News & Articles

Emissions Trading In The Northeast
Harry F. Klodowski, Esq.

This paper was presented at the Air & Waste Management Association Conference on June 24, 2003. Contact the author for more up-to-date information.

ABSTRACT

Emissions trading in the Northeast corridor has developed into distinct markets-the EPA/SIP call Allowance market for operation of large sources is replacing the OTC Allowance scheme effective since 1999; and the ERC market for construction of sources has split into the moderate areas, where credits are available, and the serious or severe areas where credits are scarce. This paper will cover the basics of trading system operations and the respective markets and discuss new rules, reciprocity agreements and agency policies that affect the trading of emission credits or allowances.

INTRODUCTION

There are two major systems of trading air pollution rights in the Northeast. The ERC system applies to construction of all "major" sources of pollution and usually VOC and NOx are traded. ERCs, in units of tons per year, are traded on a one-time basis. New Source Review (NSR) offset requirements and designation of northeastern states as the Ozone Transport Region created a regulatory framework for statewide and interstate VOC and NOx emission reduction trading. The NOx Allowance Trading Program for operation of large powerplants began in the 13 OTC states in May 1999 and was extended to most states east of the Mississippi by the EPA NOx SIP Call rules effective in May 2004 for most states and May 2003 for Pennsylvania. NOx allowances (in tons per ozone season) are sold each year, that is, for 2004 or 2005.

The program for trading ERCs or NOx Allowances is a combination of command and control regulation and free market mechanisms. The procedure for generating and consuming ERCs or NOx Allowances is specified by regulation. The purchase and transfer of ERCs and allowances are not regulated. The legal aspects of negotiating a transfer are not specified in the rules, and are analyzed from the perspective of buyer and seller. Factors in development of the market price for offsets and allowances are discussed.

REGULATORY BASIS FOR ERC TRADING

ERC trading is authorized by regulations for the construction of new large sources of air pollution called New Source Review (NSR) rules. The principles behind the NSR rules are fairly simple and practical, designed to permit new economic development in areas where air quality does not meet health-based standards. When the air is already bad, how can the government allow new pollution resulting from a new plant or expansion of an existing plant?

Both federal and state NSR rules require a new plant that is a major source of air pollutants (or a plant expansion beyond a certain size) to obtain a construction permit, install Best Available Control Technology (BACT) air pollution controls at the new source, conduct an alternatives analysis, and reduce total emissions of pollutants in the area by offsetting or reducing pollution from another source at that plant or from other plants in the area. The purpose of the ERC trading program is to establish a bank of emission offsets that can be used to allow construction of new sources. A new source must retire more pollution than it generates. The NSR offset rules create a market for ERCs that will be necessary for future industrial development.

ERC RULES

The Federal NSR rules create an offset requirement, but there are no federal rules on ERC generation. Each state has its own rules. Pennsylvania's are analyzed as an example. Pennsylvania's NSR rules, 25 Pa. Code § 127.206 et seq., became effective on January 15, 1994. The ERC rules require the Pennsylvania Department of Environmental Protection (DEP) to review ERC registration applications for compliance with regulatory requirements; maintain a statewide registry of ERCs; and deduct ERCs from the registry when ERCs are consumed in issuance of a construction permit.

An emissions reduction is any reduction in pollutants beyond the emissions level allowed by law. Under Pennsylvania's New Source Review rules, emission reduction credits can be created by over control or shutdowns. Plants that have closed, reduced production capacity, changed production processes, or substituted less polluting materials may be able to generate or register ERCs. ERCs based on plant shutdowns or decreases in production must be used within ten years; ERCs resulting from over-control never expire. ERCs must be surplus, permanent, quantified, and federally enforceable.

NOx emissions result from consumption of fossil fuels; VOC emissions primarily come from use of solvents or petroleum. Industries that have registered ERCs include glass, steel, power generation, surface coating, paint and pigment manufacturing, printing, chemical production, dry cleaning, solvent degreasing and asphalt production. The quantity of ERCs is initially calculated by the generator. An ERC registration application is due one year after the last date the source operated. DEP will review registry applications to determine if the ERCs meet all requirements. The baseline emissions rate is based on an average of emissions from the two years prior to the emissions reduction, unless another period is more representative of normal emission rates.

1. ERC Consumption Requirements

Under the NSR offset rules, a major source, major modification of an existing source, or new source at an existing facility must purchase emissions offsets in an amount greater than its projected actual emissions. A major new source is a facility with the potential to emit more than 100 tons per year of NOx or 50 tons per year VOC in Pennsylvania, excluding Philadelphia. In the Philadelphia area, a source with the potential to emit more than 25 tons per year VOC or NOx is a major source. New sources at existing facilities are those with the potential to emit 40 tons per year NOx or VOC in Pennsylvania (moderate nonattainment), or 25 tons per year in the Philadelphia area (severe nonattainment).

When ERCs are "used" in a permit, DEP must determine that they are available for use for the specific pollutant in the particular nonattainment area. The offset ratio needed for a new source depends on its location: it is 115% of emissions in most of Pennsylvania and 130% of emissions in the Philadelphia metropolitan region.

The major restriction on use of ERCs is they must be used in the same nonattainment area, for the same pollutant. Credits from a "cleaner area" cannot be used in a "dirtier" area. For VOC and NOx, credits generated in Pennsylvania can be used throughout Pennsylvania (excluding the Philadelphia metropolitan area) or within 120 miles or two days transport downwind of the generating plant. This is because the entire state is located in the Ozone Transport Region (OTR) and is considered, for regulatory purposes, to be a simple, moderate non-attainment area.

2. Issues In ERC Registration

The initial challenge for a generator of ERCs is to establish that the credits are surplus, permanent, quantified and federally enforceable for purposes of regulatory review. Generators are required to show a reduction from a 1990 baseline and an actual emission baseline of 2 more recent years. While there is a 1990 emissions inventory for Pennsylvania, the data reported is often found to be inaccurate, either because generators did not understand the inventory process, or the regulatory agency erred in compiling reports from sources.

The second challenge is in quantification of emissions. Before 1990, very few sources were required to test emissions. Most ERC generators rely on emissions estimates. Although there are standard emission factor references such as AIRS or AP-42, emission estimates are not available for some operations and regulatory personnel are often skeptical of the accuracy of emissions factors. Regulators will compare estimated emissions, compliance test results and emission fee statements to set a baseline. Lack of confidence in emission estimates results in delays in regulatory approvals. However, agency review of ERC applications before registration gives some verification of the quantity of credits.

3. Interstate Trading Of ERCs

Because all areas in the Ozone Transport Commission states are treated as if they are moderate nonattainment areas and many states have both moderate and severe areas, it was legally possible to create regional rather than statewide trading. A 3-state trading region consisting of New York, Pennsylvania and Maryland was created through interstate agreements- New York and Pennsylvania in 1996 and Maryland and Pennsylvania in December 2001. An agreement between New Jersey and Pennsylvania was not completed.

The interstate trading of ERCs has created opportunities and complications. Both New York and Pennsylvania have published fairly detailed rules, but Maryland's ERC rules remain in draft form and trades are evaluated on a case by case basis. The rules are not identical from state to state. For example, Pennsylvania shutdown credits expire 10 years after the last date the source operated; New York rules do not contain such a restriction. Pennsylvania would probably not allow 11-year-old New York shutdown credits to be transferred to Pennsylvania. This issue is specifically addressed in the more recent Maryland reciprocity agreement. The rules on credit registration and verification also differ.

BASIS FOR NOx ALLOWANCE TRADING

The OTC NOx Allowance System, 25 Pa Code §123.101, and EPA SIP Call NOx Allowance Trading System, 25 Pa Code §145.1, follow a similar pattern. The purpose is to achieve improvements in ground level ozone levels in the Northeast by causing a substantial decrease in NOx emissions from large powerplants and some other sources. This is a cap and trade system such as used earlier in the SO2 trading rules under the "Title IV" or Acid rain program rules. There is more governmental involvement in a cap and trade system than the ERC system because the government sets the emission cap, allocates the tradable allowances and enforces the system. There is an annual reconciliation date, when sources must possess enough allowances to cover their NOx emissions. The program was designed to be regional (13 or 22 states) from the beginning. Federal and state rules on NOx allowances are essentially identical. This analysis will discuss the NOx SIP rule as set out in Pennsylvania regulations at 25 Pa Code § 145.1 et seq.

1. Allocations

The emissions cap and allowance allocations were done on a state by state basis, that is, EPA gave each state a statewide ozone season NOx emissions level derived from a percentage reduction from historic emissions of large powerplants (more than 250 mmBtu/hr, or 25 MW). Each state allocated this quantity to existing emission sources, making deductions for new sources, a new source allowance pool and a compliance supplement pool. In Pennsylvania, the eventual initial allocations are published as part of the regulation. The initial round of allocations may be decreased in 2003 and again in 2008.

2. Use Of Allocations

Each source covered by this program must obtain an ORIS identification number from the Energy Information Administration (EIA) of the U. S. Department of Energy and register as part of the NATS (National Allowance Trading System). The sources must operate Continuous Emission Monitors (CEMs) for NOx and report their emissions. In some states, sources must follow both federal and state regulations on CEM operations. At the end of each year, each source must reconcile its annual emissions with the quantity of NOx allowance it has purchased for that year.

3. Trading Of NOx Allowances

As with ERCs, the trading of NOx allowances is not covered by federal or state regulations. A number of emissions brokers keep track of bids to purchase and offers to sell NOx Allowances and publish the prices for public reference.

The "bankbook" is kept by the government. Each source has an account and designates an authorized representative for trades. Each source must file a Compliance Certification Report by November 30 of each year. Allowances are deducted from the sources' compliance account. Each source also has an overdraft account and a general account.

Sources emitting less than their allowance allocation have surplus allowances that can be traded to another source or carried over to another year, subject to some restrictions. 25 Pa Code §145.55. NOx allowances are assigned an ID number. To make a transfer, both buyer and seller must write to the budget administrator, providing the ID numbers of the sources, the serial number of the allowances transferred and the name and signature of the authorized representative of the seller. The transfer must be recorded within 5 days and written notice of the transfer is given to both parties.

LEGAL ISSUES FOR BUYERS AND SELLERS

The Pennsylvania rules establish a procedure for registration of ERCs or allocation of allowances, entry into the respective registry, and consumption when they are used in the permit for a source. Except for restrictions on where ERCs or allowances can be consumed, there is little regulation of trades. In the ERC program, generators notify DEP to transfer credits to a consumer. The rules provide third parties cannot own or hold ERCs, but DEP will allow economic development agencies to hold credits. ERCs must be transferred from generator or "holder" to the consumer or permittee in the registry.

Transactions in ERCs and allowances are governed by the common law, and it is helpful to think of pollution rights as an intangible property right for purpose of transfer of credits. A sale immediately transfers credits. Generators may also sell an option to transfer credits in the future. The DEP does not have power to regulate the sale other than to ascertain that the specific ERCs satisfy offset requirements, or the allowances meet the criteria for trading. DEP need not be informed of the price paid for ERCs or allowances in any transaction. Buyers have asked for extensive warranties from sellers on the generator's regulatory compliance issues and seek escape clauses if the credits or allowances cannot be used for their intended purpose. Sellers want to avoid representations and warranties, and try to sell on an "as is, where is" basis. There is no standard form of agreement, and terms of sale are negotiated in each transaction.

Pennsylvania rules do not address the issue of whether a registered ERC or allowance is a property right. To avoid litigation over "takings" of property, regulators have been careful to define environmental permits as a permission or license to operate, revocable at the will of the agency. Older case law supports the proposition that a permit is not a property right. However, the increased attention to market-based regulatory mechanisms and emissions trading programs arguably creates an intangible property right in emission credits that can be sold to another company.

DEVELOPMENT OF A MARKET PRICE

The government does not set prices, and has limited power to regulate the trading of, ERCs and NOx Allowances. The pricing of ERCs is set by the "law" of supply and demand. There are two distinct markets for ERCs - the severe nonattainment area from Washington through Baltimore, Delaware, Philadelphia, New Jersey and New York City and the moderate nonattainment area to the east, covering most of Maryland, Pennsylvania and upstate New York.

For most of the last three years, there has been a shortage of both VOC and NOx offsets in the severe areas. Industrial expansion and new powerplant projects stimulated demand. A small initial supply and expiration of shutdown credits contributed to the shortage. Prices for NOx ERCs rose from $5,000 a ton to more than $12,000 per ton. VOC prices rose from $3,000 per ton to $6,000 per ton. In some cases, the prices quoted were illusory, as no credits could actually be found at that price. The shortage resulted in some creative ways to obtain credits: credits were resold from industrial sources or non-profits that had received them as donations. New reciprocity agreements provided a temporary solution. The ERC shortage eased in late 2002, due to the cancellation of a number of gas turbine electric generation projects.

In contrast, the moderate nonattainment areas have seen abundant supply of credits and limited demand. Despite the expiration of some Pennsylvania ERCs due to the ten-year life of shutdown credits, both NOx and VOC credits have recently sold for 25% less than they sold for four years ago.

The NOx Allowance market has more uniform pricing. OTC NOx allowances traded for about $3,000 per ton per year. The pricing of 2004 and later NOx SIP Call allowances has been in the $5,000 to $6,000 per ton range per year. In early 2003,allowances were trading at about 7,500 per ton per year. Conventional wisdom is that the prices may decrease as more SCR/SNCR units become operational on existing powerplants.

CONCLUSION

There were a number of new policy developments in late 2002. Maryland and Pennsylvania signed a trading reciprocity agreement. Maryland continues to move toward a detailed ERC rule. Drafts of the proposal indicate that Maryland may repeat flaws in Pennsylvania's system by limiting the useful life of shutdown credits and not providing a deadline for processing ERC applications. Most of the ERCs sold or currently available for sale are shutdown credits. There have been very few overcontrol credits registered in Pennsylvania since 1994. The overall amount of banked credits throughout the state continues to decline. Maryland did explore interpollutant trading, allowing use of severe VOC credits in place of severe NOx credits, at a ratio of 1.69 tons VOC to each ton of NOx. Pennsylvania obtained USEPA Region III's approval to use the same ratio in the Philadelphia severe nonattainment area.

Pennsylvania will begin using the SIP Call NOx allocation system a year before most of the surrounding states, but pricing of 2003 allowances does not show a great change from the "old" OTC system to the new program.

As noted earlier, the ERC program applies to construction of sources and the allowance system applies to operation of sources. A new NOx source such as a powerplant must comply with both trading programs. Before the collapse of the merchant electric generation industry, the scarcity of ERCs was becoming a significant hurdle in construction of new sources. New sources will have to solve this problem as the economy recovers.