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ENVIRONMENTAL FINANCE MAY 2007 21

M A R K E T V I E W

Once considered a grand exper-iment, the use of cap-and-trade programmes today is readily embracedas an efficient and effective means to reduce

air pollution.First applied on a large scale to sulphurdioxide (SO

2) emissions in the US under the

1990 Clean Air Act Amendments, cap-and-trade programmes managed by the USEnvironmental Protection Agency (EPA) havesince expanded to include the NOx BudgetTrading Program.

From an environmental standpoint, resultsfrom these two US programmes have beenoutstanding. SO

2emissions have dropped by

more than 7 million tons below 1980 levels (a41% reduction) and the greatest SO

2reduc-

tions have occurred in areas of highest emis-sions. In the NOx Budget Trading Programregion, emissions were 57% lower in 2005

than in 2000.1

These emission reduction benefits haveoccurred while electrical generationincreased significantly and have coincided withsubstantial costs savings. A 2005 study report-ed in theJournal of Environmental Managementnoted that the benefits of the Acid RainProgram in 2010 would be $122 billion annu-ally (in 2000 dollars), against costs of around$3 billion (for both SO

2and the more tradi-

tional NOX programmes).2

These tremendous benefits do not meanthat there have not been obstacles along theway. For example, lack of familiarity with pric-ing fundamentals and uncertainty from legal

challenges led to temporary price spikes inthe early days of the NOx markets. However,because only low volumes of allowances weretransacted during those spikes, the impact onthe overall market was insignificant. In fact,most NOx trading by volume has occurredwhen prices have not been volatile and whenwell below EPA projections (this has also gen-erally been the case in the SO

2market).NOx

prices self-corrected as more information

Moving to the new US

NOx and SO2 markets

The Environmental MarketsAssociation consists of more than 270members from 190 companies world-

wide. Its aim is to promote market-based trading solutions for environ-mental control

Daniel Chartierand Melanie LaCount contend that asthe US moves to the new Clean Air Interstate Rule, cap andtrade will once again deliver the desired results by building onthe success of current programmes

NOx programme creates a new annual pro-gramme to help implement the fine particu-late standard, and tightens the requirementsfor the seasonal NOx programme for ozonecontrol (see Environmental Finance,April 2005,pages 1618).

Modelling by the EPA during the ruledevelopment suggests that pre-2010 vintageSO

2allowances would be worth approximate-

ly $736 per allowance in 2010 (in 2007 dol-lars), and that 201014 vintage allowanceswould be worth approximately $368 perallowance due to the 2:1 retirement ratio.Today, with 2007 vintage allowances trading atapproximately $415 per ton (as of early April2007), observers generally agree that the SO

2

market is undervalued. But with allowancedemand low as utilities finalise complianceplans, there is little current support for high-er prices.

The EPAs modelling of the NOx market

projects prices in the annual market to be$1,440 a ton in 2010.While there will be twodistinct markets, the EPA expects that theprices in both the annual and seasonal mar-kets will be established by the cost of controlsfor annual compliance.

There has been trading activity in the2009 seasonal market, but allowances for thenew annual NOx CAIR market have yet totrade. Observers expect that trading will notoccur until state implementation plans forCAIR have been approved and NOxallowance accounts are populated.

For both the SO2and NOx markets,it will

take time for buyers and sellers to fully under-stand the fundamentals of the changes intro-

duced by CAIR.But as the CAIR markets con-tinue to develop, they do so with the advan-tage of the 14 years of maturity, experienceand sophistication gained since the first SO

2

trades were announced in 1993.Most importantly, as CAIR-related trading

activity evolves, cap and trade will ensure theenvironmental results will be achieved andthat is the true measure of success.Daniel Chartier and Melanie LaCount work inUS EPAs Clean Air Markets Division inWashington, D.C, on market-based programmedesign and implementation. E-mails:chartier.daniel@epa.gov andlacount.melanie@epa.gov

The opinions expressed in the above articleare not necessarily the opinions of the EMA, itsmembers or its member companies.

became available on the cost of controls andas the legal challenges were settled.

Compliance with the programmes hasbeen nearly 100%, with minor cases of non-

compliance mostly due to corporate account-ing errors, where a small number of firmsinadvertently held fewer allowances thanneeded at compliance deadlines. In spite ofthis, because the cap-and-trade schemes were

designed with automatic penalty provisions,including the requirement to surrender futureallowances to offset any excess emissions,their environmental integrity has never beencompromised.

Todays markets are increasingly sophisti-cated. Moving past the early days of market for-mation where participants relied on spot, for-ward or swap transactions,market participantstoday enjoy an active options market, severalalternatives for exchange-traded futures prod-ucts, and a growing market for financial settle-

ment. Adding to the maturity of the marketshas been the entrance of banks, hedge fundsand insurance companies, each adding liquidityto help increase market efficiency.

With the success of these programmesserving as the backdrop, the NOx and SO

2

markets are getting ready for the implemen-tation of the new mandates of the Clean AirInterstate Rule (CAIR).CAIR requires furtherreductions in NOx and SO

2in 29 eastern

jurisdictions to facilitate attainment of theNational Ambient Air Quality Standards forfine particulates and ozone.

Under CAIR, the existing Acid RainProgram continues, with the overlay of a new

CAIR SO2 obligation that requires 201014vintage allowances to be surrendered at a 2:1ratio,and vintage 2015 and later allowances tobe surrendered at a 2.85:1 ratio. The CAIR

EF

1 For a complete discussion of the environmental gains

see the annual progress reports for the Acid Rain and

NOx Budget Programs at www.epa.gov/airmarkets/

progress.

2 Chestnut, L G; Mills,D M,A Fresh Look at the Benefitsand Costs of the US Acid Rain Program, Journal of

Environmental Management, 2005, Vol 77, Issue 3, pp

252256.

As the CAIR markets

continue to develop, they

do so with the advantage

of the 14 years of

maturity, experience and

sophistication gained since

the first SO2

trades