AIR POLLUTION:

Uneasy emission traders seek help from Congress on CAIR replacement

Experts say the proposed replacement for the Clean Air Interstate Rule unveiled by U.S. EPA last week would do little to relieve the uncertainty that has gripped emission markets since a federal appeals court tossed out the rule two years ago.

Congressional action, emissions traders say, is needed to bolster the program.

Constraints of the court decision have forced EPA to make choices that could hamper the new program's effectiveness for curbing emissions of sulfur dioxide (SO2) and nitrogen oxides (NOx) in the eastern United States, said Paul Tesoriero, director of emissions markets at brokerage Evolution Markets Inc.

Though environmentalists have praised tighter emission caps under the rule, pollution is likely to spike in the short run as utilities prepare for the final version of the proposed rule to take effect in 2012, said Nathan Richardson, a visiting scholar at environmental think tank Resources for the Future (RFF). The agency's proposal has effectively locked in lower emissions prices for now, in the hope that the program and its tougher pollution caps will survive legal challenges, traders say.

Existing allowances of SO2 traded at about $5 per ton last week, down from about $15 per ton before the release of the transport rule. They had hovered around $300 per ton before CAIR's rejection in 2008.

"There would be all these unintended consequences and strange effects, both for regulated entities and for emissions levels, and I'm not sure that there's a whole lot EPA can do about it," Richardson said. "They really got kicked in the teeth by that ruling."

Worried that history could repeat itself after EPA's replacement for CAIR takes effect, the Environmental Markets Association (EMA) said in a statement that legislation is needed "to provide EPA with sufficient flexibility in the future to avoid the problems that EPA has encountered in trying to maintain a viable emissions trading market."

The group, which represents emission traders, is focused on a bill (S. 2995) from Sens. Tom Carper (D-Del.) and Lamar Alexander (R-Tenn.) that would give EPA explicit authority to establish an interstate trading program for SO2, NOx and mercury.

Since the court's rejection of the CAIR program, the markets for SO2 and NOx allowances "have been in complete and utter disarray," EMA wrote in an April letter to Senate Environment and Public Works Chairwoman Barbara Boxer (D-Calif.).

"Without Congressional intervention, these markets may not recover," the letter says. "We believe these experiences are undermining the public's perception of cap-and-trade and are causing people, including those intimately involved in these markets, to lose confidence in them. This, in turn, could undermine efforts in Congress to address global warming and efforts by California to establish its trading program."

Carper, a longtime supporter of multi-pollutant legislation, has said he intends to seek a committee markup after EPA releases new modeling of his legislation, and Boxer has said she would schedule a markup of his bill "whenever he has it ready." Though the modeling is expected soon, EPA air chief Gina McCarthy declined last week to give a timeline for its release.

Proponents of legislation say a clear mandate from Congress would ensure that the CAIR replacement would not face the same legal fate as its predecessor. Though the court decision constrains the agency's ability to put trading programs in place, Carper feels EPA has done well with the tools at its disposal, a Senate aide familiar with Carper's bill said this week.

Still, the proposal that emerged last week is "complicated" and "open for further lawsuits," Carper said in a statement.

"My legislation even sets greater reduction targets than this tailoring rule while at the same time giving more flexibility to businesses to make those reductions. Just as important, my legislation provides certainty for businesses and public health," Carper said. "To me the path forward is clear -- Congress must pass legislation to address the serious threat posed by air pollution this year."

'Catch-22 for EPA'

The previous trading program was struck down under the "good neighbor" provision of the Clean Air Act, which requires EPA to take action if pollution from one state is preventing another state from complying with federal air standards. Smokestack emissions of SO2 and NOx are often transported by wind, contributing to air-quality problems in Eastern states.

The U.S. Circuit Court of Appeals for the District of Columbia described CAIR as "fundamentally flawed," cautioning that "no amount of tinkering with the rule or revising of the explanations will transform CAIR, as written, into an acceptable rule." Because the program allowed unlimited interstate trading of allowances, the court said in its decision, the trading program failed to "connect states' emissions reductions to any measure of their own significant contributions."

Though EPA seems to agree that interstate trading would provide the most emissions reductions at the lowest cost, experts say, the agency concluded that allowing companies to freely trade allowances across state lines would inevitably run afoul of the court ruling.

Though total emissions would remain below the nationwide cap and individual plants would be paying for the privilege of producing more emissions under an interstate trading program, certain states would end up having a harder time complying with federal air quality rules by the sheer misfortune of being downwind from the power plants using the allowances.

That pitfall is specific to the standards for the six "criteria" pollutants, including SO2 and NOx, that EPA has been directed by Congress to regulate, RFF's Richardson said. Though the agency had tried to administratively strengthen the Title IV program, created by Congress in 1990 to fight acid rain, the court ruling also suggested that EPA had no authority to incorporate the SO2 allowances from that program, he said.

"It's kind of a catch-22 for EPA," Richardson said. "They want to get more environmental benefits by tightening the cap, but if they want to do that, the one vehicle they have prevents them from doing real cap and trade."

The agency has not yet decided whether to carry over NOx allowances from the agency's annual and seasonal ozone trading programs. The agency could choose to carry them over, exclude them or carry them over at a discounted rate, according to the rule.

"If EPA's showing a willingness to bring in those allowances, and they're looking for ideas, then there's still hope," said Evolution Markets' Tesoriero.

Though the agency's proposal includes several options and is subject to change moving forward, EPA's program will not have "open-ended flexibility in terms of interstate trading," EPA's McCarthy told reporters on a conference call last week.

Under the preferred option in EPA's proposed transport rule, each state would have an emissions cap that takes downwind effects into account, she said. Addressing worries about variability in energy demand, EPA would give states a 10 percent buffer, allowing them to exceed their emissions limits under some circumstances and pay for extra allowances later.

The Ozone Transport Commission, a coalition of Eastern states that advises EPA on air pollution issues, hailed the proposed limits on interstate trading. The group said such restrictions are necessary to protect the "tailpipe" states that have the hardest time complying with ozone standards because of the air pollution carried by air currents.

"By restricting interstate trading, each state will be required to reduce its share of transported pollution, as required by the [court] decision," OTC said in a statement.

EPA expects a legal challenge to the rule, but McCarthy said she does not expect a repeat of CAIR's fate.

"This action that we are announcing today is responsive to that court directive and to the concerns the court has raised regarding the prior CAIR proposal," McCarthy said.

She added, "We have not gone with the same old system."

'These allowances are worthless'

Under the proposed transport rule, EPA would aim to reduce SO2 emissions 71 percent from 2005 levels by 2014 while cutting NOx emissions by 52 percent. Though industry groups have criticized the stricter emissions limits, they too are seeking a measure of certainty and see a market-based system as preferable to command-and-control regulation.

The ruling that struck down CAIR was a blow for many utilities, which had spent millions on emissions controls so they could bank allowances that suddenly lost most of their value.

"On the surface, EPA's preferred approach for accomplishing these emissions cuts -- by allowing limited interstate emissions trading -- is the most reasonable of the options on the table," said Dan Riedinger, a spokesman for the Edison Electric Institute, in a statement after the release of the proposed rule. "However, the fact that EPA will put in place similar regulations in 2012 to deal with an even tighter air quality standard leaves the power sector exposed to a great deal of regulatory uncertainty."

Traders were cool to the state-by-state emissions caps and limited interstate trading included in the 1,361-page rule. The jury is still out on the proposal, but the new trading system seems to be "overly complicated," Tesoriero said.

"Traders like commodity markets to be homogeneous," Tesoriero said, referring to products such as oil and wheat. "The more you say, 'This wheat is only good for this purpose' and assign market segments, the more that really restricts the purpose of trading."

With SO2 allowances trading at about $5 per ton, and little prospect of carrying over the permits into the new program, utilities have little incentive to bank allowances or add emissions controls for the time being, traders say. Because those controls have upkeep costs beyond the original investment, some plants might even find it more cost-effective to use allowances than to turn on scrubbers that have already been installed, traders said.

"There's a balancing act. EPA wants flexibility on the one hand, and on the other hand, they have to have some limits. But in trying to pursue that balance, they've made their job of emissions traders more difficult, in part by failing to provide for the continuity between the current programs and the new trading programs," said Thaddeus Huetteman, chairman of EMA. When it comes to SO2 credits, "the market has said, 'We get the message, these allowances are worthless.'"

Barring acid rain permits from the new trading system would be the "nail in the coffin" of Congress' acid rain program, Tesoriero said. Often held up as the model for a potential cap-and-trade program for greenhouse gases, the creation of the program intended to fight acid rain was followed by a 70 percent decrease in sulfur dioxide (SO2) emissions and a 35 percent drop in emissions of nitrogen oxides.

Though some critics have described the decline of the acid rain program as a sign of the problems with cap and trade, Huetteman said they are overlooking the broader benefits of the program. While the SO2 allowances have lost almost all their value, the NOx trading programs are still kicking, he said.

"If Congress wants to use emissions trading to its ultimate benefit, which includes achieving reductions earlier and at lower cost than any other form of regulation, then it has to provide EPA with the authority to adapt over time," he said. "It can't just create a once-and-for-all trading program as it did with the SO2 acid rain program, issue allowances and say everything's going to be fine for the next 30 years."

Click here to read the proposed rule.

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