Sulfur dioxide control by electric utilities: What are the gains from trade?

Title IV of the 1990 Clean Air Act Amendments (CAAA) established a market f or transferable sulfur dioxide (SO2) emission allowances among electric uti lities. This market offers firms facing high marginal abatement costs the o pportunity to purchase the right to emit SO2 from firms with lower costs, a nd this is expected to yield cost savings compared to a command-and-control approach to environmental regulation. This paper uses econometrically esti mated marginal abatement cost functions for power plants affected by Title IV of the CAAA to evaluate the performance of the SO2 allowance market. Spe cifically, we investigate whether the much-heralded fall in the cost of aba ting SO,, compared to original estimates, can be attributed to allowance tr ading. We demonstrate that, for plants that use low-sulfur coal to reduce S O, emissions, technical change and the fall in prices of low-sulfur coal ha ve lowered marginal abatement cost curves by over 50 percent since 1985. Th e flexibility to take advantage of these changes is the main source of cost reductions, rather than trading per se. In the long run, allowance trading may achieve cost savings of $700-$800 million per year compared to an "enl ightened" command-and-control program characterized by a uniform emission r ate standard. The cost savings would be twice as great if the alternative t o trading were forced scrubbing. However, a comparison of potential cost sa vings in 1995 and 1996 with modeled costs of actual emissions suggests that most trading gains were unrealized in the first two years of the program.