With cross-state cap-and-trade, challenges await the next EPA administrator

Last week, President Obama nominated Gina McCarthy to be the new EPA administrator. Obama nominates Gina McCarthy If confirmed, McCarthy will be looking to break ground with new carbon dioxide regulations for power plants and rules of the road for hydraulic fracturing. But she will also be dogged by old regulatory challenges, including the current stalemate over cross-state air-pollution regulations.

Historically, cap-and-trade has featured very prominently in domestic efforts to control the emissions of so-called cross-state pollutants (namely, sulfur dioxide and nitrogen oxides). Pioneering efforts delivered laudable successes in both the Acid Rain Program and the NOx Budget Program, respectively. Emissions targets have been met or exceeded. Program benefits have exceeded costs by a significant margin. That was then.

Now, these cap-and-trade programs are shadows of their former selves. Repeated attempts to extend cross-state emissions trading programs have generated thousands of pages of court remands, dissenting opinions, en banc petitions – but no substantive progress.

This week’s blog post looks at two key factors that complicate policy making in this arena. And anticipates the daunting challenges ahead.

Location matters

A defining feature of so-called “cross-state” air pollution is heterogeneity. The health and environmental damages it causes vary significantly with the location and dispersion characteristics of the emissions sources. In principle, efficient emissions regulation should account for this variation. In other words, if my pollution causes twice as much damage as yours, I should be required to pay twice as much to offset my emissions.

This is not what we see when we peer into existing emissions trading programs. For the sake of simplicity, emissions permits for a given pollutant trade at a single price. This begs the question, should future policies be designed to better reflect spatial and temporal variation in emissions damages?

Nick Muller and I consider this question in a recent working paper. We demonstrate how integrated assessment modeling of pollution damages could be used to define the terms of “differentiated” emissions permit trading. If regulators are well informed about firms’ abatement costs, differentiated trading programs deliver efficiency gains over and above existing program designs.

But here’s the catch. Emissions abatement costs rarely – if ever- manifest as policy makers expect. Once this wrinkle is accounted for, the case for differentiated emissions trading gets far more nuanced. More generally, our paper underscores the importance of implementing market-based policy designs that can nimbly and flexibly respond to market conditions as they unfold. Unfortunately, this policy prescription is getting harder to fill in the current regulatory environment. This brings us to our second complication…

The legal dimension

The Clean Air Act gives the EPA has the authority to set air quality standards. Once standards are set, it is up to the states to meet these standards within their borders.  Things get complicated when emissions cross state borders, such that one state’s ability to meet a standard is impacted by pollution blowing in from an upwind state.

Enter the “Good Neighbor” provision of the Clean Air Act. This requires upwind States to take responsibility for the pollution they are sending to their downwind neighbors.

Initially, the courts did not interpret this provision to mean that emissions reductions achieved within a state had to correlate directly with the state’s relative contribution to a specific downwind nonattainment area. This was important, because it allowed for unrestricted emissions trading across state lines.

This all changed in 2008.  In a decision that overturned the Bush administration’s Clean Air Interstate Rule (CAIR), the D.C. circuit of the U.S. Court of Appeals ruled that:

“Each state must eliminate its own significant contribution to downwind pollution.”

This ruling was surprising. It seemed to disregard completely over a decade of progress with market-based emissions regulations. And ignore key economic insights regarding the reciprocal nature of emissions externalities.

Perhaps most importantly, this ruling introduced additional constraints into an already complicated policy arena. In an effort to comply with the court remand, the Cross-State Air Pollution Rule (CSAPR) was promulgated. Rather than allowing unlimited trading across state lines as previous rules had done, CSAPR prohibits interstate trading if a state exceeds its pre-prescribed emissions limit.

Last year, the D.C. Circuit invalidated CSAPR. In doing so, the court elaborated upon the ways in which the good neighbor provision should dictate state-level emissions abatement responsibilities. This latest ruling makes it even harder to imagine how the EPA can design a cost-effective, market-based emissions trading program for cross-state pollution that will pass muster with the court.

What next?

In her capacity as assistant EPA administrator, McCarthy followed the court directive to revert to the Clean Air Interstate Rule which will serve as a place holder until a new rule can be promulgated.

The good news is that, in the very near term, the need for a new cross-state rule is not immediate. Relatively low natural gas prices and the new mercury and air toxics standards are working to reduce the role of coal-fired generation. The first phase of CSAPR emissions reductions may well be achieved without a new rule.

But in the not-too-distant future, a new rule will be needed. The court will not allow CAIR to remain in effect indefinitely. And a number of states will need a more stringent cross-state rule to comply with ozone and particulate matter standards.  The new EPA administrator will almost certainly oversee a re-redesign of the cross-state air pollution rule.

The constraints that have been imposed in the name of “Good Neighbors” offer, at best, a crude means of accounting for spatial variation in pollution damages. And in limiting the market’s ability to exploit gains from trade across state lines, they increase the cost of cleaning the air. When the agency does return to the proverbial drawing board, we can only hope that the courts have become more amenable to building on – versus dismantling- past successes with market-based regulation.

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