- Email: [email protected]
Clear Skies Initiative: New Beginning or Bait and Switch?
Clear Skies Initiative: New Beginning or Bait and Switch? The Bush Administration's cap and trade program to comply with the Clean Air Act will substantially modify the New Source Review process. A cap and trade program without NSR could be better for both the power industry and the environment, if it were coupled to more aggressive emission reduction targets than currently proposed in Clear Skies. Tobey Winters, who directs Nordstar Market Consultants in West Simsbury, Connecticut, has provided energy consulting to the power industry since 1996 with a particular interest in generation markets, including distributed generation and renewable resources. In a career that spans 25 years, he has worked for Argonne National Laboratory, the Gas Research Institute, and Alstom Power in positions involving the evaluation of energy and power markets, technology, and the environment. He received a Ph.D. from the Maxwell School of Citizenship and Public Affairs at Syracuse University. Dr. Winters can be reached by email at [email protected].
56
Tobey Winters
T
he greatest challenge to implementation of the Clean Air Act has been the effort to strike a balance between national objectives and local realities, namely the realities of the wide disparity in environmental conditions throughout the U.S. The Environmental Protection Agency initiated the cap and trade approach to pollution with SO2 in an effort to allow local areas to implement national objectives in the most cost-effective ways. The SO2 program created a market place for trading pollution allowances
# 2002, Elsevier Science Inc., 1040-6190/02/$ ± see front matter PII S1040-6190(02)00331-7
(credits).1 The agency allocated emission allowances and then forced electric generators to either purchase additional allowances or install pollution abatement equipment in order to meet emission targets. As long as the allocated allowances are reduced over time, emissions decline, and progress is made toward achieving clean air goals. The utilities are able to use market forces to determine the most effective means of achieving these goals. However, most air pollution is local. Emission standards for The Electricity Journal
nitrogen oxides (NOx) and particulates require a metropolitan or regional approach. EPA is also required by the 1990 Clean Air Act to evaluate potential toxic elements in coal combustion. After many years of study, EPA has determined that one of these toxic elements, mercury, requires regulation in coal combustion.
I. Federalism in Action From a political perspective, environmental policy has become today's version of 19th century American politics of regionalism. The technical debate on air pollution regulation is factored through elaborate air shed modeling to determine who is imposing pollution on their neighbor, while implementation is settled in the courts, as states align along regional lines. To accommodate the federal nature of the problem, EPA has adopted State Implementation Plans, which allows the states the ability to allocate their ``pollution budgets'' within their own jurisdictions. This budget approach increases local control and lends itself to quanti®cation of pollution rights with cap and trade. However, unlike the SO2 program, the relevant market areas for ozone and haze are regional, leading to smaller and overlapping pollution trading areas, as well as constraints and complications in the application of trading rules. nother cornerstone to environmental policy is
A
July 2002
that pollution abatement costs less to implement in a new facility than by retrofitting an old facility. As a result, EPA has required that major generating stations undergo a ``New Source Review'' (NSR) when making a major modification (capital investment) to an existing facility, with the view that pollution reduction is less costly to implement when new investment occurs. This NSR process requires that new or
From a political perspective, environmental policy has become today's version of 19th century American politics of regionalism. modified generating units employ state-of-the-art pollution control.2 he first major test of the New Source Review process was prompted by the advent of fluid bed technology in the mid- to late 1980s. The legal test was a victory for EPA, as it required that the new technology could not be retrofitted to an existing coal plant without going through the NSR process.3 From then on fluid bed technology became a technology only used on new units, due in large part to the cost and uncertainty of how NSR would be applied. With the rapid spread of combined cycle gas turbine power
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plants in the 1990s, a cleaner and competitively priced alternative to coal emerged for new base load generation. Natural gas combined cycle became the technology of choice for new plants based on capital cost and increased ef®ciency. However, existing coal-®red capacity continued to produce competitively priced electricity, as coal prices declined as lower-cost western coal increased its market share in power plants in Midwest and Eastern states. The pollution gap between new clean generation and existing dirty generation grew.
II. The Gulf Widens It was not until the Clinton Administration that the NSR program became a lightning rod for industry. Toward the end of the Clinton Administration, a number of utilities with large ¯eets of coal units were taken to court for violating NSR, for what the utilities considered to be routine replacements of major components.4 For many years, the utilities had been careful not to increase generating capacity of the boilers, guided in their view by earlier legal precedents. The deregulation of generation at the end of the 1990s provided additional pressures. After acquiring existing plants in a competitive bid process, new and usually out-of-state owners were quickly pressed to add air pollution equipment to these existing
# 2002, Elsevier Science Inc., 1040-6190/02/$±see front matter PII S1040-6190(02)00331-7
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plants by local environmental groups and state legislators. Unlike the previous owners, the new owners do not have recourse to the ratepayer to recoup the cost of this equipment. he result was that generation owners have become increasingly frustrated with the inability to make marginal improvement to their existing steam plants. They fear being caught in a Catch-22 NSR review and required to install state-of-the-art pollution equipmentÐthe cost of which would far outweigh the economic benefits of operational changes.5 On the other hand, the environmental community has seen a growing disparity between the pollution levels of ``grandfathered'' boiler steam plants and the much less polluting new generation of gas-fired turbines. The environmental community was led to believe that coal-fired capacity would be retired and replaced with cleaner technology. The benefits of fleet ``turnover'' had been demonstrated with great success in mobile source pollution control, but coal units continued to operate economically long past their presumed 40year lifetimes.6 As generating plants were spun off into the deregulated market, it
T
became increasingly clear to plant owners that NSR had become a key issue for asset management and competition in the market. The bene®ts of any operational changes would have to be weighed against the cost and uncertainty of NSR.
III. Enter Clear Skies Initiative Although the Bush Administration is ready to jettison some or all of NSR, it is unclear what the Administration's cap and trade program offers, and whether it can unlock the ingenuity of the power industry suf®ciently to offset the lost potential future emission reductions that would have been due to NSR. The early version of the Clear Skies proposal focuses on the environmental goals. The program's focus is on three of the four main pollutants, NOx, SO2 and mercury (EPA has a new standard for the fourth, ®ne particulates). Mercury is added to the regulated list for power plants in keeping with the EPA mandate to regulate hazardous air pollutants.7 As shown in Table 1, the projected emission reductions are substantial. The ®rst-phase
reductions in NOx are calculated to meet the existing one-hour ozone standard. The courts have already sided with EPA for reductions in NOx for the ®rst phase. Further reductions are expected to be required to meet the new eight-hour standard, which is presumably included in the 2018 NOx target level of 1.7 million tons.8 The reduction of SO2 will be obtained primarily as a byproduct of required reductions in mercury. The implied strategy is to obtain mercury reduction with dry scrubbers and particulate controls. This multi-pollutant strategy obtains bene®ts of SO2 and particulate reduction as well as mercury. The Clear Skies Initiative is not a step beyond current law, but it does signal the Administration's approach to mercury control implementation. Overall there is little for the environmental community to support, knowing that other elements of enforcement will be taken away from EPA. A promise to go beyond current settled law with new reductions in Phase Two by 2018 is a remote objective too far in the future. This is particularly true since many of the original deadlines for the 1990 Clean Air Act have already
Table 1: Clear Skies Initiative Emission CapsÐTons per Year Actual 2000
First Phase Reduction
Second Phase Reduction
SO2
11.2 million
4.5 million by 2010
3.0 million by 2018
73%
NOx Mercury
5.1 million 48
2.1 million by 2008 26 by 2010
1.7 million by 2018 15 by 2018
67% 69%
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# 2002, Elsevier Science Inc., 1040-6190/02/$ ± see front matter PII S1040-6190(02)00331-7
Total Reduction by 2018
The Electricity Journal
passed by. For example, ozone attainment was targeted for most areas by 1997. Waiting another 20 years to achieve this objective in unlikely to be interpreted as aggressive by the environmental community. he Clear Skies Initiative appears to accept the status quo ante on emission targets before the Clinton EPA lawsuits. If the Administration targets define the new baseline, the selling point of the Administration proposal to the environmental community is a cap and trade program that yields larger reductions quicker than these baseline objectives. Moreover, these early implementation reductions will need to offset the emissions reductions that would have been attributable to the demise of New Source Review.
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IV. Advantages of Cap and Trade The deregulation of the generation industry has created a cadre of ``asset managers'' who actively consider how power plants can most ef®ciently deploy capital to make their units more pro®table. This does not imply that under traditional regulation managers make poor economic decisions, but under regulation these decisions are driven overwhelmingly by risk avoidance and not by opportunity. The decision to invest, depicted in Table 2, indicates that managers of both regulated and deregulated July 2002
Table 2: Manager's Investment Strategy With Cap and Trade and Without NSR Mandated by Regulation
Market-Driven
Regulated plants
Early implementation and overcompliance
Depends on state regulation
Deregulated plants
Early implementation and overcompliance
Create and sell excess emission credits
generation plants will be a lot more willing to invest in their plants (including air pollution controls) under cap and trade without NSR. The regulated utility manager will still need a nudge from state regulators to fully take advantage of emission trading for SO2, NOx, and mercury reduction. bsent environmental mandates, capital investments in existing plants are tied to economic objectives: incremental output, higher efficiency, and lower-cost operation through strategies like fuel switching. The elimination of NSR makes a lot more of these operational and strategic investments possible, and market trading makes environmental investments less costly to those who invest. Plant investment when SO2 and NOx emission prices are high motivates early compliance, particularly if environmental investment is already mandated at a future date. As it stands, plant managers are reluctant to invest in capital improvements that create NOx emission reductions, because there are limited markets to trade and value these investments. Few managers currently need additional SO2 allowances.
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The kinds of investments that cap and trade would encourage include the following: Overcompliance on pollution control equipment like selective catalytic reduction for NOx and scrubbers for mercury control. Upgrade low-NOx burners from existing early versions to more advanced controls with greater NOx reduction. Boiler steam path upgrades to increase capacity closer to original design. Neural net controls to operate units to optimize pollution control reduction. Re-powering of marginal plants to burn multiple fuels, improve efficiency and increase output. At present there are few incentives and many uncertainties to making these investments. New Source Review is one deterrent, the state regulatory situation is another, and a third deterrent is a lack of a robust markets for pollution credits. A. Owners of newly acquired plants: are they held hostage by NSR? Evidence that NSR is holding back investment in pollution
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59
reduction can be found in the sales and purchases of existing power plants. Since deregulation there has been an active market in the sale of existing plants with multiple bidders, even for the marginally productive stations. The plants have been sold at market prices that re¯ect future expectations of the purchaserÐ not the book value to the sellers. n general, the more economic base load plants were sold at prices that reflected comparable prices for new greenfield generation. Presumably, these new owners plan to make changes in the plants to increase profitability. However, the evidence indicates the contrary: little discretionary investments have been made in these plants. Released from 40 years of regulation, it is surprising that owners could not find investments that could go directly to the bottom line, investments that would not have to be approved and modified by public utility commissions. Moreover, these new owners are aware that new greenfield units will erode their competitive position over time. It is reasonable to conclude that regulatory uncertainty, and NSR in particular, is an important reason these investments have not occurred.9 Some of the more marginal plants have attracted buyers, despite their high cost of operation and doubtful pro®tability. The prices paid re¯ected close to a zero value placed on the generating equipment itself and re¯ect the location and property value of the plant. Here, buy
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and hold for future use makes more sense, but the return on investment only starts after the plant is re-powered or replaced with increased output. The emerging trend to location-based congestion pricing further con®rms the value of strategic locationÐa value that will more likely be captured with the demise of NSR.
Prices paid by new owners of existing plants indicate owners are willing to invest to re-power, modify, or retire and replace (including air pollution equipment) if the regulatory risks are manageable. Even if the owners misjudged the market and overpaid in order to enter a new market area, the realities of competition lead them to discover ways to improve operating margins. B. Societal benefits of cap and trade The direct bene®ts of cap and trade are more pollution reductions sooner, and additional power at low marginal cost. There
# 2002, Elsevier Science Inc., 1040-6190/02/$ ± see front matter PII S1040-6190(02)00331-7
are also some important indirect societal bene®ts. Marginal plants are important in reducing prices during peak periods. Re-investment in these plants, which would also increase output, adds capacity when and where it is most needed. Another indirect societal bene®t is the ability to preserve fuel diversity. The experience in California in 2000±2001, when natural gas prices were unconstrained by fuel competition, testi®es to the value of fuel diversity.10 Although this fuel diversity bene®t is mostly con®ned to the East and West coasts, the dollar value can be signi®cant. The combination of more stringent targets and the absence of NSR will likely spur investment, as owners who fail to invest lose competitive ground. What is needed is a strong forcing mechanism to invest early in air pollution control equipment, with the knowledge that the rules will not change a few years later. In its present form, NSR is a deterrent to investment in air pollution control.
V. The Disadvantages of the Clear Skies Initiative The disadvantages Clear Skies relate to three areas: (1) a free rider problem, (2) environmental justice issues, and (3) a goal-setting problem. Of the three, the current NSR program primarily addresses the elimination of the free rider. The Electricity Journal
A. Gauging effectiveness The effectiveness of the NSR program can be gauged in two ways. One is by the number of permits issued and the resulting reduction in pollution, and the other is the ``deterrent effect,'' whereby existing facilities selfregulate to reduce emissions rather than go through the NSR process. The deterrent effect takes place when facilities reduce emissions in one operation in order to make operational changes in another operation that has the potential to increase emissions. The ``deterrence'' is that the plant owner makes changes that reduce the rate of increase in pollution from existing facilities. It is dif®cult to quantify the impact of ``netting out'' emissions by owners who do not use NSR, but discussions with plant operators indicate that both utilities and industry go to great lengths to avoid NSR.11 he record compiled by EPA for plants that have used NSR indicates that the reduction in pollution at coal-fired units has been modest, with only 10 permits issued in the 1997±1999 period with an average reduction of 400,000 tons annually of SO2 emissions.12 By contrast, the reduction in NOx emissions has been significantly greater, because NSR permits were obtained for over 250 facilities with gas turbines, resulting in an average annual reduction of NOx of 822,000 tons from all sources (1997±1999 data).
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July 2002
Measured from the 2000 baseline, the direct impact of the NSR program is a 4 percent annual reduction in SO2 and a 16 percent reduction for NOx, with about one-fourth of the NOx reductions estimated to be coming from boiler steam plants. However, plants are allowed to increase total emissions even as the NSR program is implemented, so that
at the end of the day there is no net decrease in total emissions, only a decrease over what would have occurred absent the program. as turbine technology improvements in electricity conversion efficiency and NOx control helps to explain why the economics allowed far greater use of the NSR at gas turbine facilities than steam plants. By contrast, new coal units are not significantly more efficient than older plants, and pollution control is relatively more expensive and costs more to operate. These differences also account for the increased impact on NOx control relative to SO2 reduction in the NSR program.
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B. Free riders and environmental justice Pollution reduction for boiler steam plants with the NSR Program has been modest, and is mainly directed to the problem of capturing the free riders. These free riders are plants that can reduce pollution in a cost-effective manner, but would not do so absent NSR. The free rider problem is signi®cant at the local level: a coal®red unit's NOx production is on average 4.5 lbs/MWh, whereas a gas turbine plant is usually around 0.1 lbs or less. The gas turbine facility emits no SO2 or mercury. When the facility size is large, it is dif®cult for a permitting agency to reconcile a capital investment in a coal plant that does not also use the best control technology. These differences in relative emission performance among plants provide the basis for the environmental justice arguments. Even in areas where most of the air pollution is imported from out of state, there is resistance to the notion that the local plant owner can buy his way out of his emission reduction obligation. The more distant the trade between the emission credit buyer and seller, the less impact that trade has on pollution in the local area of the buyer. Local and state support for cap and trade requires pollution trading to reasonably improve the emissions in the buyer's air shed. The development of cap and trade area boundaries should be guided by
# 2002, Elsevier Science Inc., 1040-6190/02/$±see front matter PII S1040-6190(02)00331-7
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the air shed modeling, and err on the side of smaller, not larger, trade areas. f these environmental justice-based arguments are ignored, the cap and trade program undermines its argument for equity. States will impose their own local regulations, as have California, Massachusetts, New Hampshire and Connecticut, rather than fight the issue of trading rights in the legislature.13 This state pre-emption based on local politics hurts everyone. Plant owners become even more reluctant to invest, because of regulatory uncertainty, while environmental interests get the satisfaction of winning a local political fight, but without measurable gains in air quality. The proposal by the Administration to create just two trading zones for NOx is a non-starter and indicates how poorly this issue is understood within the Administration. Both the free rider problem and environmental justice issue can be signi®cantly ameliorated by how the cap and trade program operates in practice. More fundamental is the issue of emission objectives themselves. This is an issue of where to set the bar for emission reduction.
I
VI. Towards a Workable Cap and Trade Program: A Modest Proposal The Administration needs to move the process ahead and 62
simply adopt more aggressive targets in the 2008±2010 timeframe than its current proposal. The essential elements to an effective cap and trade program include: Aggressive emission targets that stimulate pollution investment, and eliminate the need for administrative Catch-22 backstop regulations.
An investment climate that encourages long-term (10±15 years) investment decisions: Make provision for a grace period to encourage low discount rates on pollution equipment investment capital recovery. The grace period is based on a fixed future date to comply (not a fixed period of time). This encourages generators to invest early in air pollution equipment. Exclude emission credits for past environmental investments, because they have a negative, not positive, impact on future investment. Provide no cap on allowance prices, which encourages
# 2002, Elsevier Science Inc., 1040-6190/02/$ ± see front matter PII S1040-6190(02)00331-7
sellers rather than purchasers of emission credits. Allow emission banking and give purchasers the option to write long-term purchase contracts for credits for use in future years. Allow industrial users to ``opt in'' to the program as an alternative to NSR. Align emission trade boundaries with air shed boundaries, so that emission reductions improve air quality for the buyer's as well as seller's area. Place limits on driving up the price of emission credits by cornering the market (except through creation of credits through pollution reduction investment). The principal problem is that the Administration proposal does not set aggressive targets. The cap and trade program needs to move beyond emission levels that have previously been vetted by the courts as settled case law. Without NSR, generators will be motivated by the increasing pro®t margins due to higher output, and ef®ciency improvements available to them. More aggressive emission targets raise the emission trade price, which in turn sends a signal to generation owners to increase the supply of air pollution investment. With a market for selling emission credits through overcompliance and banking credits for future use, generation owners will sell excess credits. Consumers are unlikely to see higher prices due to more aggressive emission targets, The Electricity Journal
because additional power will be produced from these existing plants at costs below market prices. ap and trade is a better way to improve air quality than the existing processes that rely on the courts for resolution. Congress could play the key role in bringing the parties and processes together. One approach is to offer the Phase Two reduction levels for implementation by the Phase One deadlines with the stipulation that no new regulations would be imposed before 2015. These objectives are attainable with existing technology and at reasonable cost. Without NSR, generation owners will be free to make market-based decisions. Generation owners, air quality, and the consumer would all be better offÐfar better than the zero sum game played in the courts.&
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Endnotes: 1. The terms emission ``allowance'' and ``credit'' is used interchangeably for the purposes of discussion. 2. EPA Administrator Christie Todd Whitman, before the Senate Public Works and Environment Committee on July 26, 2001, testified: ``It also assures citizens who live near new major sources of air pollution that the facilities will be as clean as possible. The requirements are different for (1) the part of the program called the Prevention of Significant Deterioration program that applies to construction projects in areas where the air is already clean, and (2) the part of the program called the non-attainment NSR program that applies to construction projects in areas where the air is unhealthy to breathe. For attainment areas, to prevent significant
July 2002
deterioration of our nation's air quality, new major sources and major modifications to existing sources must apply the best available control technology and ensure that the new pollution introduced into the environment does not adversely impact the air quality, such as in pristine areas like national parks. For nonattainment areas, in addition to applying control technology that represents the lowest achievable emission rates, new major sources and major modifications must offset their emis-
5. In non-attainment areas NSR requires ``lowest achievable emission control,'' which allows very little room to argue economics and sometimes tortures the meaning of ``proven'' technology. 6. Although coal units continually wear out with corrosion, erosion, and fatigue, there is not a fundamental driver that requires major modification to coal unit design. Fluid bed technology provided an innovation in low NOx and diverse fuel combustion, but not a major change in the economics: cost and efficiency. 7. The 1990 Clear Air Act required EPA to perform a study of the hazards to public health as a result of emissions from hazardous air pollutant emissions, report back by 1993, and develop control strategies based on the study. Only now is there an outline for a control strategy.
sions increases. This can be done by getting reductions from other sources in the general area to compensate for the increases resulting from the new air pollution sources.'' 3. In the 1980s, the development of fluid bed technology led to some early efforts to retrofit this technology at existing pulverized coal plants. This led to a test of the ``major modification'' requirement of New Source Review at the Wisconsin Electric Oak Creek generating station within the air shed of the Chicago±Milwaukee metropolitan area. The Court affirmed that the modification required backend air pollution control due to the additional output from the plant. 4. One interpretation is that the Clinton Administration under Carol Browner substituted capital investment as the sole criterion of ``major modification'' even if there had not been a change in emission output.
8. The 2.1 million NOx level is based on the average level of 0.15 lbs million per Btu, which EPA previously set and defended in court. It must be kept in mind that emission reductions required to meet a standard to be deemed ``healthy'' is a guess-andestimate process at best. 9. Another reason is that the owners are mostly interested in buying generation from which to create electricity trading profits, but the larger names in trading are not the major purchasers of these plants. 10. James T. Jensen, Oil to Gas Competition: Can It Place a Cap on Gas Prices? (manuscript available upon request by emailing [email protected]). 11. This is a somewhat perverse notion of a success, when a program is defined by alternatives industry can take to avoid the program. 12. EPA, NSR 90 Day Review Background Paper, June 22, 2001, at 8±9. 13. New England States have recent legislation directed to reducing emissions at specific plants; ``the filthy five'' and the ``sooty six.'' New Hampshire enacted its own multipollutant legislation in 2002.
# 2002, Elsevier Science Inc., 1040-6190/02/$±see front matter PII S1040-6190(02)00331-7
63
56
Tobey Winters
T
he greatest challenge to implementation of the Clean Air Act has been the effort to strike a balance between national objectives and local realities, namely the realities of the wide disparity in environmental conditions throughout the U.S. The Environmental Protection Agency initiated the cap and trade approach to pollution with SO2 in an effort to allow local areas to implement national objectives in the most cost-effective ways. The SO2 program created a market place for trading pollution allowances
# 2002, Elsevier Science Inc., 1040-6190/02/$ ± see front matter PII S1040-6190(02)00331-7
(credits).1 The agency allocated emission allowances and then forced electric generators to either purchase additional allowances or install pollution abatement equipment in order to meet emission targets. As long as the allocated allowances are reduced over time, emissions decline, and progress is made toward achieving clean air goals. The utilities are able to use market forces to determine the most effective means of achieving these goals. However, most air pollution is local. Emission standards for The Electricity Journal
nitrogen oxides (NOx) and particulates require a metropolitan or regional approach. EPA is also required by the 1990 Clean Air Act to evaluate potential toxic elements in coal combustion. After many years of study, EPA has determined that one of these toxic elements, mercury, requires regulation in coal combustion.
I. Federalism in Action From a political perspective, environmental policy has become today's version of 19th century American politics of regionalism. The technical debate on air pollution regulation is factored through elaborate air shed modeling to determine who is imposing pollution on their neighbor, while implementation is settled in the courts, as states align along regional lines. To accommodate the federal nature of the problem, EPA has adopted State Implementation Plans, which allows the states the ability to allocate their ``pollution budgets'' within their own jurisdictions. This budget approach increases local control and lends itself to quanti®cation of pollution rights with cap and trade. However, unlike the SO2 program, the relevant market areas for ozone and haze are regional, leading to smaller and overlapping pollution trading areas, as well as constraints and complications in the application of trading rules. nother cornerstone to environmental policy is
A
July 2002
that pollution abatement costs less to implement in a new facility than by retrofitting an old facility. As a result, EPA has required that major generating stations undergo a ``New Source Review'' (NSR) when making a major modification (capital investment) to an existing facility, with the view that pollution reduction is less costly to implement when new investment occurs. This NSR process requires that new or
From a political perspective, environmental policy has become today's version of 19th century American politics of regionalism. modified generating units employ state-of-the-art pollution control.2 he first major test of the New Source Review process was prompted by the advent of fluid bed technology in the mid- to late 1980s. The legal test was a victory for EPA, as it required that the new technology could not be retrofitted to an existing coal plant without going through the NSR process.3 From then on fluid bed technology became a technology only used on new units, due in large part to the cost and uncertainty of how NSR would be applied. With the rapid spread of combined cycle gas turbine power
T
plants in the 1990s, a cleaner and competitively priced alternative to coal emerged for new base load generation. Natural gas combined cycle became the technology of choice for new plants based on capital cost and increased ef®ciency. However, existing coal-®red capacity continued to produce competitively priced electricity, as coal prices declined as lower-cost western coal increased its market share in power plants in Midwest and Eastern states. The pollution gap between new clean generation and existing dirty generation grew.
II. The Gulf Widens It was not until the Clinton Administration that the NSR program became a lightning rod for industry. Toward the end of the Clinton Administration, a number of utilities with large ¯eets of coal units were taken to court for violating NSR, for what the utilities considered to be routine replacements of major components.4 For many years, the utilities had been careful not to increase generating capacity of the boilers, guided in their view by earlier legal precedents. The deregulation of generation at the end of the 1990s provided additional pressures. After acquiring existing plants in a competitive bid process, new and usually out-of-state owners were quickly pressed to add air pollution equipment to these existing
# 2002, Elsevier Science Inc., 1040-6190/02/$±see front matter PII S1040-6190(02)00331-7
57
plants by local environmental groups and state legislators. Unlike the previous owners, the new owners do not have recourse to the ratepayer to recoup the cost of this equipment. he result was that generation owners have become increasingly frustrated with the inability to make marginal improvement to their existing steam plants. They fear being caught in a Catch-22 NSR review and required to install state-of-the-art pollution equipmentÐthe cost of which would far outweigh the economic benefits of operational changes.5 On the other hand, the environmental community has seen a growing disparity between the pollution levels of ``grandfathered'' boiler steam plants and the much less polluting new generation of gas-fired turbines. The environmental community was led to believe that coal-fired capacity would be retired and replaced with cleaner technology. The benefits of fleet ``turnover'' had been demonstrated with great success in mobile source pollution control, but coal units continued to operate economically long past their presumed 40year lifetimes.6 As generating plants were spun off into the deregulated market, it
T
became increasingly clear to plant owners that NSR had become a key issue for asset management and competition in the market. The bene®ts of any operational changes would have to be weighed against the cost and uncertainty of NSR.
III. Enter Clear Skies Initiative Although the Bush Administration is ready to jettison some or all of NSR, it is unclear what the Administration's cap and trade program offers, and whether it can unlock the ingenuity of the power industry suf®ciently to offset the lost potential future emission reductions that would have been due to NSR. The early version of the Clear Skies proposal focuses on the environmental goals. The program's focus is on three of the four main pollutants, NOx, SO2 and mercury (EPA has a new standard for the fourth, ®ne particulates). Mercury is added to the regulated list for power plants in keeping with the EPA mandate to regulate hazardous air pollutants.7 As shown in Table 1, the projected emission reductions are substantial. The ®rst-phase
reductions in NOx are calculated to meet the existing one-hour ozone standard. The courts have already sided with EPA for reductions in NOx for the ®rst phase. Further reductions are expected to be required to meet the new eight-hour standard, which is presumably included in the 2018 NOx target level of 1.7 million tons.8 The reduction of SO2 will be obtained primarily as a byproduct of required reductions in mercury. The implied strategy is to obtain mercury reduction with dry scrubbers and particulate controls. This multi-pollutant strategy obtains bene®ts of SO2 and particulate reduction as well as mercury. The Clear Skies Initiative is not a step beyond current law, but it does signal the Administration's approach to mercury control implementation. Overall there is little for the environmental community to support, knowing that other elements of enforcement will be taken away from EPA. A promise to go beyond current settled law with new reductions in Phase Two by 2018 is a remote objective too far in the future. This is particularly true since many of the original deadlines for the 1990 Clean Air Act have already
Table 1: Clear Skies Initiative Emission CapsÐTons per Year Actual 2000
First Phase Reduction
Second Phase Reduction
SO2
11.2 million
4.5 million by 2010
3.0 million by 2018
73%
NOx Mercury
5.1 million 48
2.1 million by 2008 26 by 2010
1.7 million by 2018 15 by 2018
67% 69%
58
# 2002, Elsevier Science Inc., 1040-6190/02/$ ± see front matter PII S1040-6190(02)00331-7
Total Reduction by 2018
The Electricity Journal
passed by. For example, ozone attainment was targeted for most areas by 1997. Waiting another 20 years to achieve this objective in unlikely to be interpreted as aggressive by the environmental community. he Clear Skies Initiative appears to accept the status quo ante on emission targets before the Clinton EPA lawsuits. If the Administration targets define the new baseline, the selling point of the Administration proposal to the environmental community is a cap and trade program that yields larger reductions quicker than these baseline objectives. Moreover, these early implementation reductions will need to offset the emissions reductions that would have been attributable to the demise of New Source Review.
T
IV. Advantages of Cap and Trade The deregulation of the generation industry has created a cadre of ``asset managers'' who actively consider how power plants can most ef®ciently deploy capital to make their units more pro®table. This does not imply that under traditional regulation managers make poor economic decisions, but under regulation these decisions are driven overwhelmingly by risk avoidance and not by opportunity. The decision to invest, depicted in Table 2, indicates that managers of both regulated and deregulated July 2002
Table 2: Manager's Investment Strategy With Cap and Trade and Without NSR Mandated by Regulation
Market-Driven
Regulated plants
Early implementation and overcompliance
Depends on state regulation
Deregulated plants
Early implementation and overcompliance
Create and sell excess emission credits
generation plants will be a lot more willing to invest in their plants (including air pollution controls) under cap and trade without NSR. The regulated utility manager will still need a nudge from state regulators to fully take advantage of emission trading for SO2, NOx, and mercury reduction. bsent environmental mandates, capital investments in existing plants are tied to economic objectives: incremental output, higher efficiency, and lower-cost operation through strategies like fuel switching. The elimination of NSR makes a lot more of these operational and strategic investments possible, and market trading makes environmental investments less costly to those who invest. Plant investment when SO2 and NOx emission prices are high motivates early compliance, particularly if environmental investment is already mandated at a future date. As it stands, plant managers are reluctant to invest in capital improvements that create NOx emission reductions, because there are limited markets to trade and value these investments. Few managers currently need additional SO2 allowances.
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The kinds of investments that cap and trade would encourage include the following: Overcompliance on pollution control equipment like selective catalytic reduction for NOx and scrubbers for mercury control. Upgrade low-NOx burners from existing early versions to more advanced controls with greater NOx reduction. Boiler steam path upgrades to increase capacity closer to original design. Neural net controls to operate units to optimize pollution control reduction. Re-powering of marginal plants to burn multiple fuels, improve efficiency and increase output. At present there are few incentives and many uncertainties to making these investments. New Source Review is one deterrent, the state regulatory situation is another, and a third deterrent is a lack of a robust markets for pollution credits. A. Owners of newly acquired plants: are they held hostage by NSR? Evidence that NSR is holding back investment in pollution
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reduction can be found in the sales and purchases of existing power plants. Since deregulation there has been an active market in the sale of existing plants with multiple bidders, even for the marginally productive stations. The plants have been sold at market prices that re¯ect future expectations of the purchaserÐ not the book value to the sellers. n general, the more economic base load plants were sold at prices that reflected comparable prices for new greenfield generation. Presumably, these new owners plan to make changes in the plants to increase profitability. However, the evidence indicates the contrary: little discretionary investments have been made in these plants. Released from 40 years of regulation, it is surprising that owners could not find investments that could go directly to the bottom line, investments that would not have to be approved and modified by public utility commissions. Moreover, these new owners are aware that new greenfield units will erode their competitive position over time. It is reasonable to conclude that regulatory uncertainty, and NSR in particular, is an important reason these investments have not occurred.9 Some of the more marginal plants have attracted buyers, despite their high cost of operation and doubtful pro®tability. The prices paid re¯ected close to a zero value placed on the generating equipment itself and re¯ect the location and property value of the plant. Here, buy
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and hold for future use makes more sense, but the return on investment only starts after the plant is re-powered or replaced with increased output. The emerging trend to location-based congestion pricing further con®rms the value of strategic locationÐa value that will more likely be captured with the demise of NSR.
Prices paid by new owners of existing plants indicate owners are willing to invest to re-power, modify, or retire and replace (including air pollution equipment) if the regulatory risks are manageable. Even if the owners misjudged the market and overpaid in order to enter a new market area, the realities of competition lead them to discover ways to improve operating margins. B. Societal benefits of cap and trade The direct bene®ts of cap and trade are more pollution reductions sooner, and additional power at low marginal cost. There
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are also some important indirect societal bene®ts. Marginal plants are important in reducing prices during peak periods. Re-investment in these plants, which would also increase output, adds capacity when and where it is most needed. Another indirect societal bene®t is the ability to preserve fuel diversity. The experience in California in 2000±2001, when natural gas prices were unconstrained by fuel competition, testi®es to the value of fuel diversity.10 Although this fuel diversity bene®t is mostly con®ned to the East and West coasts, the dollar value can be signi®cant. The combination of more stringent targets and the absence of NSR will likely spur investment, as owners who fail to invest lose competitive ground. What is needed is a strong forcing mechanism to invest early in air pollution control equipment, with the knowledge that the rules will not change a few years later. In its present form, NSR is a deterrent to investment in air pollution control.
V. The Disadvantages of the Clear Skies Initiative The disadvantages Clear Skies relate to three areas: (1) a free rider problem, (2) environmental justice issues, and (3) a goal-setting problem. Of the three, the current NSR program primarily addresses the elimination of the free rider. The Electricity Journal
A. Gauging effectiveness The effectiveness of the NSR program can be gauged in two ways. One is by the number of permits issued and the resulting reduction in pollution, and the other is the ``deterrent effect,'' whereby existing facilities selfregulate to reduce emissions rather than go through the NSR process. The deterrent effect takes place when facilities reduce emissions in one operation in order to make operational changes in another operation that has the potential to increase emissions. The ``deterrence'' is that the plant owner makes changes that reduce the rate of increase in pollution from existing facilities. It is dif®cult to quantify the impact of ``netting out'' emissions by owners who do not use NSR, but discussions with plant operators indicate that both utilities and industry go to great lengths to avoid NSR.11 he record compiled by EPA for plants that have used NSR indicates that the reduction in pollution at coal-fired units has been modest, with only 10 permits issued in the 1997±1999 period with an average reduction of 400,000 tons annually of SO2 emissions.12 By contrast, the reduction in NOx emissions has been significantly greater, because NSR permits were obtained for over 250 facilities with gas turbines, resulting in an average annual reduction of NOx of 822,000 tons from all sources (1997±1999 data).
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Measured from the 2000 baseline, the direct impact of the NSR program is a 4 percent annual reduction in SO2 and a 16 percent reduction for NOx, with about one-fourth of the NOx reductions estimated to be coming from boiler steam plants. However, plants are allowed to increase total emissions even as the NSR program is implemented, so that
at the end of the day there is no net decrease in total emissions, only a decrease over what would have occurred absent the program. as turbine technology improvements in electricity conversion efficiency and NOx control helps to explain why the economics allowed far greater use of the NSR at gas turbine facilities than steam plants. By contrast, new coal units are not significantly more efficient than older plants, and pollution control is relatively more expensive and costs more to operate. These differences also account for the increased impact on NOx control relative to SO2 reduction in the NSR program.
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B. Free riders and environmental justice Pollution reduction for boiler steam plants with the NSR Program has been modest, and is mainly directed to the problem of capturing the free riders. These free riders are plants that can reduce pollution in a cost-effective manner, but would not do so absent NSR. The free rider problem is signi®cant at the local level: a coal®red unit's NOx production is on average 4.5 lbs/MWh, whereas a gas turbine plant is usually around 0.1 lbs or less. The gas turbine facility emits no SO2 or mercury. When the facility size is large, it is dif®cult for a permitting agency to reconcile a capital investment in a coal plant that does not also use the best control technology. These differences in relative emission performance among plants provide the basis for the environmental justice arguments. Even in areas where most of the air pollution is imported from out of state, there is resistance to the notion that the local plant owner can buy his way out of his emission reduction obligation. The more distant the trade between the emission credit buyer and seller, the less impact that trade has on pollution in the local area of the buyer. Local and state support for cap and trade requires pollution trading to reasonably improve the emissions in the buyer's air shed. The development of cap and trade area boundaries should be guided by
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the air shed modeling, and err on the side of smaller, not larger, trade areas. f these environmental justice-based arguments are ignored, the cap and trade program undermines its argument for equity. States will impose their own local regulations, as have California, Massachusetts, New Hampshire and Connecticut, rather than fight the issue of trading rights in the legislature.13 This state pre-emption based on local politics hurts everyone. Plant owners become even more reluctant to invest, because of regulatory uncertainty, while environmental interests get the satisfaction of winning a local political fight, but without measurable gains in air quality. The proposal by the Administration to create just two trading zones for NOx is a non-starter and indicates how poorly this issue is understood within the Administration. Both the free rider problem and environmental justice issue can be signi®cantly ameliorated by how the cap and trade program operates in practice. More fundamental is the issue of emission objectives themselves. This is an issue of where to set the bar for emission reduction.
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VI. Towards a Workable Cap and Trade Program: A Modest Proposal The Administration needs to move the process ahead and 62
simply adopt more aggressive targets in the 2008±2010 timeframe than its current proposal. The essential elements to an effective cap and trade program include: Aggressive emission targets that stimulate pollution investment, and eliminate the need for administrative Catch-22 backstop regulations.
An investment climate that encourages long-term (10±15 years) investment decisions: Make provision for a grace period to encourage low discount rates on pollution equipment investment capital recovery. The grace period is based on a fixed future date to comply (not a fixed period of time). This encourages generators to invest early in air pollution equipment. Exclude emission credits for past environmental investments, because they have a negative, not positive, impact on future investment. Provide no cap on allowance prices, which encourages
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sellers rather than purchasers of emission credits. Allow emission banking and give purchasers the option to write long-term purchase contracts for credits for use in future years. Allow industrial users to ``opt in'' to the program as an alternative to NSR. Align emission trade boundaries with air shed boundaries, so that emission reductions improve air quality for the buyer's as well as seller's area. Place limits on driving up the price of emission credits by cornering the market (except through creation of credits through pollution reduction investment). The principal problem is that the Administration proposal does not set aggressive targets. The cap and trade program needs to move beyond emission levels that have previously been vetted by the courts as settled case law. Without NSR, generators will be motivated by the increasing pro®t margins due to higher output, and ef®ciency improvements available to them. More aggressive emission targets raise the emission trade price, which in turn sends a signal to generation owners to increase the supply of air pollution investment. With a market for selling emission credits through overcompliance and banking credits for future use, generation owners will sell excess credits. Consumers are unlikely to see higher prices due to more aggressive emission targets, The Electricity Journal
because additional power will be produced from these existing plants at costs below market prices. ap and trade is a better way to improve air quality than the existing processes that rely on the courts for resolution. Congress could play the key role in bringing the parties and processes together. One approach is to offer the Phase Two reduction levels for implementation by the Phase One deadlines with the stipulation that no new regulations would be imposed before 2015. These objectives are attainable with existing technology and at reasonable cost. Without NSR, generation owners will be free to make market-based decisions. Generation owners, air quality, and the consumer would all be better offÐfar better than the zero sum game played in the courts.&
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Endnotes: 1. The terms emission ``allowance'' and ``credit'' is used interchangeably for the purposes of discussion. 2. EPA Administrator Christie Todd Whitman, before the Senate Public Works and Environment Committee on July 26, 2001, testified: ``It also assures citizens who live near new major sources of air pollution that the facilities will be as clean as possible. The requirements are different for (1) the part of the program called the Prevention of Significant Deterioration program that applies to construction projects in areas where the air is already clean, and (2) the part of the program called the non-attainment NSR program that applies to construction projects in areas where the air is unhealthy to breathe. For attainment areas, to prevent significant
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deterioration of our nation's air quality, new major sources and major modifications to existing sources must apply the best available control technology and ensure that the new pollution introduced into the environment does not adversely impact the air quality, such as in pristine areas like national parks. For nonattainment areas, in addition to applying control technology that represents the lowest achievable emission rates, new major sources and major modifications must offset their emis-
5. In non-attainment areas NSR requires ``lowest achievable emission control,'' which allows very little room to argue economics and sometimes tortures the meaning of ``proven'' technology. 6. Although coal units continually wear out with corrosion, erosion, and fatigue, there is not a fundamental driver that requires major modification to coal unit design. Fluid bed technology provided an innovation in low NOx and diverse fuel combustion, but not a major change in the economics: cost and efficiency. 7. The 1990 Clear Air Act required EPA to perform a study of the hazards to public health as a result of emissions from hazardous air pollutant emissions, report back by 1993, and develop control strategies based on the study. Only now is there an outline for a control strategy.
sions increases. This can be done by getting reductions from other sources in the general area to compensate for the increases resulting from the new air pollution sources.'' 3. In the 1980s, the development of fluid bed technology led to some early efforts to retrofit this technology at existing pulverized coal plants. This led to a test of the ``major modification'' requirement of New Source Review at the Wisconsin Electric Oak Creek generating station within the air shed of the Chicago±Milwaukee metropolitan area. The Court affirmed that the modification required backend air pollution control due to the additional output from the plant. 4. One interpretation is that the Clinton Administration under Carol Browner substituted capital investment as the sole criterion of ``major modification'' even if there had not been a change in emission output.
8. The 2.1 million NOx level is based on the average level of 0.15 lbs million per Btu, which EPA previously set and defended in court. It must be kept in mind that emission reductions required to meet a standard to be deemed ``healthy'' is a guess-andestimate process at best. 9. Another reason is that the owners are mostly interested in buying generation from which to create electricity trading profits, but the larger names in trading are not the major purchasers of these plants. 10. James T. Jensen, Oil to Gas Competition: Can It Place a Cap on Gas Prices? (manuscript available upon request by emailing [email protected]). 11. This is a somewhat perverse notion of a success, when a program is defined by alternatives industry can take to avoid the program. 12. EPA, NSR 90 Day Review Background Paper, June 22, 2001, at 8±9. 13. New England States have recent legislation directed to reducing emissions at specific plants; ``the filthy five'' and the ``sooty six.'' New Hampshire enacted its own multipollutant legislation in 2002.
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