PDF _ RL34235 - Air Pollution as a Commodity: Regulation of the Sulfur Dioxide Allowance Market
31-Oct-2007; Larry Parker and Mark Jickling; 25 p.

Abstract: A number of congressional proposals to advance programs that reduce greenhouse gases (GHGs) have been introduced in the 110th Congress. Proposals receiving particular attention would create market-based GHG reduction programs along the lines of the allowance trading provisions of the current acid rain reduction program established by Title IV of the 1990 Clean Air Act Amendments. Under the program, an allowance is limited authorization to emit a ton of pollutant.

However, there are several important differences. For example, the scope of the greenhouse gases control program would be substantially greater than the Title IV program, involving more covered sectors and entities. This diversity multiplies as the global nature of the climate change issue is considered, along with the multiple GHGs involved. Thus, a carbon market is likely to involve far greater numbers of affected parties from diverse industries than the current Title IV program.

It will also involve far greater numbers of tradeable allowances than the current Title IV program. Under the current program, about 9 million allowances are allocated to over 2,000 emission sources annually. In contrast, a greenhouse gas program that capped emissions in the electric power, transportation, and industry sectors at their 1990 levels at some point in the future would be allocating about 4.85 billion allowances annually. Trading activities under Title IV has been increasing since 2005. However, it doesn’t approach the anticipated volumes that would occur if a greenhouse gas cap-and-trade program was instituted. Likewise, the economic value of a future carbon market is likely to be substantially greater than the Title IV program. Currently, the annual allocation of SO2 allowances has a market value of about $4.5 billion. Using estimates of $15 to $25 an allowance, the annual allocation of 4.85 billion allowances posited above for a greenhouse gas program would have a market value of $72.8 billion to $121.3 billion. Despite these differences in scope and magnitude, there are trends in Title IV trading that are likely to continue in a carbon market. First, there is a trend toward more diverse, non-traditional participants in the Title IV market. Like the Title IV market, the economic importance of a carbon market will likely draw in entities not directly affected by the reduction requirements, such as financial institutions. These entities’ motivations may be equally diverse, including facilitating projects involving the need for allowances, portfolio balancing, intermediary fees, and trading profits.

Second, as noted, there is a trend in the Title IV market toward using financial instruments to manage allowance price risk. Given the greater economic stakes involved in a carbon market, this trend toward more sophisticated financial instruments is likely to emerge early as a hedge against price uncertainty. The emergence of entities well-versed in the use of these instruments may reinforce the trend and make options, collars, strangles, and other structures as common in the allowance market as they are in other commodity markets. With a more liquid and dynamic market, a carbon market may look more like other energy markets, such as natural gas and oil, than the somewhat sedate SO allowance market.  [read report]

Topics: Air, Pollution, Economics & Trade

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