State-Level Air Emissions Trading: The Michigan and Illinois Models

Journal of the Air & Waste Management Association ISSN: 1047-3289 (Print) (Online) Journal homepage: http://www.tandfonline.com/loi/uawm20 State-Level Air Emissions Trading: The Michigan and Illinois Models Barry D. Solomon & Hugh S. Gorman To cite this article: Barry D. Solomon & Hugh S. Gorman (1998) State-Level Air Emissions Trading: The Michigan and Illinois Models, Journal of the Air & Waste Management Association, 48:12, 1156-1165, DOI: 10.1080/10473289.1998.10463751 To link to this article: http://dx.doi.org/10.1080/10473289.1998.10463751 Published online: 27 Dec 2011. Submit your article to this journal Article views: 139 View related articles Citing articles: 6 View citing articles Full Terms & Conditions of access and use can be found at http://www.tandfonline.com/action/journalinformation?journalcode=uawm20 Download by: [37.44.207.170] Date: 02 January 2017, At: 05:21

TECHNICAL Solomon and PAPER Gorman ISSN 1047-3289 J. Air & Waste Manage. Assoc. 48:1156-1165 Copyright 1998 Air & Waste Management Association State-Level Air Emissions Trading: The Michigan and Illinois Models Barry D. Solomon and Hugh S. Gorman Graduate Program in Environmental Policy, Department of Social Sciences, Michigan Technological University, Houghton, Michigan ABSTRACT Since passage of the 1990 Amendments to the U.S. Clean Air Act, there has been growing interest in the use of economic incentives for air pollution control. This trend is epitomized by the federal Acid Rain Program and the RE- CLAIM program for smog control in the Los Angeles basin. The adoption of these programs for attainment of the ozone standard is problematic, because of vexing issues of geography, atmospheric chemistry, source coverage, and monitoring and enforcement. These issues are especially salient in the use of emission reduction credit (ERC) trading systems. Cap and trade programs circumvent some of these difficulties by limiting total emissions and increasing source coverage but may still face monitoring challenges. Finally, the U.S. Environmental Protection Agency (EPA) is currently proposing that states use another incentive program, known as Open Market Trading. Michigan and Illinois have both developed new market incentive programs for ozone compliance. Michigan adopted an ERC model for NO x and VOCs, while Illinois opted for a cap and trade program to reduce VOCs in the Chicago area. Though these programs are fairly young, their strengths and weaknesses can be identified. Problems with the Michigan program are so serious that it has been initially disapproved by the EPA out of concern that downstate areas could backslide into non-attainment status. IMPLICATIONS Use of economic incentives such as emission trading schemes for air pollution control has increased since passage of the Clean Air Act Amendments of 1990, as part of efforts to increase the cost-effectiveness of environmental protection. There are significant challenges in applying these programs to control of local ozone precursors requiring strategic choices in policy design. Three major program types are available: the emission reduction credit (ERC), cap and trade, and open market trading systems. This paper critiques these programs, highlighting recent applications of state-level emissions trading in Michigan (ERC) and Illinois (cap and trade). Among the concerns are pre-enactment ERCs and counting ERC generation from facility shutdowns and curtailments. Although the Illinois program is more promising, it has problems of its own, such as low emission source coverage. Nonetheless, it is only through experimentation with market programs that their ultimate utility for ozone compliance can be determined. INTRODUCTION Firms in Illinois and Michigan will soon have more flexibility and responsibility in determining how to control their air emissions. Regulators in those states are developing emissions trading programs to help their states meet and maintain air quality standards more cost-effectively and with less conflict than is possible under the command and control system. Similar programs have been implemented elsewhere, with the RECLAIM program in southern California and the trading of sulfur dioxide (SO 2 ) emissions at the federal level being two of the most visible examples. This paper examines the trading programs being developed in Illinois and Michigan and critiques the ability of each to encourage verifiable improvements in air quality, integrate economic incentives into the regulatory system, and reduce the administrative burden associated with the traditional regulatory process. The driving force behind each program is the need to meet and maintain federal standards for the ozone (O 3 ) concentration of ambient air. Both states contain urban areas that routinely exceed the federal O 3 standard (Chicago is in the severe category) and must develop plans to reach and maintain compliance. Under a traditional command and control regime, state air agencies must explicitly determine how emission reductions are to be made. In addition, they must actively manage the process by which increases in emissions due to new sources are offset by emission reductions achieved by existing sources. Emissions trading programs are designed to facilitate these tasks by using market incentives to discourage emissions and reward emission reductions. In non-attainment areas, such markets also reduce the regulatory 1156 Journal of the Air & Waste Management Association Volume 48 December 1998

burden associated with distributing the required emissions reductions among firms in a region. The need to meet federal O 3 standards automatically focuses attention on its precursors nitrogen oxides (NO x ) and volatile organic compounds (VOCs). Both are key ingredients in the photochemical reactions that lead to O 3 concentrations capable of irritating human respiratory systems, damaging vegetation, and attacking material such as rubber. The U.S. Environmental Protection Agency s (EPA) new rules to reduce the air concentration of O 3 from 120 ppb (averaged over one hour) to 80 ppb (averaged over eight hours) promises to make the control of emissions of NO x and VOCs an even greater concern to state regulators. In general, controlling emissions of VOCs represents the greatest challenge. First, many more sources emit VOCs (e.g., refineries, gasoline distribution terminals, chemical plants, solvent-based industrial processes, motor vehicles, lawn mowers, consumer products such as paints and lighter fluids, and various types of biomass). Second, there is no simple relationship between the concentration of VOCs and the quantity of O 3 produced by photochemical reactions. On calm, sunny days with temperature gradients that trap emissions, the production of O 3 will be high. Days with much rainfall and wind will experience little O 3 production. Third, some VOCs are more active in the production of O 3 than others, complicating any comparison of emission sources. Regulating each compound separately on the basis of reactivity, however, is impractical. Fourth, changes in the concentration of other precursors further complicates the chemistry of O 3 production. One simulation study sponsored by the states bordering Lake Michigan suggested that slight decreases in local emissions of NO x had the potential for increasing O 3 production. 1 Finally, wind can carry pollutants from one area to another, creating a situation in which sources located in Chicago can contribute to the concentration of O 3 in Wisconsin and Michigan. Although regulators in both the Illinois and Michigan programs plan to use economic incentives to encourage reductions in the emissions of VOCs, their two programs reflect different philosophical approaches and vary in significant ways. For instance, the Illinois program is specifically designed to bring the Chicago area into compliance with the existing O 3 standard and will initially focus on emissions of VOCs from stationary sources in that area. The Michigan program is more ambitious and establishes a framework for trading all criteria pollutants except O 3, as well as VOCs, in all parts of the state. After reviewing the typology of possible trading programs and placing these two recent examples within this framework, the paper examines the specific strengths and weaknesses of each approach. ADVANTAGES OF ECONOMIC INCENTIVES AND STATE PROGRAMS The EPA s initial recognition of emissions trading came in the mid 1970s, as the agency grappled with the vexing issue of how to allow increases in air emissions that accompanied economic growth in non-attainment areas in Southern California and elsewhere. The strategy that EPA codified into the 1977 Clean Air Act Amendments (CAAA) was to require New Source Review, whereby new sources installed pollution control technology consistent with the Lowest Achievable Emission Rate (LAER) and offset any remaining air emissions of the same type by obtaining even greater reductions (e.g., 10 30%) elsewhere in the region. The policy broadened over time to include bubbles and netting at sources under common ownership and modified sources, respectively, and, in some cases, the banking of emission reductions. 2 At the time, monitoring technology was not well advanced, and federal enforcement efforts were uneven at best. As a result, the EPA proposed a formal policy on emissions trading on April 7, 1982, which was issued in final form on December 4, 1986, as the Emissions Trading Policy. 3 The statement officially recognized the generation and use of Emission Reduction Credits (ERCs). ERCs became the common metric for balancing increases in emissions with greater decreases elsewhere, in the interest of environmental improvement and integrity. The use of economic incentives for environmental protection received a major boost through their application to EPA s phase-down of leaded gasoline. First, lead levels in gasoline at petroleum refineries were allowed to be averaged (or bubbled) from 1979 to 1982, in part because continuous monitoring of each refinery s output at the time was deemed impractical. Next, refineries were allowed to trade and bank lead usage rights as they completed the phase-down from 1983 to 1987. EPA estimated that these latter provisions saved the refinery industry about $265 million while substantially improving air quality. 4 The other types of emissions trading were estimated to result in additional cumulative savings of several billion dollars. 5 This set the stage for the SO 2 allowance trading provisions under EPA s Title IV Acid Rain Program of the Clean Air Act Amendments of 1990, which are expected to save electric utilities more than $2 billion per year for the next decade. 6 Title I of the CAAA encourages states to develop economic incentives programs and stipulates that a sanction for failure to demonstrate compliance with the National Ambient Air Quality Standards (NAAQS) is adoption of such a program. 7 These requirements, known as the Economic Incentive Program (EIP) provisions, are applicable in serious, severe, and extreme O 3 and serious carbon monoxide (CO) non-attainment areas. Rules were issued Volume 48 December 1998 Journal of the Air & Waste Management Association 1157

on April 7, 1994, and apply to stationary, area, and mobile sources. 8 The EIP covers emission limiting activities such as emission trading; market response programs such as pollution charges or taxes; and directionally sound incentives such as education programs, though the latter are not acceptable strategies for complying with Title I. Interest in increased decentralization and state regulatory authority for environmental protection has grown concomitantly with this shift to economic incentives during the 1990s. State agencies have an important advantage over federal environmental regulators by being closer to the sources of pollution and, presumably, are able to design more sensible incentive programs to best suit their needs (e.g., as part of State Implementation Plan (SIP) revisions). State programs are also easier to approve than regional ones, even though the latter may be more efficient. States already have enacted over 250 environmentally related charges, waste fees, and green tax incentives. 9 Of course, state resource commitments and performance on environmental protection have always been uneven, based on various economic and political factors. 10 With this in mind, the EPA has proposed the latest policy evolution for state level emissions trading, the open market trading program, also to be discussed in the next section. TYPOLOGY OF AIR CREDIT TRADING PROGRAMS Emission Reduction Credit Model The first and most traditional type of trading program is based on the generation and use of ERCs. The ERC system was developed in the 1980s by the EPA as a flexible and cost-effective way to manage offsets and meet the NAAQS in non-attainment areas by permitted stationary sources of air pollution (i.e., criteria pollutants except for O 3, and VOCs). 3,11,12 Each ERC represents a one ton decrease in air emission of a specified type. ERCs are required to be real (i.e., they must result from a reduction in actual emission levels), permanent (for the life of the source), quantifiable (with an official emission baseline and measurement procedures), enforceable (by the agency issuing the permit and the EPA), and surplus (to any reductions required under a SIP). Consequently, ERCs must be certified by the air quality regulator by permit modification, and a trade must be approved by the regulatory body. The development of the ERC system does not override the most basic requirements of the CAAA, such as permitting, and the achievement of the NAAQS must still be followed by states and sources. It has been severely criticized, however, by some of the strongest advocates of emissions trading, such as the Environmental Defense Fund (EDF). They point to an inefficient market for ERCs, with a limited scope for trading and improvements in air quality, high costs (though also high cost savings), and opposition by many regulators and members of the public. 7 Indeed, the ERC trading model still requires significant involvement by state and federal regulators, a far cry from the free market idea advocated by economists. Cap and Trade Model The cap and trade model of emissions trading is typified by both the national system of virtually unlimited SO 2 allowance trading by electric utilities under the CAAA 13 and regional systems with geographic restrictions on NO x and SO 2 trading, such as the RECLAIM program of California s South Coast Air Quality Management District. 14 Two inherent flaws in the ERC trading model the loss of a source s flexibility to increase actual emissions to the permitted level when generating ERCs and some inconsistency in establishment of emission baselines can be fixed by a cap and trade system. A cap and trade system requires the establishment of an initial emissions cap based on a complete source inventory. After that inventory is completed, a fixed number of emission allowances are allocated to all or most of the major sources based on baseline emissions, meteorological conditions, and other pertinent factors. Typically the cap and reductions to that cap are phased in over time to reduce compliance costs, with sources able to sell and possibly bank allowances that they do not need in the current period. Strict and consistent emissions monitoring and an allowance accounting system by an environmental regulator or another party are also necessary. There is little or no need for the air regulator to review and approve allowance trades and compliance strategies, however, since each source is required to hold an equal or greater number of allowances than its total emissions during each compliance period. This does require the regulator, of course, to cap emissions at a level that will ultimately ensure attainment in the case of O 3. Unlike the ERC model, trading in this model is restricted to the predetermined sources included in the system. Although each source typically is required to reduce emissions from previously permitted levels, sometimes substantially, there is flexibility to increase emissions by acquiring additional allowances and comfort in knowing that other sources must abide by the same rules. While the cap and trade model has significant advantages over an ERC system, such as the greater ease and consequently lower compliance costs of trading, it also has led to major challenges when policymakers have applied it to regional pollution control and multiple pollutants. First, determining an acceptable allowance allocation scheme is quite difficult. Affected sources typically will ask for the largest possibly allocation, arguing that their circumstances are somehow unique. Second, on a 1158 Journal of the Air & Waste Management Association Volume 48 December 1998

regional basis, it may be very tough to establish a relevant trading area, since air pollution does not respect political boundaries. Third, it is also very difficult to establish reliable and cost-effective monitoring standards or protocols for all sources, particularly such diverse emissions as VOCs, which also have varying reactivities. A common measurement metric may be crucial to ensure the integrity of the commodity being traded and trust in the program. Finally, no universal equivalency factors have been established for related pollution compounds that contribute to common air quality problems, such as the precursors of urban O 3 or acid rain. These considerations make it very challenging for environmental regulators to minimize their role in the allowance market, which could significantly lower the potential cost savings. Discrete Emission Reduction Model A third model of emissions trading emerged as a new concept for non-attainment areas in 1994, as part of the trend toward decentralizing environmental authority while increasing reliance on market instruments. The EPA took this concept and proposed its Open Market Trading Rule the following year, 15 which was designed to greatly increase state programs for air emissions trading while lessening involvement of the EPA. The proposed unit of measure is the Discrete Emission Reduction (DER). Under this proposal, air regulators would not have to certify DERs until a purchaser proposes to use them for compliance, after the fact. Thus, the DER model is a buyer beware approach. Presumably, only DERs generated by reputable sources with sufficient documentation of the reductions would be demanded by the market. An advantage of DERs over ERCs is that sources can generate them by being credited for the difference between permitted and actual emissions, though the difference needn t be permanent. Not too surprisingly, the EDF (among other parties) is quite critical of this approach to emissions trading too. 16 The EDF identified three flaws with the proposal: (1) The lack of a credible emissions baseline for nonattainment areas. Why should DERs be counted below current emission levels yet above levels needed for attainment? This problem is compounded by EPA s new, stricter O 3 standard; (2) The use of DERs to offset current emission increases, again jeopardizing compliance with air quality standards; and (3) The undermining of enforcement. This could occur because of the ex post facto certification and monitoring structure in the proposal. Not only could this weaken the ability of air regulators to determine if a DER is fully valid, but this uncertainty also could diminish the interest in the credits by many potential buyers. The EPA is expected to issue the final version of the Open Market Trading proposal as a guidance document for states in 1998. While the three emissions trading models share common features, such as the voluntary nature of trading and the need for emissions measurement or monitoring, their differences are critical to the success or failure of the programs. For example, if a cap is needed to achieve an environmental objective such as O 3 attainment, an ERC or DER program would be ineffective, and a full and accurate emissions inventory is required. Alternatively, if a program is developed in a state with little or no attainment problems, an ERC program may be a good choice. On the other hand, even a well-designed ERC program could be rendered less effective if it does not account for emissions from a neighboring state that effects its air quality. It is precisely such considerations that we turn to next in the design of the new emissions trading programs in Michigan and Illinois. TWO CASE STUDIES Michigan s ERC Trading System Before describing Michigan s emissions trading program, it is useful to review the state s air quality status. As is the case in most urbanized and industrialized states, Michigan s primary air quality concern has been compliance with the NAAQS for O 3. At the time of the CAAA of 1990, ten counties were classified as moderate non-attainment areas seven in the Detroit and Ann Arbor Metropolitan Statistical Areas (MSAs) and three in the Grand Rapids-Holland and Muskegon MSAs. 17 Twenty-seven other counties were unclassified non-attainment areas because of insufficient data. By the November 1996 deadline, nine of the ten moderate non-attainment areas were reclassified by the EPA as attainment/maintenance areas (all except for Muskegon County). In addition, 22 of the 27 other suspect counties were reclassified in 1996 to be in attainment. 18 In this context, Michigan s Department of Environmental Quality (DEQ) adopted its emissions trading program. The state approved its Part 12 rules on Emissions Averaging and Emission Reduction Credit Trading, which took effect on March 16, 1996. 19,20 These rules are expected to be approved by the EPA in 1998 as part of revision to Michigan s SIP. The EPA, however, gave the state an initial notice of program disapproval in December 1996; its concerns will be addressed later in this paper. The rules are primarily designed to provide flexible, market-based incentives for the maintenance and attainment of the O 3 NAAQS in the southeastern and southwestern corridors of the state. There are intertemporal banking provisions that encourage early emissions reductions and technological innovations. The design of the program appears Volume 48 December 1998 Journal of the Air & Waste Management Association 1159

to be based on both the EPA s ERC model as well as the EIP and the proposed broader open market trading system. For example, the rules allow for participation by virtually any stationary, area, or mobile source for criteria pollutants and VOCs, trading is permitted in both attainment and non-attainment areas, and the program includes provisions for interstate trading. Importantly, monitoring requirements are the same as those in each source s Renewable Operation Permit (ROP). To qualify for the new program, a source in Michigan must have been included in the most recent emissions inventory and made emissions reductions on or after January 1, 1991. While this start date may be up to five years or more before issuance of the rules, any early ERC generation would be discounted 50%. ERCs can be generated by the usual range of mechanisms: installation or modification of production processes, production equipment, or air pollution control equipment; reformulation of fuels, raw materials or products; energy conservation or pollution prevention programs; early compliance with future emissions reduction requirements; area or mobile source controls; and curtailments or shutdowns. ERCs and emissions averaging (or bubbling) may be used for several purposes. These circumstances include increasing operational flexibility; delayed or alternative compliance with Reasonably Available Control Technology (RACT) requirements; offsets for major new or modified sources or netting for modified sources (ERCs only); avoidance of New Source Review (NSR) for synthetic minor sources that make temporary increases in emissions to above the major source threshold; Best Available Control Technology (BACT) and LAER compliance, as long as the required control equipment is installed and properly operated and maintained; and ERC retirement or donation. Sources that participate in the program must have the ERCs or emissions averaging plans listed in the emissions trading registry of Clean Air Registry, Inc. An $8 12/ton fee is required by Clean Air Action Corporation, developer of the registry for the state, for transfer or generation of ERCs. There are several restrictions on Michigan s trading program. ERCs and emissions averaging cannot be used by sources to avoid or comply with NAAQS violations, SIP maintenance plan requirements, federal mobile source requirements, O 3 season restrictions, Prevention of Significant Deterioration (PSD), New Source Performance Standards (NSPS), Maximum Achievable Control Technology (MACT), National Emission Standards for Hazardous Air Pollutants (NESHAPs), and BACT for Toxic Air Contaminants (T-BACT). In addition, the use of ERCs for criteria pollutants (except O 3 ) and VOCs is limited to minor or insignificant levels, which could consequently limit the ERC market in the state. The potential benefits of the program are both economic and environmental. Since the program is voluntary, it can be expected that sources will only generate and sell or use ERCs or emissions averaging when it is cost-effective to do so. This will especially be the case for intra-firm transactions. The environmental benefits will be due to earlier and more frequent emissions reductions under the trading program, especially in light of the intertemporal banking provision. ERCs may be used or traded for up to five calendar years, though their use during the O 3 season is only allowed when they are generated in the same year. Furthermore, the DEQ requires that 10% of the ERCs generated are permanently retired upfront, which are not returnable to a source even if it withdraws its credits. Additional benefits may be achieved by improved procedures for measuring and monitoring emissions. While as of this writing just two and a half years have passed from the time the Michigan emissions trading rules were issued, it may be instructive to review the ERC activity to date. Thus far there have been 58 notices of ERC generation. Among these, most of the activity involved small reductions in VOCs. As of spring 1998, 785 tons of VOCs were reduced and 537 VOC ERCs were registered. The types of companies that have participated in the program include metal furniture painting operations, steel, plastics, and printing firms, and gasoline providers. In addition, there were 37,665 tons of NO x reduced and 24,730 NOx ERCs were registered. The NO x ERCs, while considerably greater, were almost all generated by Detroit Edison for the early installation of low-no x burners at a coalfired electric power station. Only five, minor cases of ERC use in Michigan have occurred thus far. Illinois VOC Emissions Trading System As in Michigan, regulators in Illinois turned to emissions trading primarily as a way to reduce O 3 concentrations in an area that exceeds federal standards for that pollutant. Unlike Michigan, Illinois plans to use a cap and trade program, and participation is limited to major sources in the non-attainment area. This area includes eight counties of the Chicago MSA. Initially, the Illinois EPA (IEPA) sought to develop a market system for NO x modeled after California s RE- CLAIM program. However, after studies pointed to VOCs as the more important precursor to O 3 in the area around Lake Michigan, the IEPA shifted its focus to VOCs. 1 The proposed Illinois emissions trading system is a seasonal (May 1 to September 30) cap and trade program in which approximately 275 industrial emitters of VOCs will be required to participate. 21 This pool of sources includes those firms that emit more than ten tons of VOCs during the O 3 season, and which already are required to 1160 Journal of the Air & Waste Management Association Volume 48 December 1998

participate in the Illinois Clean Air Act Permit Program (CAAPP). Altogether, these sources contribute 90% of all VOC emissions coming from stationary sources in the Chicago area. The proposed emissions trading program also provides some incentives for smaller sources to reduce emissions through the generation of trading credits outside the normal allocation procedure. The rules governing Illinois emissions trading program, recently submitted to EPA for final approval, focus on the cap and trade component of the program. After an initial allocation period in which all participating sources establish a baseline for their emissions, the IEPA will provide each firm with Allotment Trading Units (ATUs) equal to 88% of their emissions. Each ATU represents 200 pounds of emissions, and the initial reduction from the baseline stems from a provision of the CAAA that explicitly requires a 12% reduction in non-attainment areas by 1999. Sources will determine their baselines by taking the average of their two highest seasonal emissions in the years 1996 1999, quantities that they are already required to report under Illinois permitting system. To ensure as fair an allocation as possible, the IEPA has included several requirements that adjust each source s baseline according to the degree to which it is out of compliance, has already reduced emissions beyond that previously required, or can show that emissions from previous years are more representative. The allocation of ATUs to existing sources will be complete by the year 2000. After receiving their allocation of ATUs, all participating sources must submit a balance sheet at the end of each annual five-month O 3 season. The quantity of VOCs the source emitted during that season must be balanced with the appropriate number of ATUs. For example, a firm that receives an allotment of 500 ATUs per O 3 season can release 50 tons of VOCs without being required to secure more ATUs. However, if that firm releases more than 50 tons of VOCs during the O 3 season, it must purchase additional ATUs through a market managed by the IEPA. If that same firm releases less than 50 tons either because of improved processes, better control equipment, or production decreases it can sell any extra ATUs to other firms or can bank them for use during the next season. The IEPA will facilitate transactions by operating an electronic bulletin board that brings buyers and sellers together. In addition, all ATUs are assigned serial numbers, accounted for in an IEPA database, and expire when used to cover an emission or if unused for more than a year. Each year, the IEPA will release a new stream of ATUs to existing sources that established a baseline. No new stationary sources capable of emitting more that ten tons of VOCs during an O 3 season will be allowed to operate in the non-attainment area, unless those sources can secure the necessary ATUs from the market at a ratio of 1.3 to 1. Hence, new sources must make multi-year purchases for ATUs allocated to other sources. Improvements in air quality will stem from both a decreasing allotment of ATUs and any ATUs that expire before being used. In addition, all sources must comply with existing pollution control regulations. For example, new sources must keep their emissions below levels consistent with LAER technology even if they can secure enough ATUs to cover higher emission levels. Although the IEPA will record all transactions, the agency will not directly monitor trades between firms. The balance sheet submitted by firms within 90 days after the end of the O 3 season will be the one report audited by the IEPA. Penalties provide firms with an incentive to submit these reports on time and to secure the ATUs necessary to cover their emissions. The IEPA can fine firms that do not submit a report within 90 days up to $10,000 per day; the same fine can be applied to firms that fail to secure any additional ATUs needed. To ensure that some ATUs will be available when firms need them, the IEPA will maintain a special account from which firms can purchase ATUs for twice the market price or $1,000, whatever is less. The IEPA will supply this special account with ATUs by setting aside 1% of all seasonal ATUs, with the owners of these ATUs receiving a prorated amount of the funds generated by any sales. In addition, when sources receiving a yearly stream of ATUs shut down their operations, 20% of their ATU stream will be deposited into the special account. The other 80% will continue to be allocated to the firm that shut down its operations. Clearly, the success of this program depends on the ability of companies to accurately determine the quantity of VOCs they are releasing and on the ability of the IEPA to audit each firm s seasonal records. In general, emissions of VOCs are more difficult to measure than emissions of NO x or SO 2, which are the pollutants that existing cap and trade programs have been designed around. Emissions of NO x and SO 2 come from a fairly welldefined class of combustion sources, and practical continuous emissions monitoring systems (CEMS) are available for such sources. For example, the RECLAIM program of Southern California requires continuous emissions monitoring of both SO 2 and NO x, with data from these monitoring systems fed directly into a compliance database. Many processes that emit VOCs, however, do not have a single exhaust or are run in flexible batches, which makes continuous monitoring impractical. Designers of the RECLAIM program considered establishing a third independent market for VOCs, but decided not to because of industry opposition to the proposed caps and the added complications associated with monitoring this pollutant. 14 Volume 48 December 1998 Journal of the Air & Waste Management Association 1161

In general, the IEPA recognizes that protocols for quantifying emissions of VOCs differ from process to process and encourages firms to be both conservative and consistent in the methods they use to compute emissions. Engineers at a refinery might base the fugitive emissions leaking from thousands of valves on design data supplied by the supplier of the valves. Engineers at a manufacturing plant might compute the emissions coming from paint booths by determining how much paint was used during the O 3 season and multiplying that quantity by the percentage of solvent in the paint. In some cases, periodic testing and operational monitoring may be necessary. In still other cases, such as when a central exhaust is available, a continuous monitoring system might be appropriate. 22 In all cases, the IEPA is likely to put more emphasis on the accuracy of logs. After all, if a firm computes the quantity of VOCs released from a process by recording the amounts and types of coatings used in the process, every pound of coating not recorded in the log represents an error source. Although the IEPA faces a difficult monitoring task, methodologies for computing emissions of VOCs are being studied and refined, with much of the interest motivated by the need to reduce the emission of toxic VOCs. 23 As long as engineers consistently and conservatively use the same protocol when determining emissions from similar units both during the allotment period (when they have an incentive to overestimate emissions) and at the end of each O 3 season (when they have an incentive to underestimate emissions) the IEPA generally will accept the protocol for at least three years. As the IEPA gains experience in the auditing process and the engineering community gains experience with ways to measure or compute emissions, the IEPA may require specific protocols to be used with certain processes. CRITIQUE OF PROGRAM DESIGNS In an earlier paper, one of the authors discussed ten lessons from SO 2 emissions trading, based on 4.5 years of experience in helping to develop and implement that program at EPA. 24 The six primary lessons are somewhat applicable to the Michigan and Illinois programs and will be discussed, along with other important aspects of their policies: (1) Credit Allocations: Should be based on a simple, easily defended formula, with all sources included in the program in a single phase, which in turn should be based on a credible emissions baseline. (2) Emissions Monitoring and Enforcement: Strict requirements for monitoring and enforcement are essential to the integrity of emissions trading. (3) Administrative Scale: The higher the geographic scale the better. (4) Emissions Cap: An emissions cap, especially one that reduces emissions, is essential for the stimulation of cost-effective compliance choices. (5) Trading Volume: While establishing a robust market is important, the emissions trading volume can be a misleading indicator of the benefits of trading if there is credit banking. (6) Education: Sources, regulators, environmentalists, the press, and others need to be educated about the environmental and economic benefits of trading. Michigan The Michigan program, with the ERC model, involves neither emission credit allocation nor a cap. The emissions baseline, however, is very relevant for the generation of ERCs. The EPA noted that the Michigan program does not explicitly provide procedures for the establishment of a baseline for ERC use; 25 the Part 12 rules provide only general guidance. It is even possible that baselines can be calculated with data from before the enactment of the CAAA. More specific procedures are needed to clarify how compliance will be determined using ERCs. As currently structured, the Michigan program can result in inconsistent baseline procedures between sources, and uncertainty about compliance determination. Another reason the Michigan program was disapproved by the EPA in 1996 was that it allows ERC generation from facility shutdowns and curtailments, which cannot account for production shifting in an uncapped trading system. 25 The use of such ERCs could compromise attainment and maintenance plans by unwittingly leading to double-counting of emissions. A related issue of concern is the use of pre-enactment ERCs, which are to be discounted 50%. Since O 3 formation is regulated as an acute threat to human health, the concern is that the market could be flooded with cheap credits and the continuing generation of new ones. The most significant source of these ERCs to date is Detroit Edison s early NO x credits. Until the total quantity and lifetime of pre-enactment ERCs in Michigan is clearly established, along with their potential effect on the attainment or maintenance of the O 3 standard, this provision will remain a concern. The Michigan program also allows for the use or trading of ERCs for up to a five-year future banking period, which can provide significant cost savings to sources. This provision is environmentally defensible because credits generated in the non-ozone season may only be used in the same or five subsequent calendar years in the non-ozone season. There may be a problem, however, because, while even though ERC use in an O 3 season is restricted to credits generated during an O 3 season (which will be discounted 10% per subsequent O 3 season), an attainment 1162 Journal of the Air & Waste Management Association Volume 48 December 1998

or maintenance problem is conceivable if a large ERC bank was emptied in a subsequent ozone season. There are significant monitoring and enforcement problems with the Michigan program because of the broadness of the monitoring and quantification requirements and the burden of proof. Essentially, while requiring the methods to be credible, accurate, and replicable, the rules cannot ensure this since they allow any method from stack testing, fuels and materials sampling, massbalance calculations, and unspecified alternatives to a CEMS. While the latter have monitored utility NO x emissions in the Acid Rain Program with a mean relative accuracy of 4.27%, 26 the accuracy of most of the other methods, especially for VOCs, may be much worse, highly variable, and unknowable. The EPA also disapproved the Michigan program because it allows sources to use an alternative monitoring method that has not been federally approved and without indicating the criteria that would be used by the DEQ to judge such protocols. 25 More generally, the EPA found the initial Michigan emissions trading program deficient because the rules place no clear responsibility on sources to demonstrate that a use of ERCs would not result in a NAAQS violation. Other reasons given by EPA for program disapproval include the potential for synthetic minor sources to avoid NSR if they make a temporary increase in emissions for less than 12 months and not more than once in 24 months; the lack of geographic restrictions on the use of ERCs; the allowance of interstate trading without a Memorandum of Understanding between states; inadequate evaluation and audit procedures, especially with respect to air toxics emissions; and the potential for notices submitted under the Michigan program to contain or reference confidential information. Illinois In the proposed Illinois emissions trading program, implementation concerns associated with establishing baselines, measuring and monitoring emissions, and maintaining a level of participation sufficient to sustain the program pose less of a problem than such concerns do in the Michigan program. The Illinois program focuses on one class of pollutant (VOCs), establishes a baseline of emissions coming from the largest sources in a limited geographical area, and caps future emissions at a level slightly below that baseline. However, potential problems exist and are associated with mechanisms that allow large companies to opt out of the program, efforts to integrate mobile and unregulated stationary sources into the program by allowing them to generate ERCs, variations in the reactivity of VOCs, and the difficulty of solving a regional problem with a program limited to the non-attainment area. Generating enough trading volume to sustain the program could be a problem if enough participants choose to opt out of the program, which they can do by establishing their baseline emissions and permanently cutting their emissions by 18% or by agreeing to keep their VOC emissions under 15 tons per O 3 season. If enough firms opt out of the program, the volume of transactions among participants may not be sufficient to sustain a viable market. Firms that do not participate will lose the flexibility to increase their emissions above their adjusted baseline, but that restriction may not be a problem for firms that do not expect increases or fluctuations in production levels. If a significant level of trading activity fails to develop, a major attraction of this program its ability to balance fluctuations and offsets without the need for command and control decisions disappears. Another factor that complicates the Illinois program is the IEPA s decision to allow mobile sources and unregulated stationary sources (those emitting below ten tons of VOCs per O 3 season) to generate ERCs that can be purchased by firms in the cap and trade program. This provision stems from the fact that potential participants stationary sources emitting over ten tons of VOCs per O 3 season only account for approximately 23% of all VOC emissions within the non-attainment area. Mobile on-road sources account for about 36%; area sources (such as VOCs from gasoline filling stations and from consumer products) account for another 20%; mobile off-road sources, 10%; biomass, 8%; and unregulated point sources (such as print shops and other small businesses that emit less than ten tons of VOCs per season), 3%. 27 Integrating emission reduction credits into a cap and trade program reflects a desire to increase the impact of the program, but the rules governing such credits are poorly defined. For example, should the IEPA give the owner of a small business credit for shutting down an onsite gasoline filling station? After all, shutting down that private station is likely to result in an increase elsewhere. Making such decisions is time consuming. In general, validating that emissions reductions generated by mobile sources and unregulated stationary sources are real and permanent complicates what would otherwise be a simpler regulatory task. Variations in the reactivity of different VOCs pose another complication. 28 A potential outcome of emissions trading is one in which sources cut emissions of VOCs that are not very active in the production of O 3 and sell their trading credits to firms that release highly reactive VOCs. If that happened, the net result could be a net increase in O 3 production. Although there is no reason to expect this outcome, the IEPA plans to track the net increase or decrease in the reactivity of VOCs emitted and to revisit the issue if regulators detect such a trend. As Volume 48 December 1998 Journal of the Air & Waste Management Association 1163

with the effort associated with quantifying emissions, the effort associated with tracking the reactivity of emissions represents a task that also needs to be performed under a command and control regime. The complication is not unique to emissions trading. The IEPA will also encounter significant problems in attempting to evaluate the program s success. Even if successful in terms of reducing emissions of VOCs, the program will only have a modest impact on the O 3 concentration within the Chicago non-attainment area. Ozone drifting into the Chicago non-attainment area and VOCs emitted from mobile and area sources play a far larger role in determining the area s O 3 concentration. For example, during a field study undertaken in 1991, O 3 concentrations of 80 110 ppb were observed near the upwind boundary of the non-attainment area. Under certain conditions, emissions of VOCs in the Chicago metropolitan area would have to be reduced by 90% to reach attainment of the NAAQS for O 3. 27 Much of the O 3 drifting into the non-attainment area stems from large emissions of NO x by downstate electric power plants. The IEPA might have attempted to address the downstate source of precursor NO x first but did not do so for two reasons. First, section 182(b)(1) of the CAAA specifically calls for state regulatory agencies to submit plans showing how they plan to reduce the total quantity of VOCs emitted in moderate non-attainment areas by 15%. The IEPA s emissions trading program for Chicago allows the state to meet this requirement. Second, if a statewide NO x trading program was not carefully designed, it could be counterproductive. As mentioned previously, O 3 production models showed that cutting emissions of NO x from sources within the VOC-rich non-attainment area did not reduce and sometimes increased the production of O 3. Hence, the IEPA decided to focus only on VOCs. In the long term, the IEPA plans to develop a NO x trading program aimed at reducing O 3 concentrations at the boundaries. Until that time, only a slight reduction in the O 3 concentrations within the Chicago non-attainment area can be expected especially if the area sees increases in activities such as automobile use, lawnmower use, the number of houses being painted, and the frequency of cookouts making it important to evaluate the trading program as one component of a larger strategy. At the same time, potential benefits associated with shifting the burden of managing offsets from a command and control regime to an emissions trading market remain and should be considered in any evaluation. CONCLUSIONS State regulators responsible for controlling air pollution are increasingly turning to emissions trading programs as a way to attain and maintain required levels of O 3 more cost effectively than is possible under current command and control regimes. The success of a particular emissions trading program, however, cannot be taken for granted. The transition from a command and control system to one guided by economic incentives is difficult to make. A poorly designed emissions trading program one that does not anticipate potential problems, loopholes, and conflicts can do more harm than good, both in terms of environmental quality and the regulatory effort needed to reach a certain goal. The emissions trading programs proposed in Illinois and Michigan are two examples of the general trend to integrate market incentives into the regulatory process. Rules governing the Michigan proposal were submitted to the EPA in spring 1996 and are now being negotiated. The Illinois proposal, which has undergone significant in-state review and revision, will be submitted for federal approval by the end of 1998. Both programs involve the creation of a market in which companies buy and sell units associated with the right to emit pollutants. Both are also designed to help state agencies attain and maintain compliance with the federal ambient air standard for O 3, and both are at the same general stage of policy development. There are also significant differences, however, and comparing those differences provides some insights into the range of problems and concerns associated with implementing emissions trading programs. Barring any unforeseen complications, the Illinois program a cap and trade program limited to several hundred large emitters of VOCs in the Chicago non-attainment area is likely to receive federal approval. Some changes will undoubtedly be needed, but the basic program structure is solid. The program establishes a baseline of current emissions, caps the amount of allowable emissions at a level below the baseline, and distributes the number of trading units equivalent to that cap. Firms can then buy or sell the right to emit VOCs, with the main role of regulators being to audit computation of seasonal emissions and verify that each firm holds enough trading units to cover the emissions. The main risk associated with this program is that not enough sources will choose to participate, preventing the formation of a market capable of replacing the present command and control system. The Michigan case, an ERC-based program in which trading units are generated rather than allocated, is more problematic. The market is open to participants in all areas of the state, involves more than one pollutant, allows extensive banking, and embraces emissions reduction from stationary, mobile, and area sources. Generators of ERCs not only must compute actual emissions a task with some uncertainty but must also estimate the reductions from curtailments, adjustments to processes, or 1164 Journal of the Air & Waste Management Association Volume 48 December 1998