Emissions T rading,Electricity Industry Restructuring,and
Investment in Pollution Abatement
Meredith Fowlie
University of Michigan-Ford School of Public Policy and Department of Economics;
National Bureau of Economic Rearch(NBER)
mfowlie@umich.edu
January2009
Abstract
This paper analyzes an emissions trading program that was introduced to reduce smog-causing pollution from large stationary sources(primarily electricity generators).Using vari-
ation in state-level electricity industry restructuring activity,I empirically identify the e¤ect
of economic regulation on pollution permit market outcomes.There are two main…ndings.
First,deregulated plants in restructured electricity markets were less likely to adopt more
capital intensive environmental compliance options as compared to regulated or publicly
owned plants.Second,as a conquence of heterogeneity in electricity market regulations,a
larger share of the permitted pollution is being emitted in states where air quality problems
tend to be more vere.This suggests that heterogeneous economic regulation of the electric-
ity ctor has likely incread the environmental and health damages caud by permitted
emissions.
I am grateful to the University of California Energy Institute for providing support that made this rearch pos-sible.I thank Severin Borenstein,Michael Hanemann,Guido Imbens,Nat Keohane,Erin Mansur,Sam Napolitano, Je¤rey Perlo¤,Ken Train,Frank Wolak,Catherine Wolfram,and two anonymous referees for helpful conversations and suggestions.I also thank minar participants at Columbia,Cornell,NBER,Resources for the Future,UC Berkeley,UC Davis,UC San Diego,the UC Energy Institute,the University of Michigan and the University of Wisconsin for uful comments.I am
indebted to Ed Cichanowicz,Bonnie Courtemanche,Joe Diggins,Nichole Edraos,Thomas Feeley,Richard Himes,Allan Kukowski,Bruce Lani,Dan Musatti,John Pod,Galen Richards, David Roth,Ravi Srivastava,Donald Tonn,Chad Whiteman and David Wojichowski for providing data and taking time to help me understand the technical side of electricity generation and NOx control.All remaining errors are mine.
When the U.S.federal government…rst began regulating major sources of air pollution in the 1960s,the conventional approach to meeting air quality standards involved establishing maxi-mum emissions rates or technology-bad standards for regulated stationary sources.However, economists have long maintained that an emissions permit market could more e¢ciently coordi-nate pollution abatement activities,provided a ries of assumptions are met.Over the past few decades,market-bad“cap and trade”(CAT)approaches to regulating industrial point sources of air pollution have become a centerpiece of environmental regulation in the United States.
In the theoretical…rst-best permit market equilibrium,the total social cost of meeting an emissions cap is minimized.Each…rm choos a level of pollution abatement such that its mar-ginal cost of reducing pollution is t equal to the social marginal bene…t from emissions reduction. In practice,pre-existing distortions in product markets that are subject to CAT regulation may interfere w
ith the emissions permit market’s ability to operate e¢ciently.This paper studies the e¤ects of heterogeneous electricity market regulation on permit market outcomes in the context of a major issions trading program(the NOx Budget Program).The recent wave of elec-tricity industry restructuring in the United States has resulted in signi…cant inter-state variation in economic regulation.Conquently,facilities in the same CAT program face very di¤erent economic regulation and investment incentives in their respective electricity markets.Whereas rate-ba regulated plants are guaranteed to earn a rate of return on prudent investments in pol-lution abatement equipment,"deregulated"plants operating in restructured electricity markets are o¤ered no such assurances.This could lead regulated plants to invest relatively more heavily in capital intensive environmental compliance options.
The central question addresd by this paper:has heterogeneity in electricity market regu-lation a¤ected how coal plant managers cho to comply with a regional NOx emissions trading program?I estimate a random-coe¢cients logit model of the…rm’s environmental compliance de-cision that controls for unit-level variation in choice ts and compliance costs and accommodates correlation across choices made by the same decision maker.I…nd that deregulated plants in restructured electricity markets were less likely to choo more capital intensive compliance op-tions(which are associated with more signi…cant emissions reductions)as compared to physically
similar plants that are either subject to rate regulation or publicly owned.The results are robust to alternative speci…cations and assumptions about how environmental compliance decisions are made.
In the cond part of the paper,I asss the practical implications of interactions between economic regulation and environmental compliance.The econometric model is ud to simulate the environmental compliance decisions that plant managers most likely would have made if all electricity generators had faced the same economic regulatory regimes in their respective electricity markets.Two counterfactuals are constructed:one in which all coal plants in the emissions trading program are subject to electricity rate regulation,and one in which all facilities operate as deregulated entities supplying restructured electricity markets.This exerci allows me to isolate the e¤ects of economic regulation in the electricity industry on emissions permit market outcomes.
An immediate…nding is that deregulated facilities in restructured electricity markets ac-count for a smaller share of permitted emissions in equilibrium when the distortionary e¤ects of asymmetric economic regulation are removed.This has two potentially important implications for permit market e¢ciency.First,if economic regulation plays a signi…cant role in determining which plants invest in pollution control equipment,plants with relatively low abatement costs may not be the plants investin
g in abatement.Conquently,total compliance costs may not be minimized.However,simulation results indicate that neither comprehensive rate regulation nor comprehensive deregulation would have signi…cantly reduced compliance costs in aggregate.
The cond cau for concern pertains to the nature of the pollution problem.Epidemiological studies consistently…nd a statistically signi…cant association between NOx related air quality problems and incread mortality and morbidity(Bell et al.2004;WHO,2003).Becau NOx is a"non-uniformly mixed"pollutant,health and environmental damages caud by NOx emissions depend signi…cantly on the location of the source.Conquently,although the total quantity of NOx emissions is exogenously determined by the emissions cap,the total damages will depend on the spatial distribution of the permitted emissions.1
Simulation results indicate that asymmetric economic regulation in the electricity industry 1The NOx Budget Program does not explicitly account for spatial variation in marginal damages from emissions;
a permit can be ud to o¤t a unit of NOx emissions,regardless of where in the program region the unit is emitted.
may have incread the health and environmental damages caud by NOx emissions permitted under the NOx Budget Program.The vast majority of deregulated electricity producers are located in the Northeast and Mid-Atlantic regions where ozone nonattainment problems are particularly vere.Simulated levels of investment in capital intensive compliance options increa among deregulated facilities when asymmetries in economic regulation are eliminated.This shifts more than100tons of daily NOx emission(or approximately2-4percent of permitted emissions)out of relatively high damage areas and into regions where the pollution will cau less damage.2To put this in perspective,a recent study…nds that shifting11tons of NOx emissions from a"high damage"area(a location in Maryland)to a"low damage"area(a location in North Carolina) over a ten day period could avoid the loss of approximately one life on average(Mauzerall et al. 2005).
This paper contributes to our understanding of how electricity generators in di¤erent industry environments respond to incentives created by market-bad environmental regulation.In contro-versial court rulings,Federal proposals to achieve further reductions in electricity ctor emissions using market-bad policy instruments have recently been the source of much controversy.At issue in much of this litigation is the appropriateness of emissions permit trading when damages vary signi…cantly across states.In the particular ca of NOx,Federal regulators have been asked to re-a
nalyze propod interstate trading programs"from the ground up"in order to carefully re-evaluate whether emissions in each a¤ected state would remain below a level that avoids"sig-ni…cant contribution"to nonattainment(North Carolina v.EPA,No.05-1244(D.C.Cir.Jul.11, 2008)).The analysis prented here demonstrates the importance of reprenting economic reg-ulation and industry structure when modeling permit market outcomes and associated damages.
A failure to do so will likely result in underestimation of the share of emissions permits‡owing to restructured electricity markets.
The…ndings are also germane to strands of both the industrial organization and environmen-tal economics literatures that consider the e¤ects of economic regulation and industry structure on 2During the design and ex ante analysis stages of the NOx Budget Program,the US Environmental Protection Agency identi…ed states that contributed more to the ozone transport problem.Seven states were identi…ed as having particularly high ozone-related damages(CT,DE,MA,MD,NJ,NY,PA)as compared to other states in the program(US EPA,1998c).
…rms’investment decisions.3Previous empirical work that considers how economic regulation in electricity markets has a¤ected…rms’CAT compliance choices has focud predominantly on the Aci
d Rain Program(e,for example,Arimura,2002;Bailey,1996;Keohane,2006;Sotkiewicz, 2003).Becau the Acid Rain Program started before restructuring began,the papers u more subtle variations in cost recovery rules and coal protection measures to identify an e¤ect of elec-tricity market regulation on compliance choices.Results have been mixed.I revisit this question post-restructuring,now that there is signi…cantly more interstate variation in electricity indus-try regulation and investment incentives,and thus incread potential for variation in economic regulation to undermine the e¢ciency of the permit market.
Finally,there is a growing academic literature that considers market-bad regulation of non-uniformly mixed pollutants.Studies that evaluate the merits of designing CAT programs to account for spatial variation in emissions damages typically assume strict cost minimization on behalf of all…rms(Farrell et al.,1999;Krupnick et al.,2000;US EPA,1998c).Findings prented here imply that variation in industry structure and economic incentives are an important con-sideration when analyzing how alternative permit market designs might a¤ect spatial patterns of investment and emissions.
The next two ctions describe the emissions trading program,electricity market regulation and restructuring in the United States.Section III describes the data and prents summary statistics.Sec
tion IV introduces a model of the…rm’s compliance decision.Estimation results are prented in Section V.In Section VI,I u the econometric model to asss the practical impli-cations of the relationship between economic regulation and environmental compliance.Section VII concludes.
I.The NOx Budget Program
The NOx Budget Program(NBP)is an emissions trading program that limits emissions of NOx from large stationary sources in nineteen Eastern states.The NOx emissions contribute to the formation of ozone.4High ambient ozone concentrations have been linked to incread mortality, 3In the environmental economics literature,previous work has demonstrated that,in theory,economic regulation can undermine the ability of a pollution permit market to operate e¢ciently(e Bohi and Burtraw,1992;Coggins and Smith,1993;Fullerton et al.,1997).
4NOx emissions also contribute to the formation of both particulate matter,contribute to acid rain in some
