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Handbook Content
Emissions Trading Education Initiative Please click here for a full text Adobe Portable Document File (.pdf) Chapter I. Introduction At the heart of the cap and trade approach to emissions trading is a focus on environmental performance rather than on technological compliance. This shift in focus protects the environment while allowing regulated sources to determine the best means of compliance in the context of other decisions facing each source. This flexibility enables regulated sources to minimize the cost of pollution control and also provides incentives to develop innovative and cost effective substitutes and pollution control strategies. Although cap and trade is not appropriate in all settings, it has been used successfully in past programs and may be applicable to address future pollution problems. How We Got Here Early pollution control programs often required sources to install a specific technology or to achieve specific emission rates, concentrations or percent reductions at all facilities. The overall goal of the Clean Air Act was to protect public health. And, the regulatory approach was to pick levels of control that were fair _ both in term of the amount of pollution they would remove and the individual cost that would be born by sources. That said, regulations typically contained provisions to exempt specific sources if it was found that compliance would be too costly or physically impossible. The problem with this approach was that as the economy grew, the total number of sources and the total number of hours of operation increased. As a result, regulations could not keep up with increasing levels of pollution, and air quality deteriorated. Regulations continued to limit the flexibility of sources to emit. Rules required that sources install certain technologies or meet even lower emission rates. In certain cases, the regulations required that no additional sources be placed in areas where air quality had become unhealthful. But even this was not enough to control pollution. One problem with the approach was that it implicitly allocated a scarce resource _ the ability to emit pollutants _ to the first taker rather than according to a strategy which accounted for the value of that resource. As cities and towns grew they began to find that they could not afford, from an air quality perspective, to allow new sources to locate within their borders, nor could they allow existing sources to expand. It was determined that this situation was untenable and regulations needed to change to increase flexibility. The first steps to this increased flexibility came in the form of "bubbles" and "offsets". Bubbles are a type of compliance mechanism, which allows a regulated facility with multiple sources to combine their total emissions targets for the facility under a "bubble". Facility operators could apply pollution control technologies to whichever source under the bubble had the most cost-effective pollution control options, but the total amount of emissions under the "bubble" would have to be less than what would have been allowed if each source met the conventional requirement. Bubbles allowed for the first form of emissions trading through intra-facility trading. Reductions and trades were negotiated with regulators on a case-by-case basis. While this cumbersome process was expensive, the system at least allowed for expansion at existing sources. New sources inside the bubble could be brought on line as long as the old sources reduced overall pollution amounts to compensate. Offsets represent the next iteration of bubbles and have been used to account for new growth. Offsets are created when a source makes voluntary, permanent emissions reductions that are legally recognized by a regulator. Existing sources could trade offsets to new sources to cover growth or relocation as long as each trade was approved by regulators. These offsets were generally called emissions reduction credits or ERCs. Although these early trading programs saved money and added flexibility, they were cumbersome to administer and had high transaction costs. The programs required the conversion of technology or emissions rate requirements into a tradable commodity, such as tons of a pollutant emitted. This required all parties (emissions credit generator, emissions credit receiver, and governmental authority) to negotiate and agree on a number of factors, including: baseline and future utilization rates for credit generating and receiving sources; the time over which the trade would be valid; and whether or not the reductions for credit would have happened but for the trade. Moreover, all parties had to agree on how emissions at both sources would be quantified. Finally, it was also often necessary to ascertain that the air quality would not be worsened by the transaction. This process could be resource intensive and time consuming with changes to the agreement often requiring renegotiation. The process created significant transaction costs and limited the number of trades (and later the creation of ERCs) to those circumstances where there were clear and substantial economic benefits. Despite the considerable efforts to ensure that transactions would not worsen the environment, most air regulators and environmentalists remained suspicious of emissions trading. The 1990 Clean Air Act Amendments included a section devoted to ozone control and further clarified the role and opportunity for offsets and potentially for other emissions trading. As a result, states and other policy advocates have worked with EPA to develop programs that enhanced flexibility while retaining the basic structure of a command and control program. At the same time that this evolution in command and control regulation was taking place, a separate market mechanism was developing for SO2 allowances under a completely different regulatory framework _ that of cap and trade. A separate section in the 1990 Clean Air Act Amendments created a cap and trade program to address SO2 emissions, the precursor to acid rain. The success of this program has influenced the design of recent NOx control programs for addressing ground level ozone. Today, there is one operating NOx cap and trade program being operated in the Northeast states, and a second is planned for a broader set of Eastern States. This model is also being assessed for its applicability to other pollution problems. Where Are We Today?
About the ETEI Handbook Sections III and IV provide "how-to" information to get participants started. This information includes extensive explanations of how existing cap and trade programs function. These sections also contain information on how the market is constructed and what types of risk management tools are available. The reader will find that the discussion about market construct, transaction structures, and portfolio risk management is applicable for any commodity. That is because a well-designed cap and trade program can transform an environmental management program into a commodity market without losing sight of the goal: protecting the environment and human health. Finally, the last section gives the reader an overview of other programs that employ the basic cap and trade framework and are being designed to address the environmental hazards of smog and ground level ozone. These programs are just underway, but regulators and industry have hopes that the successes of the Acid Rain Program's cap and trade system can be achieved in these programs, as well. To Reprint or Reproduce To Order Download or order online. Chapter II. Cap and Trade in Action
(A.) The U.S. Acid Rain Program: A Case Study on the Use of Cap and Trade The Problem:
Scientists identified the cause of the continuing environmental damage as air pollutants arising from power plants and industrial facilities. Sulfur dioxides (SO2) and nitrogen oxides (NOx), were undergoing a chemical reaction in the atmosphere when combined with moisture. The reaction involving SO2 forms a destructive dilute sulfuric acid, which became known as "acid rain." The primary source of SO2 and NOx are large plants that burn fossil fuels to produce energy, although there are other significant sources as well. The Program: The Acid Rain Program set the cap at 8.95 million tons of SO2 per year. The program is implemented in two phases. In Phase I, which began in January 1995, the largest, highest emitting electric utility generating units were required to reduce emissions. In Phase II, which will begin in 2000, virtually all electric utility units will be required to reduce their emissions to roughly one-half of 1980 levels or the 8.95 million ton cap. Under the program, sources are required to hold allowances equal to each year's emissions. Participants are free to choose how they want to comply, but at the end of each year they have to surrender enough allowances to EPA to cover their actual emissions. Failure to comply with this provision results in automatic penalties, which are enforced by EPA. An effective tool for harnessing the power of the open market was found in a cap and trade system. It is viewed by many as a model for other environmental programs. Under the Acid Rain Program, the "cap" was firmly set and reduced emissions to levels that were roughly half of those in 1980. Looked at another way, the cap reduced the level of SO2 emissions utilities were allowed to emit by 50%. The cap was denominated in allowances, which were provided to all affected sources. Strictly speaking, an allowance authorizes a unit within a utility to emit one ton of SO2 during a given year. Allowances are standardized and issued by vintage years, or the first year in which the allowance can be surrendered to the EPA to cover a source's actual emissions for that year. Allowances are also bankable, meaning unused allowances can be used in future years. Most importantly, allowances are tradable, and any individual can open an account to buy or sell them. These attributes make allowances both an asset and a rationed commodity, empowering the involvement of financial markets. Although at its core the SO2 market is a part of a regulatory program, it has many attributes of a financial market as well. For example, market institutions such as brokerage houses and law firms specializing in contracts have emerged with the market. Allowances are transferred and traded among parties, creating an efficient market mechanism. Utilities can chose among a host of options with which to reduce their emissions, including switching from high-sulfur fuels (primarily coal) to lower sulfur fuels (low-sulfur coal or natural gas) or installing pollution control equipment. Trading allows the market to redistribute the rights to emit SO2, thereby determining a more efficient and economic source of reductions. Sources are required to execute allowance transactions through the EPA's allowance tracking system (ATS). The ATS allows the public to review all transactions as well as the accounts of all market participants. Improvements in the ATS have also allowed the EPA to reduce the At the end of each year, each unit must hold a number of allowances at least equal to its actual annual emissions. Utilities not in compliance face severe penalties and find no reprieve from their responsibilities to reduce overall emissions. The penalties include a $2,000 per ton fine adjusted for inflation. And, the offending source must supply offsetting allowances in the next year through reduced allocations or an emission reduction proposal submitted to EPA. The Results: Just as importantly, the cost of protecting the environment through the U.S. Acid Rain Program has fallen softer on the economy than originally anticipated. The economic efficiencies gained through compliance flexibility and the trading and banking provisions are thought to be primarily responsible for these cost savings. Reductions were projected to cost utilities between $4 billion and $8 billion annually when the program was fully implemented in 2010. However, more recent projections indicate that the program will cost around $1 billion annually when it is fully implemented. For more information check these Web addresses:
(B.) Acid Rain Success Story: Wisconsin Electric Plays the Market
The on-the-ground experience of one large Midwestern utility provides an example of how the cap and trade mechanics of the U.S. Acid Rain Program work. Wisconsin Electric Power Company (WE), a subsidiary of Milwaukee-based Wisconsin Energy Corporation, has used the cap and trade program to reduce emissions of SO2 and still produce low-cost power, providing both economic and environmental benefits for its customers and the community.
At the outset, WE devoted considerable resources to compliance planning. In the early 1990s, the company ran scores of scenarios looking at projected power sales and power plant usage well into the future. Computer programs estimated how much the utility would run each of its affected units and then calculated the resulting emissions of SO2 and NOx. These projections were then compared to their allocations under the U.S. Acid Rain Program. After running the initial numbers in 1994, WE found themselves with 200,000 to 250,000 excess allowances for the five years of Phase I compliance. Excess allowances came largely from pollution control measures the company had previously implemented. However, the company found itself short 30,000 allowances per year for Phase II compliance, starting in 2000. Excess allowances for Phase I could be banked or sold into the emissions trading market. In addition, the utility had several options relating to meeting Phase II requirements. These included: switching to low-sulfur coal; installing pollution control technology at the plant site; making modifications in the way they dispatched various electric generating units; and entering the market to purchase allowances. After comparing options, WE found fuel switching to be the most economic choice and one that would have the smallest impact upon its customers' power bills. It was estimated that fuel switching would reduce roughly 10,000 to 20,000 tons of SO2 emissions. Taking all this into account, WE determined that the most cost-effective strategy would be to sell the excess Phase I allowances and purchase additional Phase II allowances, as required. WE testimony in July 1997 before the Joint Economic Committee of the U.S. Congress stated that making up the shortfall through alternative means, such as the installation of scrubbers on at least two units, would have been too expensive. By choosing a route combining fuel switching and strategic allowance sales and purchases, the company estimated that it saved $100 million. With over 200,000 excess Phase I allowances for sale and the decision to enter the market to make up its shortfall for Phase II, WE put in place a trading strategy. The company would sell its excess allowances over time while simultaneously buying allowances for Phase II. This technique applied the principles of time weighting, in which the company engages in a steady flow of smaller trades over an extended period of time. This approach takes away the highest and lowest prices, but seeks the best price on average. Overall, the program has been very successful, and WE met 100% of its compliance targets in a cost-effective and efficient manner. Chapter III. The Basics of Trading The goal of ETEI and this Handbook is to provide you with the "how-to" background that will empower your participation in cap and trade systems. The next two sections of the Handbook will introduce you to the basic tools of the market, and also provide information on how to use some of the advanced structures that are available. This section discusses trading basics, using the U.S. Acid Rain Program as an example, and describes how to participate in an emissions trading market using the basic tools of that market. It includes a discussion on compliance planning, market construction, execution of a basic trade, and settlement. The next section begins to explain some of the more advanced risk management tools available for portfolio management, such as forward settlements, swaps, option, and hybrid structures. It then gives one company's example of entering the SO2 market and transacting an emissions trade to demonstrate how some of these tools have been put to work in a real world situation. (A.) Compliance Planning Today, electric utilities have a host of pollution control options before them and choosing the mix of options that best fits from both an economic and environmental perspective can be a difficult task. A utility's planning process is complex and must factor in demand for power and the emissions associated with generating it. From there, the utility needs to assess its pollution control options, including participation in allowance trades. These variables are influenced by a large number of factors, which give rise to an astounding range of permutations in compliance planning. However, breaking the decision process down into its core components, applying time-honored economic techniques, and using computer technology can assist in mapping a course for compliance. The experience of a few utilities can be helpful and their perspectives are provided below. Long-Term Strategy No matter how the compliance planning team is assembled, it is essential that the team set in place a comprehensive long-term strategy that spans several years, yet is flexible enough to be fine tuned on a weekly or even daily basis. Aside from making fundamental infrastructure decisions, emissions control is essentially a function of making changes to the way a utility generates power. Because power plants represent massive capital expenditures that can take up to 10 years to design, permit, and construct, a compliance plan needs to take a long view on how these resources will be used. For its part, Pepco operates with a ten-year compliance plan. The long-range plan is compiled by the entire compliance planning team, including the emissions trading practitioner, who provides insight on market supply and demand for allowances. The trader adds value to the long-term compliance planning process by outlining emissions trading strategies that can assist in managing compliance cost risks. In addition to evaluating the effect of allowance trading markets, the compliance planning team will generate emissions projections based on an analysis of a number of factors that can affect demand for power generation. Demand factors that these teams tend to watch most closely include:
In addition to the demand side variables, compliance teams also keep an eye on the supply side as well. Utilities must determine which plants are in operation and with what source of fuel. For example, a utility that owns several generating plants, including a nuclear plant, may decide to increase generation at a fossil fuel plant while it shuts down its nuclear plant for refueling, resulting in more emissions. Quantitative Analysis In comparing expected emissions with the allowances it holds, a utility may find that it faces one of two situations: the utility may hold fewer allowances than its expected emissions making it short on allowances; or the utility may hold more allowances than its expected emissions, making it long on allowances. Whether a utility's position is short or long will determine its actions in the market as it develops future strategies to address the situation. Emissions Reduction Measures If the utility is in a short position, it has to decide whether to cut emissions in the coming months to bring them in line with allowance holdings or to purchase allowances in the market. Again, the cross-functional team will analyze base case scenarios using sensitivity analysis to explore the emissions performance and costs associated with various pollution control options. The emissions trading practitioner plays an important role in this process. The emissions trading practitioner informs the compliance planning team of the current trading prospects and prices in the marketplace, as well as supply and demand trends for allowances. The team then compares these figures, which are compiled from a variety of market sources including published indexes and figures quoted by other market participants, with the other strategies available in the compliance plan. In the current SO2 market there are several emission reduction strategies available:
Short-Term Refinements Utilities continually revise their demand projections by adjusting for increases or decreases in power sales, changes to power pool requirements, and changes to their to long-term position. Also, demand projection adjustments must be made to account for changing weather patterns. One of the single greatest factors affecting the demand side for utilities continues to be the weather, and compliance planning teams are constantly assessing weather conditions for the upcoming season (or the next week) for its affect on demand for power. Meeting as frequently as weekly, compliance planning teams create quantitative analyses of these demand and supply factors and develop base case scenarios for emissions. These scenarios are then compared to initial projections in the long-term plan. As needed, the teams will again run sensitivity analyses on various emissions reductions strategies to guide short-term actions for compliance. Keep An Eye On The Bottom Line This type of planning activity is akin to treating pollution control as an input to power production. Finding the lowest cost emissions reduction solution is vital, and analyzing the costs and benefits of various compliance measures has a distinct reward component. Most utilities have computer programs developed internally to assist in running demand and supply forecasts. These programs can evaluate individual options as well as combinations of pollution control measures. Some also can track emissions records and automatically produce the reports required by the EPA under the U.S. Acid Rain Program. No matter how sophisticated these programs are, their basis is always grounded in simple economic theory. Cost curves, a basic economic tool, can aid in determining the compliance decision for an individual unit. The concepts behind cost curves are explained below.
(B.) Market Construct Having assessed compliance needs and weighed options in the marketplace; the next step is to prepare for entrance into the emissions trading markets. This begins by establishing an account. The U.S. Acid Rain Program requires that participants register with the EPA in its Allowance Tracking System (ATS). The ATS is administered by the EPA Acid Rain Division and is the official record of emission allowances transactions and account balances. As mentioned earlier, an important feature of the U.S. Acid Rain Program's emissions trading system is the availability of complete, transparent information on the allowances being traded. The ability for all market participants, and, indeed, the general public, to track the movement of allowances is vital to the program's success. At the center of this effort is the ATS, which is a database that holds the official record of all allowances as they change hands and, eventually, are retired or removed from the system. The ATS assigns a unique serial number to each allowance. It is possible to track an individual allowance throughout its life from initial allocation, through each trade, all the way to retirement. The serial number consists of 12 numbers, the first four of which indicate the first year the allowance can be used for compliance purposes _ in other words its vintage year. For instance, allowance 2000-01234567 is a vintage year 2000 allowance and cannot be included by a utility in its year-end compliance report until the year 2000. Allowances not used in their vintage year can be banked or saved for use in future years. Transactions involving allowances are tracked and categorized by the EPA. The agency collects information about the buyer and seller and the serial numbers of the transacted allowances. EPA does not, however, record the allowance price, instead deferring to the market, which can more efficiently process this information. Also, because companies are not required to report allowance transfers to EPA until the allowances are used for compliance, many transactions have not yet been recorded in ATS even though the private agreements are in place. EPA also does not track option trades and other transactions that have not been reported to EPA. The ATS has two types of accounts: unit accounts and general accounts. The unit account holds allowances that were initially issued to those sources required to participate in the program. In addition, unit accounts track allowances as they are traded, withdrawn for compliance purposes, and ultimately retired for compliance. General accounts are much like unit accounts in which trades are tracked. However, EPA does not adjust these accounts during annual compliance period reconciliation. These accounts can be opened free of charge by anyone wishing to participate in emissions trading—including sources that already have unit accounts. The allowances in general accounts are not subject to allowance deductions to cover actual emissions and can be held indefinitely. Traders, environmental groups, citizens and other entities operate through general accounts in the ATS. General accounts are opened by submitting an Allowance Account Information form to the EPA. Once the agency has received this form, it will send confirmation of the new account, and the applicant is ready to trade. Over-the-counter Market The prices for buying or selling emissions are fluid and determined with each individual trade. Because of the over-the-counter format, there is no central recording structure for current allowance bids and asks. Price information is readily available from market sources, such as brokers, traders, and indexes published by trade journals. The buyers and sellers in emissions trading are individuals, organizations, or corporations that have a position in the market. Their motivations vary. Some trade to achieve regulatory compliance, others to retire allowances, or still others simply to turn a profit. Each buyer and seller has a publicly identified representative. This allows the buyer or seller to do due diligence and ensure its trade is legitimate. There are three ways to participate in the over-the-counter emissions trading market, including bilateral transactions, trades transacted through a broker, and allowances purchases in the annual allowance auction. Bilateral Trades This relationship-based approach, however, is usually employed by active market players who have extensive experience - and contacts - in the marketplace. Unless you possess this type of market presence, it is difficult to fully assess trading options without some assistance. One set of market participants that has this market presence are Traders. Traders are likely to be counterparties with the emissions trading practitioner in bilateral trades, but often their market profile differs from the practitioner. Traders put their own money at risk in the market. Their motivation for participation in emissions markets is much like their motivation would be for entering stock markets or commodities markets: profit. Seldom do Traders make decisions based on the need for compliance. Because Traders are willing to take positions in either direction of the market, they assist in generating liquidity. Their ability to generate a flow of deals makes some Traders "market makers", in which they play a role similar to that of a stock specialist on an equity exchange. Liquidity refers to a volume of trading in the market that allows buyers to find sellers at prices reasonable to both. Without sustained liquidity, the market would have improper pricing information discouraging any type of emissions trading practitioner from participating. Traders operate under a long-term view that looks to profit from the market's movement— up or down. Traders profit from arbitrage opportunities by buying and selling allowances to capture the value between spreads. This can be executed, for example, through the simple standard of buying low and selling high, working the price spreads to turn a profit. Brokers The hands-on-role of the broker also enables it to engage in structured transactions, which can be more time consuming than a normal cash settlement or option transactions. Deals involving complex swaps of vintage years, cross-pollutant trading, or cross-commodity trading are likely to involve a broker who can provide expertise to the transaction as well as the manpower to shepherd a deal to completion. Brokers profit from the market through commissions charged on brokered transactions. Annual Allowance Auction Therefore, the Clean Air Act Amendments set up an auction system designed to ensure a measure of allowance market liquidity and provide valuable price information. The auction is held annually on the last day of March and is run by the Chicago Board of Trade. To supply the auctions with allowances, EPA set aside a Special Allowance Reserve of approximately 2.8% of the total allowances allocated to all units. During Phase I, when the allocated allowances total 5.7 million allowances annually, 150,000 allowances are available each year for auctions. During Phase II, when allowance allocations total 8.95 million allowances annually, 250,000 allowances are earmarked annually for auctions. The sale starts with the highest priced bid and continues until all allowances have been sold or the number of bids is exhausted. Credits purchased in the advance auction cannot be used until seven years after purchase. EPA may not set a minimum price for allowances used in the auction. The end results are posted by EPA on its Web site. For more information check these Web addresses: (C.) Execution Having set forth a trading strategy and gathered information on market players, you are ready to execute trades. In fact, you are lucky: the rapid advancement of the SO2 market has substantially shortened the learning curve for new participants. Just a few years into the program, there is a fully developed trading system, free-flowing market information, and healthy volume of transactions. Starting with the most basic of trades—a cash spot market transaction—this section explains the contracting issues you should be aware of as you close a deal and how to report the trade to regulatory authorities. Spot Market Trades Before entering the market, it makes sense to assess your needs and set your price parameters relative to the market. If you are short allowances and decide to turn to trading to make up the difference, the compliance planning you executed earlier should provide you with a "buy strategy" that will determine your transaction volume and the price at which you are comfortable buying. Conversely, if your position is long on allowances you will use your compliance planning scenarios to get a sense of how many allowances to offer in the market and at what minimum price you will sell. Once you have determined your price targets, you are ready to trade. This can be done through a broker or executed bilaterally. No matter which direction you choose, the next step is to communicate your price to the marketplace. Individuals with standing bids and asks are approached first to determine their interest in a purchase or sale of allowances at your price. As interested participants counter with alternative prices, the market is made. From this point forward you can revise your price to move closer to the market and receive another counter bid or offer. This process continues until you have found a price in the market that satisfies your needs. Having found a price that you are comfortable with, you are ready to lock in and seal the deal. The first step is to give a verbal confirmation or sign a confirmation sheet, which indicates your willingness to lock in the price and begin work on hammering out the contracting details. (Of note: this is also the point at which a broker will reveal the counterparties' identities to each other, should you have decided to go that route.) Credit Risk The emissions trading system dictates that, while allowances are granted by the government, there is no guarantee provided by regulators as to the ability of the seller to provide these credits. Therefore, the onus is on the buyer to determine the credit worthiness of the seller. Credit worthiness can be measured by credit rating agencies, such as Standard & Poor's, DCR, or Fitch IBCA. Often this is determined before choosing a counterparty for a bilateral trade, and an emissions trading practitioner working through a broker can stipulate that bids and asks should only be considered for counterparties meeting its pre-established credit criteria. In any case, credit risk is directly addressed in the contracting phase of the transaction. Standard Contracts Despite the standard nature of the documentation, contracting parties must still keep an eye out for basic trading issues. Foremost is the ability of your counterparty to come through with their end of the deal, whether it be providing cash for your allowances or allowances for your cash. In most cases, contracts will contain provisions protecting against the default of either counterparty. Their ability to pay is often measured by credit rating agencies. These independent assessments are often incorporated into the contracting process. Contracts commonly use protections, such as: setting up lines of credit (LOCs) to back the transaction; gathering guarantees from a counterparty's parent company; or securing recourse to the parent company. Once the contract has been executed, it is time to let the allowances and the cash change hands. Typically the seller of allowances will deliver an Allowance Transfer Form (ATF) to the buyer. This is a standard EPA document that confirms the movement of allowances from one account to another. The buyer will then fill out the ATF and forward it to the EPA, which will input the information in its tracking system. Cash or other payment for an immediate settlement transaction is usually made within three business days of an electronic or written confirmation by the EPA that the contracted allowances have been transferred in the ATS. EPA is moving toward electronic transactions rather than paper transactions. With regard to the administration requirements for an allowance trading system, the Handbook has focused on the mechanics of opening allowance accounts and transferring allowances. These requirements apply to everyone participating in the market, not just the regulated industry. Of course, companies with compliance obligations under the U.S. Acid Rain Program are also responsible for filing other forms and reports with EPA. For more information on these requirements, see the Acid Rain web site at: http://www.epa.gov/acidrain. For more information check these Web addresses: Chapter IV. Portfolio Management
(A.) Why Advanced Structures?
Until now we have primarily discussed one type of emissions trading transaction structure, the immediate settlement. As you might expect, this is just the beginning. Financial markets have been dealing in the trade of commodities for more than a century, and over that time increasingly complex vehicles have been developed. As structures gain market acceptance, they are often modified to create new ones, ever innovating to satisfy the demands of increasingly sophisticated market participants. The motivating factor behind the genesis of advanced structures in commodity markets is always to create new and better ways to manage risk. Risk Management To take an example from emissions trading, consider a utility that projects it will be short on allowances in the year 2002. The company is determined to make up their shortfall in the trading market and sees that the going rate for 2002 allowances is $150. This utility has the risk that the price of 2002 allowances, which is holding at $150 today, may rise significantly in the future. This would increase the cost it must pay to purchase its allowances if it buys allowances in the future. On the other hand, a utility holding an excess of allowances in 2002 confronts a risk directly opposing that of the previous example. If the utility is long on 2002 allowances, it certainly would not mind the price going up from $150. But, the utility is also hoping that the price will not fall and reduce the value of its allowance holdings. Although through the first half of 1999 SO2 trading market has been relatively stable, it has demonstrated considerable volatility since its inception, making price risk very real. Dollar Cost Averaging Since it is almost impossible to consistently buy at the bottom of the market and sell at the top, a strategy can be employed that averages out the highest of the highs and the lowest of the lows to produce consistent results. This strategy, known as dollar cost averaging, enables a utility to achieve consistent results by spreading out the buying or selling of allowances over a period of time. Doing so hedges the risk that prices will move aggressively against one by buying or selling in small increments at the current best available price. Under this strategy, the average price will be near to the annual average price. Rise of Advanced Structures The rise of advanced structures can also be pegged to the growing experience of the average emissions trading participant. An increasing amount of the activity in the market today contributes to liquidity and hinges on financial plays. Most trades take place in order to ensure compliance, but an increasing number of transactions are structured to capture value in the market's movement much like the transactions in commodities markets. (B.) Advanced Structures Below we begin to outline some of the most widely used financial structures. Forward Settlement
This premium reflects how the market prices future deliveries and payments, which usually incorporates the seller's cost of carry interest rate plus a premium assessed by the market to create a calculation known as the allowance loan rate. The market assumes prices will escalate between 6% to 8% every year, going out seven years. The rate is compounded yearly. In the above example, the rate used was 7%, but in reality this rate will reflect whatever the market will bear2. Therefore the difference in terms of cost to the seller of holding on to the vintage 2001 allowances for delivery in July 2001, rather than selling them immediately, is around $22.50 for each allowance. As the contract term extends past the year 2004, this cost decreases due to regulatory uncertainty. Swaps Viewed in the context of compliance for the U.S. Acid Rain Program, swaps have the ability to use the market to efficiently distribute allowances. Take for example, utility A, which has plenty of SO2 allowances for the year 2000, but is short 10,000 vintage 2002 allowances. On the other hand, utility B is short on vintage 2000 allowances yet is long by at least 10,000 allowances for the year 2002. Through a swap transaction, utility A could exchange its surplus vintage 2000 allowances for utility B's surplus 2002 allowances.
Options Call As the exercise date approaches, the option buyer needs to decide how to act. If the market price for allowances is higher than the option strike price, the option buyer will exercise the option and buy the allowances for the strike price. If the market price for allowances is equal to or lower than the strike price, the option buyer will simply enter the market and purchase the allowances over-the-counter. In this case, the penalty associated with rising prices is limited to the premium paid by the option buyer. Put
(C.) Hybrid Structures At the core of the advanced structures discussed above is a focus on managing price risk. Price risk can vary depending on one's perspective and therefore, requires varying management strategies. The numerous tools available in emissions trading markets can be used in varying combinations and at different times in order to execute a comprehensive market strategy to protect both upside and downside risk. There is no limit on the combinations of these risk management tools, and with the increasing volume and sophistication of emissions markets, new combinations and variations emerge frequently. The creative use of calls and puts is one example. The basic option tools of calls and puts are being combined and utilized in creative ways to manage risk in increasingly sophisticated ways. Calls and puts on their own allow the buyer to hedge price risk in one direction, either the upside risk for buying allowances or the downside risk for selling allowances. However, hybrid structures can mitigate price risk in both directions at the same time. Below are a few basic hybrid structures that are currently being employed by market participants. These combinations should present an idea of the potential for customizing the use of these tools. Collars Here is an example. To hedge against the risk of market prices going above $200 an allowance, a utility buys a call option with this strike price for a premium of $10. At the same time, a utility may be willing to sell allowances for not less than $150. In this case, the utility sells a put option with a strike price of $150 for a premium of $10. If price goes above $200, the utility exercises the put, buys at $200, and saves money. Or, if price drops below $150 the utility sells at $150 and makes a profit. With these transactions the utility "collared" its price risk, and the options have cancelled each other out. This equates to a "zero-cost" collar. Strangles In order to hedge against this risk, the utility could execute a strangle. The strangle is another combination of a call and a put. It involves buying both call and put options at different strike prices. To protect against the risk of rising allowance prices in case the utility needs to buy allowances in the future, it can purchase a call option with a strike price higher than the current allowance market spot price. This is called an out-of-the-money call option. At the same time, the utility can protect itself from the risk of decreasing allowance prices in the event it finds itself long on allowances. This can be done by purchasing a put option with a strike price lower than the current allowance market spot price. This is known as an out-of-the-money put option. The out-of-the-money options typically sell for premiums that are lower than the premiums for options with strike prices closer to actual market price. Like a collar, the strangle allows the utility to protect against unforeseen price risks, but also enables it to save money on options. Selling Covered Call Options If prices stay stagnant or decrease, the buyer of the call option will simply go the market to purchase allowances, while the utility collects the premium and retains ownership of the allowances. On the other hand, if the market price rises above the call strike price, the option buyer will likely exercise the option and purchase the contracted allowances. The utility has collected the premium and transferred allowances. Typically, the utility does not sell options for all of its allowances and so it can then sell additional allowances into the market at the higher market price. Or, the utility can sell another call option, going through the same process. Writing Covered Put Options If emission allowance prices stay stagnant or trend upward, the purchaser of the covered put option is likely to sell its allowances in the over-the-counter market where it can get prices higher than the strike price of the covered put option. The utility, as the seller of the option, simply receives the option premium. If prices begin to fall, the purchaser of the option will now exercise the covered put option and sell allowances to the utility at the strike price. In this case, the utility usually has more allowances to purchase and is presented with the opportunity to sell another put option (and reap another premium) or buy inventory at lower market prices. Other Issues That said, however, there are other considerations which may influence a person or company's decision to trade or to choose the appropriate transaction structure. These issues are beyond the scope of this Handbook, but include, among others, the following:
(D.) Mississippi Power Company Example In the Spring of 1999, the Southern Company's emissions forecasts indicated that one of its subsidiary operating companies, Mississippi Power Company, would not have sufficient allowances for compliance in the year 2000. This was due to a number of factors, but the bottom line was that the revised SO2 emissions for the company's power plants were higher than projected. Hence, it would be approximately 10,600 allowances short the following year. Southern's environmental compliance personnel ran a quantitative analysis to determine the best course to ensure Mississippi Power's continued compliance. After running through scenarios involving plant dispatch, fuel switching, and the application of emissions reductions technology, the company determined that picking up allowances in the emissions trading market would be the most cost-effective short-term strategy. But how would Southern participate in the market? The company could seek out bilateral trades with other market participants, including utilities and traders. Southern, the largest electricity generator in the U.S., feels it does not always get the best over-the-counter prices from traders who may price deals with Southern's deep pockets in mind. As a result, Southern turned to a market broker, Natsource, LLC, allowing it to benefit from detailed market information and to maintain its anonymity in the marketplace. Structure Sourcing Pricing Placing the Bid Negotiating Price Consummating the Deal Contracting Chapter V. More Applications for Cap and Trade So far, the Handbook has discussed the basics of cap and trade and participation in emissions trading markets in the context of the U.S. Acid Rain Program. The remainder of the Handbook will provide an overview of two other programs that employ the framework of cap and trade systems. In addition, the Handbook will review two potential applications of cap and trade principles. (A.) RECLAIM: Cap and Trade as Part of the Solution for Smog in L.A. Smog has become a part of daily life in the Los Angeles region. Smog is known to affect children, the elderly and asthmatics. Recent studies are also linking it to long-term respiratory illness and impaired lung capacity. The smog in Los Angeles is a major health concern for the area's citizens. The area is under pressure to meet national health standards for air quality by 2010. In turn, industries and businesses have been tasked to cut emissions of the smog producing pollutants nitrogen oxides (NOx) and sulfur oxides (SOx). The emissions cuts amount to fully 80% reductions by 2003. Market-based Solution Sought Stationary sources in the Los Angeles area emitting more than four tons of NOx and SO2 annually have their emissions capped to preserve environmental benefits. Those caps are then gradually decreased to ensure steady improvement in the overall air quality. Under the declining cap, these sources have been assigned three emissions targets for NOx and SO2 which include an initial allocation in 1994, the mid-point reduction in 2000, and ending allocations in 2003. Basinwide, by the year 2003, NOx emissions from RECLAIM sources are to be reduced by 75% and SOx emissions by 61%. As with the U.S. Acid Rain Program, sources can conserve credits by reducing emissions to a level that is lower than their target. These RECLAIM Trading Credits (RTCs) then become an asset that is fully transferable and can be freely traded. Transparency is vital to the program's success. The SCAQMD maintains a registry and keeps a public bulletin board listing each facility's emissions record, allocations, and compliance activity. Compliance for affected sources comes on a staggered 12-month cycle. At the end of the year, operators of affected sources make their final annual report to the SCAQMD, but still have the benefit of a two-month reconciliation period. During this time, a facility lacking sufficient RTCs to cover their emissions can enter the RTC market to make up for its shortfall. Similar to the U.S. Acid Rain Program, stiff penalties strongly encourage compliance. Facilities failing to meet requirements have RTCs deducted from their account the following year and are subject to monetary penalty. With a fully operational cap and trade program in place in the Los Angeles area for more than a half-decade, the results are already apparent. SOx and NOx emissions from affected sources have been successfully reduced, although there is still much more to go. The most striking benefit of the RECLAIM program has been its dramatic effect on the economic impact of reductions. It was once thought that NOx credits would trade at around $25,000 per ton, however, the recent RECLAIM market price is roughly $640 to $5,560 per ton. At the outset of the program, the SCAQMD projects annual savings in compliance costs relative to command and control regulation averaging $58 million annually or 42%. However, while RTC costs are far below projections, actual savings have been far greater. These gains notwithstanding, additional environmental benefits and the real economic test for the RECLAIM program will occur next year when the next set of reductions are mandated. For more information check this Web address:
(B.) OTC NOx - Regional Ozone Program in Place As the federal SO2 program demonstrates, acid rain presents a complex set of problems for policy makers, regulators, environmentalists, and American industry. When compared to NOx controls, however, the SO2 program seems relatively straightforward. NOx contributes to the acid rain problem nationwide and it contributes to the ground level ozone problems in the East and in certain densely populated areas in the rest of the country. In relation to acid rain, the concern about NOx is the issue of accumulation. The pollutant's effects build up over time and can have a lasting effect on the environment. In relation to ozone, the concern is about acute loading in which the build up of NOx emissions at any given time during the summer season is when the environmental and health impact is most great. It is these temporal and spatial concerns that have influenced the design of NOx trading programs. Power plants in the Northeast increase generation in the summer months to meet their customers' needs for more electricity to run their air conditioners. These power plants are also emitting nitrogen oxides (NOx) that, combined with summer sunshine and other pollutants known as volatile organic compounds (VOCs), create ground-level ozone across the northeast region. Northeastern states have adopted a multi-state approach to address these concerns.
The OTC's efforts included the September 1994 signing of a memorandum of understanding with the EPA. The agreement, signed by all OTC states except Virginia, put in place a cap and trade system with boundaries reflecting the regional nature of the problem. Compliance In Summer Months As with all programs covered under Title I of the Clean Air Act, the OTC NOx trading programs is a state compliance measure. States establish their own rules, which include allocation strategies and other measures. Efforts were made to ensure that rules were consistent from state to state to allow for regional emissions trading, however, program aspects such as emissions allocation methodology do vary considerably between states. Also, EPA acts as an agent for the states by administering the allowance tracking system. Each allowance in the OTC trading program is equal to one ton of NOx released into the atmosphere during the compliance period. The allowances are fashioned to be standardized and tradable, but bankable only in limited amounts. The limit on banking is a design feature that addresses the particular temporal and spatial concerns about ozone formation. Significant inroads to reduce NOx emissions had to be reached each season or the environmental gains would be limited. This dynamic precluded long-term banking provisions. Trading Market Already Developed The OTC market has already steadily developed in its first season. Trading began in 1998 for compliance activities related to the 1999 summer season. According to one estimate, over 35,000 tons were traded before the start of the 1999 season. Information on current volumes and prices for NOx allowances can be obtained from emissions trading brokers, as well as publications such as Air Daily and the Utility Environment Report. The market also exhibited signs of maturation as trades for future vintage allowances also have been made, with prices reflecting the emerging spreads between current vintage year allowances and those of future years. Similar spreads are evident in SO2 allowance markets, as well. For more information check these Web addresses: ( C.) Potential Applications for Cap and Trade As stated earlier, cap and trade is viewed by many as a model that may be appropriate for other environmental programs on a regional or global scale. Recently, cap and trade is being examined in the context of two other environmental problems: ozone transport and global climate change. Ozone Transport Seeking to stem the effects of ground level ozone on human health and the environment, policy makers were again looking for a regional solution—but one that would extend its parameters borders to reach all relevant sources. As a result, the 37 eastern-most states in the country Under the Clean Air Act, all states have to prepare SIPs or state implementation plans. The NOx SIP call requires the twenty-two eastern most states to include provisions for addressing ozone transport in their SIPs. NOx emissions reductions are to be achieved by the 2003 compliance season. Levels of NOx emissions are to be cut by 28% or by 1.1 million tons a year. The EPA rule allows states to consider cap and trade programs in their SIPs. Climate Change The problem associated with greenhouse gases is thought to be one of accumulation. Greenhouse gas emissions contribute to climate change regardless of where the emissions occur, and climate change can be addressed by reductions in greenhouse gas emissions no matter where they occur. This suggests that emissions trading could be a useful tool in addressing climate change. A series of reports by the United Nations outlining concerns about climate change compelled world leaders to action. International momentum led to a global summit in Rio de Janeiro, Brazil in 1992. The participating nations signed several documents including the United Nations Framework Convention on Climate Change, in which over 180 nations committed to an objective of preventing dangerous interference in the world's climate system. The Framework Convention guided several additional international meetings in the succeeding years, and these discussions resulted in the The Kyoto Protocol has provisions for emissions trading as a mechanism under the agreement. Emissions trading would allow the marketplace to identify the lowest-cost reduction options. Key questions remain, not the least of which is who would be allowed to trade, what they would trade, and how it would be traded. Nonetheless, countries and private entities are beginning to explore the viability of greenhouse gas emissions trading. A handful of trades have already been executed, and most market participants expect trading to ramp up once the future of international markets is made more clear. For more information check these Web addresses: Chapter VI. Glossary The following terms are defined as indicated for their use in this Handbook. A Accumulation: the build up of a particular pollutant over time
Acid Rain: term applied to acid precipitation formed when emissions of sulfur dioxide (SO2) and oxides of nitrogen (NOx) react in the atmosphere with water and other compounds Acid Rain Program: created under the Clean Air Act to reduce acid rain; employs a cap and trade framework to achieve SO2 reductions Acute Loading: a term that applies to the short-term build up of a pollutant and which suggests that, in the short-term, significant amounts of a pollutant can accumulate Allowance: the term generally used to refer to the emission reduction unit traded in emissions trading programs; in the Acid Rain Program this term specifically means the limited authorization to emit one ton of SO2 during a given year. Allowance Loan: transaction wherein an owner of allowances, the lender, allows another party, the borrower, to use the allowances. The borrower customarily promises to return the allowances after a specified period of time with payment for their use, called interest. The allowances returned are not necessarily the exact ones loaned, but are allowances of similar vintage years Allowance Loan Rate: payment for the lending of allowances over a specified period of time, calculated including the cost-of-carry charge Allowance Tracking System (ATS): a computerized system administered by EPA and used to track the allowances and allowance transactions by all market participants Allowance Transfer Form (ATF): official form used to report allowance transfers to the ATS. The ATF lists the serial numbers of the allowances to be transferred and includes the account information of both the transferor and the transferee Ask: the price a prospective seller is willing to accept (a.k.a. "offer") Average Weighted Price: calculation used to determine price taking into account the quantity of allowances sold B Bear Market: prolonged period of falling allowance prices.
Bid: price a prospective buyer is willing to pay Broker: person who acts as an intermediary between a buyer and a seller, usually charging a commission Bubble: a regulatory term which applies to the situation when a company combines a number of its sources in order to control pollution in aggregate; under a bubble facility operators are allowed to choose which sources to control as long as the total amount of emissions from the combined sources is less than the amount each source would have emitted under the conventional requirement Bull Market: prolonged rise in the price of allowances. Bull markets usually last at least a few months and are characterized by high trading volume
C Call Option: a contract that grants the right to buy, at a specified price, a specific number of allowances by a certain date
Clean Air Act Amendments of 1990: reauthorization of the Clean Air Act; passed by the U.S. Congress; strengthened ability of EPA to set and enforce pollution control programs aimed at protecting human health and the environment; included provisions for Acid Rain Program Clearing Price: price at which a buyer and seller agree to transact a trade Collar/Zero-cost Collar: set of contracts used to hedge against the risk of prices moving in both directions; involves purchasing a call option and selling a put option. Option premiums in a collar that cancel each other out are "zero-cost" collars Confirmation Sheet: formal memorandum from a broker to a client giving details of an allowance transaction Cost-of-carry: out-of-pocket costs incurred while an allowance holder retains allowances for future transfer Counterparty: the party opposite the buyer or seller in a transaction Credit Risk: the financial risk that an obligation will not be paid and a loss will result
D Deferred Swap: a trade of one allowance for another in order to exchange the vintage years of the allowances; settlement occurs after more than 180 days Demand-side: a term referring to the need (or demand) for power generation among a utility's customers Designated Representative: for a unit account, the individual who represents the owners and operators of that unit and performs allowance transfer requests and all correspondence with EPA concerning compliance with the Acid Rain Program; for general accounts this refers to the person who is authorized to transact allowances from each account Dispatch: the ordered use of generation facilities by an electric power utility including which units will operate, when they will operate, and at what capacity E Exercise Date (or Expiration Date): last day on which an option can be exercised
F Forward Settlement: purchase or sale of a specific quantity of allowances at the current or spot price, with delivery and settlement scheduled for a specified future date G General Accounts: accounts in the SO2 or NOx ATS's which were created after the initial allocation; general accounts can be opened by any individual and they are not automatically adjusted for compliance Global Climate Change: change in the earth's climate; caused by increasing greenhouse gas (GHG) concentrations in the atmosphere; human activities considered to be major new source of GHGs Greenhouse Gases: variety of gases including carbon dioxide, methane, and nitrous oxide; the buildup of these gases in the atmosphere prevents energy from the sun to escape back out into space, creating the "greenhouse effect" Ground-level Ozone: the occurrence in the troposphere (at ground level) of a gas that consists of 3 atoms of oxygen (03); formed through a chemical reaction involving oxides of nitrogen (NOx), volatile organic compounds (VOC), heat and light; At ground level, ozone is an air pollutant that damages human health, vegetation, and many common materials and is a key ingredient of urban smog. H Hedge: strategy used to offset investment risk. A perfect hedge is one eliminating the possibility of future gain or loss I Immediate Settlement: conclusion of an allowance trade in which a party pays for allowances within days of the confirmation of the transaction Immediate Vintage Year Swap: an trade of one allowance for another in order to exchange the vintage years of the allowances; settlement occurs within days (or at least less than 180 days) J
K
Kyoto Protocol: an agreement under the UNFCC signed by 84 nations; establishes greenhouse gas targets ("budgets") and framework for implementation; the Protocol has been agreed to and signed by the U.S. and now awaits ratification by the U.S. Senate L Long: a market position in which a party records (or anticipates recording) emissions less than its yearly emissions allocation, thus it has surplus allowances Long-term Forward purchase or sale of a specific quantity of allowances, with delivery and settlement scheduled for a specified future date, usually more than one year out M Market Maker: an individual or company that maintains firm bid and offer prices in allowances by standing ready to buy or sell allowances at market prices
N National Ambient Air Quality Standards (NAAQS): health-based standards for a variety of pollutants set by EPA that must be met by states across the country Natural long: a party whose allowance allocation is greater than its actual emissions Natural short: a party whose allowance allocation is less than its actual emissions Nitrogen Oxides (NOx): gases produced during combustion of fossil fuels in motor vehicles, power plants and industrial furnaces and other sources; is a precursor to acid rain and ground-level ozone NOx Budget Program: a NOx cap and trade program adopted by 13 jurisdictions in the Northeast to address ozone transport in that region
O Offers: price at which someone who owns an allowance is willing to sell (a.k.a. "Ask") Option: a contractual right to buy or sell allowances at an agreed price; the option buyer pays a premium for this right. If the option is not exercised after a specified period it expires Option Premium: amount per share paid by an option buyer to an option seller for the option Out-of-the-money Call Option: term used to describe an call option whose strike price for an allowance is higher than the current market value Out-of-the-money Put Option: term used to describe a put option whose strike price for an allowance is lower than the current market value Over-the-counter Market: Market in which allowance transactions are conducted through the direction interaction of counterparties rather than on the floor of an exchange Ozone Transport Assessment Group (OTAG): a multi-stakeholder workgroup convened to address problems associated with the long-range transport of ozone and its precursors; encompassed stakeholders in 37 jurisdictions P Put Option: a contract that grants the right to sell, at a specified price, a specific number of allowances by a certain date Power Pool: a situation where output from different power plants are "pooled" together, scheduled according to increasing marginal cost, technical and contractual characteristics (so-called must-runs), and dispatched according to this "merit order" to meet demand Q
R
Regional Clean Air Incentives Market (RECLAIM): initiated in 1993; a set of market initiatives designed address air pollution in the Greater Los Angeles area of California; includes cap and trade programs for NOx and SOx Retire (Allowances): to remove a portion of allowances from the market S Scrubbers: a pollution control technology utilized in power plants to remove pollutants from plant emissions. Short: a market position in which a party records (or anticipates recording) emissions in excess of its yearly emissions allocation, thus it has a deficit of allowances Short-term Forward: purchase or sale of a specific quantity of allowances at the current or spot price, with delivery and settlement at a specified future date, usually within one year Smog: originally meaning a combination of smoke and fog, smog now generally refers to air pollution; ground level ozone is a major constituent of smog SO2 Allowance Auction: provided for in the Clean Air Act, the SO2 auction is held annually by the US EPA; the auctions help to send the market an allowance price signal, as well as furnish utilities with an additional avenue for purchasing needed allowances South Coast Air Quality Management District (SCAQMD): the air pollution control agency for the four-county region including Los Angeles and Orange counties and parts of Riverside and San Bernardino counties Special Allowance Reserve: roughly 2.8 percent of the cap set aside each year to supply the annual allowance auction State Implementation Plan (SIP): the plan that each state must develop and have approved by the US EPA which indicates how the state will comply with the requirements in the Clean Air Act; each State's SIP is amended as they address specific or new requirements such as the NOx reductions required in the NOx SIP Call Strangle: sale or purchase of a put option and a call option on the same underlying instrument, with the same expiration, but at strike prices equally out of the money. Strike Price (or Exercise Price): price at which the allowance underlying a call or put option can be purchased (call) or sold (put) over the specified period. Sulfur Dioxide (SO2): a gaseous pollutant which is primarily released into the atmosphere when as a by-product of fossil fuel combustion; the largest sources of SO2 tend to be power plants that burn coal and oil to make electricity Supply-side: a term referring to the generation (or supply) of power by a utility Swap: an exchange of one allowance for another to exchange the vintage years of the allowances held in accounts T Time Weighting: an investment strategy in which allowance purchases and sales are transacted over an extended period of time and in small increments, thereby eliminating risk associated with highs and lows in the market Trader: anyone who buys or sells allowances with the intention of making a profit
U Unit Accounts: accounts in the SO2 or NOx ATS's which hold allowances initially allocated to those sources required to participate in either the acid rain or OTC NOx programs; EPA adjusts these accounts for compliance each year United Nations Framework Convention on Climate Change (UNFCC): a treaty signed in 1992 by 165 countries and ratified by 160 countries (including the U.S.); took effect in March 1994; set a target of stabilizing greenhouse gas concentrations in the atmosphere to a level that would prevent dangerous anthropogenic interference with the climate system; established a framework for agreeing to specific actions V Vintage Year: represents the first year in which the allowance can be used for compliance W
X Y Z
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time and cost of completing transactions to minutes. 
technologies can be applied to a unit in order to clean up emissions as the pollutants move through the smoke stack. However, most pollution control device decisions are long-term and rather large capital investments. Therefore, they afford little flexibility to adapt to changes in short-term market conditions.
specified price by a certain date. They can best be related to insurance policies in which an individual pays out a premium to the seller or "insurer." The insurer provides a "policy" to cover the buyer's risk of prices going up or down, depending on where the buyer sees their exposure. 
The Clean Air Act Amendments of 1990 set National Ambient Air Quality Standards (NAAQS) for ground-level ozone that must be met by states across the country. In the Clean Air Act, Congress also established the Ozone Transport Commission (OTC), a working group made up of twelve Northeast states and the District of Columbia to assist states in the Eastern U.S. to meet these targets. The OTC created a NOx Budget Program to help reduce regional ozone levels. 
joined with industry, environmentalists, and the EPA to address the issue of long-range transport of NOx emissions. The interested parties formed the Ozone Transport Assessment Group, and in September 1998, EPA promulgated a rule seeking additional NOx emissions reductions to address the problem of ozone transport. This rule making is commonly known as the NOx SIP Call. 
gases. The accumulation of greenhouse gases in the atmosphere are thought to contribute to a rise in worldwide temperatures. The greenhouse effect occurs when greenhouse gases act like a blanket and trap heat from the sun that would otherwise escape back out into space. 
Kyoto Protocol. Adopted in 1997, the Kyoto Protocol would commit 38 industrialized countries to reduce greenhouse gases an average of 5.2% from 1990 levels over the period between 2008 and 2012. The Protocol has not yet been brought before the US Senate for ratification.