NOx only.

3. Allocation Method for Opt Ins In the SNPR, EPA proposed allocating allowances to optin units on a yearly basis. The amount of allowances allocated would be calculated by multiplying an emission rate by the lesser of a baseline heat input or the actual 79 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite heat input monitored at the unit in the prior year.

The baseline heat input would be calculated by using the most recent 3 years of quality assured part 75 monitoring data. When less than 3 years of quality assured part 75 monitoring data is available, the heat input would be based on quality assured part 75 monitoring data from the year before the unit opted in.

For SO2, EPA proposed that the emission rate used to calculate allocations would be the lesser of, the most stringent State or Federal SO2 emission rate that applied in the preceding year or the emission rate representing 50 percent of the unit's baseline SO2 emission rate ( in lbs/ mmBtu) for the years 2010 through 2014 and 35 percent of the unit's baseline SO2 emission rate ( in lbs/ mmBtu) for 2015 and beyond. For NOx, EPA proposed that the emission rate would be the lower of the unit's baseline emission rate, the most stringent State or Federal NOx emission limitation that applies to the opt in unit at any time during the calender year prior to opting into the CAIR Program, or 0.15 lb/ mmBtu for the years 2010 through 2014 and 0.11 lbs/ mmBtu for the years 2015 and beyond.

In today's final rule, EPA is making a number of changes to its proposed methodology for calculating allocations for opt in units. 80 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite With regards to baseline heat input, EPA is requiring that sources may only use part 75 monitored data for years in which they have maintained at least a 90 percent monitor availability. The EPA is making this change because part 75 contains missing data provisions that require substitution of data when monitors are unavailable. When units have low monitor availability, units are required to report more conservative ( e. g., higher) heat input values. This is to provide an incentive to maintain high monitor availability ( since under a cap and trade program sources would be required to turn in more allowances if they reported higher emissions). When setting baselines, sources have the opposite incentive, reporting a higher heat input would result in a higher baseline and thus a greater allocation.

With regards to the SO2 emission rate used to calculate allocations, EPA is requiring that the emission rate used to calculate allocations would be the lesser of, the most stringent State or Federal SO2 emission rate that applies to the unit in the year that the unit is being allocated for,

or the emission rate representing 70 percent of the unit's baseline SO2 emission rate ( in lbs/ mmBtu). The EPA is changing the percentage emission reduction upon which allocations are based because some commenters suggested that instead of using percentage emission reduction requirements 81 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite that are the same as the requirements for EGUs as a basis for allocating to opt ins, EPA should require emissions reductions based on similar marginal cost of control. The EPA agrees with the basic concept that emissions reductions for opt ins should be based on similar marginal costs. One commenter submitted results from a study of industrial boiler NOx and SO2 control costs that indicated the use of similar marginal cost of control would result in approximately a 30 percent reduction in NOx and SO2 by 2010.

While the commenter provided limited data to allow EPA to evaluate the commenter's estimates, EPA is using this percentage reduction requirement for the opt in provision.

The same commenter stated that it may be possible to achieve more than a 30 percent reduction in SO2 and NOx by 2015 by employing future unspecified technology advances. Because these future technology advances are not specified nor demonstrated, EPA is not requiring more than a 30 percent reduction in SO2 and NOx in 2015 and beyond for opt ins.

The EPA is changing the requirement to use the lowest required emission rate for the year preceding the year in which allowances are being allocated to the lowest emission rate for the year in which allowances are being allocated.

The EPA is making this change because EPA believes that such data should be available and that this more accurately 82 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite reflects the intent of the rule to ensure that the source is not being allocated a greater number of allowances than the emissions a source would be allowed to emit under the regulations it is subject to in the year the allocations are being made. The EPA is finalizing parallel provisions with respect to NOx.

4. Alternative Opt In Approach Some commenters suggested that EPA include an alternative approach to opting into the CAIR. This alternative would allow units to opt in as early as 2010 and receive allocations at their current emission levels in return for a commitment to make deeper reductions by 2015 than would be required under the general opt in provision described above. Therefore, for the years 2010 through 2014, the unit would be allocated allowances based on the same heat input used under the general opt in provision ( e. g., the lesser of the baseline heat input or the heat input for the year preceding the year in which allocations are being made) multiplied by an emission rate. This emission rate would be the lower of the emission rate for the year or years before the unit opted in or the the most stringent State or Federal emission rate required in the year that the unit opts in. For SO2 for the years 2015 and beyond, the unit would be allocated allowances based on the 83 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite same heat input multiplied by an emission rate. This emission rate would be the lower of a 90 percent reduction from the baseline emission rate or the most stringent State or Federal emission rate required in the baseline year. For NOx, the same methodology would be used, except that the emission rate used for the years 2015 and beyond would be the lower of 0.15 lbs/ mmBtu or the most stringent State or Federal emission rate required in the baseline year. The EPA believes the environmental benefit of achieving deeper emissions reductions in the future ( 2015) from sources that may otherwise not make such deep emissions reductions is worth including in this final rule.

5. Opting Out In the SNPR, EPA proposed that opt in units be required to remain in the program a minimum of 5 years after which time they could voluntarily withdraw from the CAIR. Some commenters expressed concern over this proposed approach,

arguing that because EGUs affected by the CAIR are not allowed to voluntarily withdraw from the CAIR that opt in sources should not be allowed to voluntarily withdraw either. The EPA recognizes that opt in sources such as industrial boilers and turbines tend to be more sensitive to changing market forces than EGUs. As a result, EPA believes it is appropriate to allow opt in sources who voluntarily 84 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite participate in an emissions reductions program to be able to end their participation or (" opt out") after a specified period of time. As proposed, EPA believes a period of 5 years is appropriate and is finalizing a rule to allow optin sources to opt out after participating in the CAIR for 5 years. This option to opt out after 5 years does not apply to sources that opt in under the alternative approach.

Sources that opt in under the alternative approach may not opt out at any time.

6. Regulatory Relief for Opt in Units The CAIR does not offer relief from other regulatory requirements, existing or future, for units that opt in to the CAIR cap and trade program. Any revision of requirements for other, non CAIR programs would be done under rulemakings specific to those programs.

As discussed above, EPA is including two different approaches for opt in units to follow, a general and an alternative approach. The EPA is including both approaches in this final rule in response to comments supportive of including an alternative means and to provide greater flexibility for sources to participate in the CAIR trading program. Opt in sources may select which approach is more appropriate for their particular situation. An opt in source may not switch from one approach to the other once in 85 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite the program. States have the flexibility to choose to include both of these approaches, one of these approaches,

or none of them in their SIPs. EPA is not requiring States to include an individual unit opt in provision because the participation of individual opt in units is not required to meet the goals of the CAIR. However, States cannot choose to have an individual unit opt in approach different than what EPA has finalized in this rule and still participate in the inter State trading program administered by EPA.

H. What Are the Source Level Emissions Monitoring and Reporting Requirements?

In the NPR, the EPA proposed that sources subject to the CAIR monitor and report NOx and SO2 mass emissions in accordance with 40 CFR part 75.

The model trading rules incorporate part 75 monitoring and are being finalized as proposed. The majority of CAIR sources are measuring and reporting SO2 mass emissions year round under the Acid Rain Program, which requires part 75 monitoring. Most CAIR sources are also reporting NOx mass emissions year round under the NOX SIP Call. The CAIRaffected Acid Rain sources that are located in States that are not affected by the NOx SIP Call currently measure and report NOx emission rates year round, but do not currently report NOx mass emissions. These sources will need to 86 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite modify only their reporting practices in order to comply with the proposed CAIR monitoring and reporting requirements.

Because so many sources are already using part 75 monitoring, there were very few comments on the source level monitoring requirements in this rulemaking. The comments the EPA received related to sources not currently monitoring under part 75. Commenters suggested that alternative forms of monitoring ( e. g., part 60 monitoring) would be appropriate for these sources. The EPA disagrees.

Consistent, complete and accurate measurement of emissions ensures that each allowance actually represents one ton of emissions and that one ton of reported emissions from one source is equivalent to one ton of reported emissions from another source. Similarly, such measurement of emissions ensures that each single allowance ( or group of SO2 allowances, depending upon the SO2 allowance vintage)

represents one ton of emissions, regardless of the source for which it is measured and reported. This establishes the integrity of each allowance, which instills confidence in the underlying market mechanisms that are central to providing sources with flexibility in achieving compliance.

Part 75 has flexibility relating to the type of fuel and emission levels as well as procedures for petitioning for 87 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite alternatives. The EPA believes this provides the requested flexibility.

Should a State( s) elect to use the example allocation approach, the EPA would modify the part 75 monitoring and reporting requirements to collect information used in determining the allowance allocations for Combined Heat and Power ( CHP) units. More specifically, provisions for the monitoring and reporting of the BTU content of the steam output would be added to the existing requirements. The information on electricity output currently reported under part 75 would not need to be revised to allow States to implement the example allowance allocation approach.

In the SNPR, the EPA proposed continuous measurement of SO2 and NOX emissions by all existing affected sources by January 1, 2008 using part 75 certified monitoring methodologies. New sources have separate deadlines based upon the date of commencement of operation, consistent with the Acid Rain Program. These deadlines are finalized as proposed.

I. What is Different between CAIR's Annual and Seasonal NOx Model Cap and Trade Rules?

Today's action finalizes not only the proposed CAIR annual NOx program and annual SO2 program, but also a CAIR 88 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite ozone season NOx program. Because the CAIR ozone season NOx program is the only ozone season NOx cap and trade program that the EPA will administer, NOx SIP Call States wishing to meet their NOx SIP Call obligations through an EPAadministered regional NOx program will also use the CAIR ozone season rule. The EPA believes that States and affected sources will benefit from having a single,

consistent regional NOx cap and trade program. This section of today's action highlights any key differences between the CAIR ozone season NOx model rule and the NOx SIP Call model rule, as well as the CAIR annual and ozone season NOx model rules.

Differences Between the CAIR Ozone Season NOx Model Rule and the NOx SIP Call Model Rule While the CAIR ozone season NOx model rule closely mirrors the NOx SIP Call rule ( as does the other CAIR rules), the EPA has incorporated into the CAIR model rules its experience with implementing trading programs ( including seasonal NOx programs). These modifications include the following.

Unrestricted banking: The CAIR ozone season NOx model rule will not include any restrictions on the banking of NOx SIP Call allowances ( vintages 2008 and earlier)

or CAIR ozone season NOx allowances. The NOx SIP Call 89 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite rules include " progressive flow control" provisions that reduce the value of banked allowances in years where the bank is above a certain percentage of the cap. ( See section VIII. E. 1 of today's rule for a detailed discussion).

Facility level compliance: The CAIR ozone season NOx model rule will allow sources to comply with the allowance holding requirements at the facility level.

The NOx SIP Call rules required unit by unit level compliance with certain types of allowance accounts providing some flexibility for sources with multiple affected units. ( See the June 2004 SNPR, section IV for a detailed discussion).

The EPA believes that these changes improve the programs and that both CAIR and NOx SIP Call affected sources will benefit from complying with a single, regionwide cap and trade program.

Differences Between the CAIR Ozone Season and Annual NOx Model Rules The CAIR ozone season and annual NOx model rules are designed to be identical with the exception of ( 1)

provisions that relate to compliance period and ( 2) the mechanism for providing incentives for early NOx reductions.

For compliance related provisions, the EPA attempted to 90 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite maintain as much consistency as possible between the CAIR annual and ozone season NOx model rules. For example,

reporting schedules remain synchronized ( i. e., quarterly reporting) for both of the CAIR NOx model rules. For the annual and ozone season NOx model rules, the EPA did define 12 month and 5 month compliance periods, respectively.

Incentives for early NOx reductions differ between the CAIR annual and ozone season programs. For the annual NOx program, early reductions may be rewarded by States through a CSP. ( See section VIII. F. 2 of today's action for a detailed discussion.) The CAIR ozone season NOx model rule provides incentive for early emissions reductions by allowing the banking of pre 2009 NOx SIP Call allowances into the CAIR ozone season program.

J. Are There Additional Changes to Proposed Model Cap and Trade Rules Reflected in the Regulatory Language?

The proposed and final rules are modeled after, and are largely the same as, the NOx SIP Call model trading rule.

Today's final rule includes some relatively minor changes to the model rules' regulatory text that improve the implementability of the rules or clarify aspects of the rules identified by the EPA or commenters. ( Note that sections VIII. B through VIII. H of today's action highlight the more significant modifications included in the final 91 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite model rules).

One example of a relatively minor change is the inclusion of language in the SO2 model rule that implements the retirement ratio ( 2.00) used for allowances allocated for 2010 to 2014 and the retirement ratio ( 2.86) used for allowances allocated for 2015 and later, that clarifies the compliance deduction process and that provides for roundingup of fractional tons to whole tons of excess emissions.

More specifically, the definition of " CAIR SO2 allowance"

states that an allowance allocated for 2010 to 2014 authorizes emissions of 0.50 tons of SO2 and that an allowance allocated for 2015 or later authorizes emissions of 0.35 tons of SO2   which corresponds with the 2.86 retirement ratio.

Other, less significant modifications were also included in the regulatory text of the final model rules.

These include:

Units and sources are identified separately for NOx and SO2 programs ( e. g., CAIR NOx units, CAIR Nox ozone season units, and CAIR SO2 units) since States can participate in one, two, or three trading programs;

The definition of " nameplate capacity" is clarified;

The language on closing of general accounts is clarified; and, 92 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite

Process of recordation of CAIR SO2 allowance allocations and transfers on rolling 30 year periods is added to make it consistent with Acid Rain regulations.

Another example of where today's final model trading rules incorporate relatively minor changes from the proposed model trading rules involves the provisions in the standard requirements concerning liability under the trading programs. The proposed CAIR model NOX and SO2 trading rules include, under the standard requirements in § 96.106( f)( 1)

and ( 2) and § 96.206( f)( 1) and ( 2), provisions stating that any person who knowingly violates the CAIR NOx or SO2 trading programs or knowingly makes a false material statement under the trading programs will be subject to enforcement action under applicable State or Federal law.

Similar provisions are included in § 96.6( f)( 1) and ( 2) of the final NOx SIP Call model trading rule. The final CAIR model NOx and SO2 trading rules exclude these provisions for the following reasons. First, the proposed rule provisions are unnecessary because, even in their absence,

applicable State or Federal law authorizes enforcement actions and penalties in the case of knowing violations or knowing submission of false statements. Moreover, these proposed rule provisions are incomplete. They do not purport to cover, and have no impact on, liability for 93 Section VIII 1/ 25/ 05 DRAFT Do Not Quote or Cite violations that are not knowingly committed or false submissions that are not knowingly made. Applicable State and Federal law already authorizes enforcement actions and penalties, under appropriate circumstances, for non knowing violations or false submissions. Because the proposed rule provisions are unnecessary and incomplete, the final CAIR model NOx and SO2 trading rules do not include these provisions. However, the EPA emphasizes that, on their face, the provisions that were proposed, but eliminated in the final rules, in no way limit liability, or the ability of the State or the EPA to take enforcement action, to only knowing violations or knowing false submissions.