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Authors' Note: The following paper was presented at the Annual Meeting of the A&WMA in June, 1996. Since then, I have completed over 30 ERC trades and have resolved lawsuits against DEP over the ERC program. Contact me for up to date information on ERC trading. HFK November, 2008.

Ozone Offset Trading in Pennsylvania

©Harry F. Klodowski, Jr.

KEYWORDS: Environmental Law, Air Pollution, Ozone, Emissions Trading, Market Mechanisms

The Pennsylvania New Source Review offset requirements and Ozone Transport Region designation created a regulatory framework for statewide VOC and NOX emission reduction trading in January, 1994. The experience of a number of industries attempting to register ERCs illustrate a number of issues not contemplated in the rulemaking process, including verification of credits, adjustments for controls imposed after source shutdowns, errors in the 1990 baseline inventory, and the role of minor or area sources and mobile sources in generating credits for new source review permits.

The legal aspects of negotiating a transfer of ERC's are not specified in the rule, and will be analyzed from the perspective of buyer and seller in early trades under this program. The presentation will explore the factors in development of the market price for VOC and NOX offsets.

INTRODUCTION

The Pennsylvania New Source Review (NSR) offset requirements and designation of Pennsylvania as a state in the Ozone Transport Region created a regulatory framework for statewide VOC and NOX emission reduction trading in January 1994. The experiences of a number of industries attempting to register Emission Reduction Credits (ERCs) in the first two years of this program reveal a number of problems and opportunities not contemplated in the rulemaking process, including verification of credits, errors in the 1990 baseline inventory, and the role of minor sources in generating credits for new source review permits.

The program for NSR emissions offsets or ERCs is a combination of command and control regulation and free market mechanisms. The procedure for generating and consuming ERCs is specified by regulation. The purchase and transfer of ERCs are not regulated. The legal aspects of negotiating a transfer of ERCs are not specified in the new source rule, and are analyzed from the perspective of buyer and seller in early trades under this program. Factors in development of the market price for NOX offsets are discussed.

The NSR emission trading program is only one of five possible emission trading programs that will be in effect in Pennsylvania in the next few years. The other trading programs are the existing Title III Emission Allowance program, the Open Market Trading Rule (OMTR) expected in 1996, and future trading programs under the Ozone Transport Commission Memorandum of Understanding (OTCMOU) and Ozone Transport Assessment Group (OTAG) now being developed. The possibility of five different trading programs, each with its own currency and rules, creates the potential for an enormously complex emissions trading environment.

FUNDAMENTALS OF NEW SOURCE REVIEW

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 Pennsylvania 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 Lowest Achievable Emissions Rate 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 in Pennsylvania.

REGULATORY FRAMEWORK

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 or operation permit.

Because the entire state is in the Ozone Transport Region, the NSR rules and offset requirements apply throughout the entire state for Volatile Organic Compounds (VOC) and oxides of nitrogen (NOX).

1. ERC Generation Rules
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" -- controlling emissions to a lower level than is required by law,
  • new technology, materials or processes that reduce emissions,
  • vehicle fuel changes,
  • improved control measures, including control of fugitive emissions,
  • shutdown of a facility, or
  • permanent reduction of production or operating hours.

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, as defined in the regulations. 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 date of the emission reduction. DEP concedes this is an arbitrary deadline. 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.

2. 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, or 25 tons per year in the Philadelphia area.

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 restrictions 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 in moderate non-attainment.

ISSUES IN ERC REGISTRATION

The rules for registration of ERCs for new source offsets are fairly detailed and well defined, particularly when compared to other contemplated emission trading programs such as the OMTR. Even so, experience in the first two years of Pennsylvania's program has shown that implementation of the program can be complex and time consuming.

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. While there is a 1990 emissions inventory for Pennsylvania, the data reported is often found to be inaccurate when later reviewed, either because generators did not understand the inventory process, or the regulatory agency erred in compiling reports from sources. Accuracy of the 1990 inventory was not a high priority for either industry or regulators under laws in effect at that time. However, because the 1990 inventory was part of Pennsylvania's State Implementation Plan (SIP), a revision to the 1990 inventory is a revision to the SIP which must be approved by state and federal agencies. SIP revisions are lengthy processes, and it appears an inventory revision is likely to take at least a year if both the local agency and federal review proceed expeditiously. An increase in historical emission inventory figures might result in an increase in emission fees due for those years.

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. 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.

Surplus reductions are reductions in excess of a legal control requirement, and reductions in credits allowed can occur before and after registration. The most common control requirement for VOC or NOX sources in Pennsylvania is the Reasonably Available Control Technology (RACT) program established by regulation in January 1994. Under RACT, sources that could eliminate NOX reductions for $1,500 per ton or VOC emissions for $3,000 per ton were required to install this control technology by May 31, 1995. A source operating in 1990 that shut down in 1992 would have its ERCs reduced by the amount that would have been eliminated by the RACT program (or any other control requirement) before the ERCs can be entered in the ERC registry. Credits in the ERC registry will be discounted by future control requirements that become applicable before the ERCs are consumed. For example, a surface coating facility that closed in 1995 would have its banked emissions reduced if a MACT standard became applicable to the facility in 1997.

DEP initially interpreted the regulation as allowing only major sources to register ERCs, but has changed its policy to allow minor sources to register ERCs if they are shown to be surplus, permanent, quantified and federally enforceable. Federal enforceability for an operating minor source can be accomplished quickly through a state or minor source operating permit when state permit rules are approved as part of the SIP. A shutdown source must find another, probably time consuming method of proving federal enforceability.

LEGAL ISSUES FOR BUYERS AND SELLERS

The Pennsylvania rules establish a procedure for the registration process, entry into the ERC registry, and consumption of ERCs when they are used in the operation permit for a new source. Except for restrictions on where ERCs can be consumed, there is little regulation of ERC trades. Generators notify DEP to transfer credits to a consumer. The rule provides third parties cannot own or hold ERCs, but DEP will allow economic development agencies to hold credits. ERCs must be transferred from generator to consumer in the registry.

Transactions in ERCs are governed by the common law, and it is helpful to think of ERCs as an intangible property 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. DEP need not be informed of the price paid for ERCs in any transaction. Buyers have asked for extensive warranties from sellers on the generator's regulatory compliance issues discussed above, and seek escape clauses if the credits 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 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. The market value of ERCs for various pollutants is not yet clear because the rules creating them are relatively new and there have not been many trades under this program. The pricing of ERCs is set by the "law" of supply and demand.

However, there is a theoretical floor for valuation of NOX and VOC credits, based on the cost of technology to reduce emissions. A new source that has existing operations in Pennsylvania has the option of decreasing emissions at an operating plant to create ERCs for the new facility. Because ERCs must be surplus, that is, more than required by existing law, the cost of controls now required of a source sets a minimum price for ERCs. For example, for VOC and NOX emissions, Pennsylvania's RACT program requires a major source to spend up to $1,500 per ton to reduce NOX emissions and up to $3,000 a ton of VOC emissions. Therefore, to generate a ton of VOC ERCs from an existing plant, the plant is required to install more effective and more expensive controls to make the ERCs "surplus". The actual cost of additional controls at any given operation will vary depending on the configuration of the plant, but experts advise that a rule of thumb is two times the RACT control cost. Under this theory, a ton of NOX ERCs should be worth at least $3,000 per ton and VOC ERCs should trade for at least $6,000 per ton. These values are consistent with recent trades reported in California and Texas for new source offsets.

Proof of this theory will depend on actual trades of ERCs, since the law of supply and demand will establish the trading price. There have only been a handful of major new sources constructed in Pennsylvania (outside of the Philadelphia area) in the last twenty years, but there are now about ten projects under construction or in the planning phase.

There have been a small number of private trades for new source ERCs, but only one public sale of NOX ERCs. In February 1995, a bankrupt glass plant sold about 500 tons of NOX ERCs in a public auction in the bankruptcy court. There were three active bidders and the credits were sold for $2,800 per ton. Other trades of NOX are believed to be near this price. In the Philadelphia area, prices discussed are about four to five times higher, but an actual trade at these levels has not been reported.

At the present time there appear to be more ERC sellers than buyers and pricing is at the lower end of the theoretical value. However, there is reason to suspect the future will see more buyers, and the sales price will increase dramatically.

Pennsylvania is required to publish a quarterly summary of the ERC registry in the Pennsylvania Bulletin, the equivalent of the Federal Register. The first publication of the registry is expected in 1996. A prepublication summary indicates that there are less than 10,000 tons of NOX and 3,000 tons of VOC ERCs in the inventory for the entire state of Pennsylvania. A single new glass plant now under construction will consume over 1,200 tons NOX and 200 tons of VOC ERCs. Simple mathematics indicates that about eight more such plants can be built before the ERC bank runs dry. Furthermore, many of the ERCs now identified are shutdown credits and will be eliminated from the bank when their ten-year life expires. The size of the emissions "bank" could be increased by deleting the arbitrary one- year deadline for filing registry applications, and the 10-year sunset period for shutdown credits.

CONCLUSION

A review of experience under Pennsylvania's new source ERC program for VOC and NOX emissions leads to regulatory and practical concerns for future operation of the new source offset program, and other types of future emission trading programs. First, the new source ERC program is conceptually simple, but has taken more time than expected to put into operation. More than two years into the program, DEP is still promising to publish an incomplete listing of the statewide ERC registry. The requirements for regulatory review of ERC applications and ERC consumption at both the state and federal levels results in an expensive and time consuming process. It appears it takes at least a year, and perhaps two to three years to work through the process. In commercial practice, approvals for new construction that take longer than 6 to 12 months impose an impediment to the development. DEP has indicated it wants to revise the NSR process to simplify the procedure, and some of the delays attributable to federal review should be eliminated when EPA approves the state permitting program. However, future trading programs such as OMTR and OTC MOU trading are more complicated, may take even more time to implement, and may impose additional barriers to new development.

The relatively low quantity of ERCs contained in the Pennsylvania registry indicates that pricing is now low, but will likely increase as projects consume the credits now banked. It appears that a small number of new plants, perhaps a dozen, could completely exhaust the available supply of ERC offsets in the entire state of Pennsylvania. While it is true that rising prices will make it more attractive for generators to create overcontrol ERCs, the increased cost of offsets or the exhaustion of the bank will make it difficult or impossible to locate a new source in Pennsylvania in the future.