Emissions Trading, Electricity Restructuring, and Investment in Pollution Abatement

When the US federal government first began regulating major sources of air pollution in the 1960s, the conventional approach to meeting air quality standards involved establishing maximum emissions rates or technology based standards for regulated stationary sources. However, economists have long maintained that an emissions permit market could more efficiently coordinate pollution abatement activities provided a series of assumptions are met. Over the past few decades, market based “cap and trade” (CAT) approaches to regulating emissions from industrial point sources have become a centerpiece of environmental regulation in the United States. In the theoretical first-best permit market equilibrium, the total social cost of meeting an emissions cap is minimized. Each firm chooses a level of pollution abatement such that its marginal cost of reducing pollution is set equal to the social marginal benefit from emissions reduction. In practice, preexisting distortions in product markets that are subject to CAT regulation may interfere with the emissions permit market’s ability to operate efficiently. This paper studies the effects of electricity market regulation on permit market outcomes in the context of a major US emissions trading program (the NOx Budget Program). The recent wave of electricity industry restructuring in the United States has resulted in significant interstate variation in economic regulation. Consequently, facilities in the same CAT program face very different economic regulation and investment incentives in their respective electricity markets. Whereas rate base regulated plants are guaranteed to earn a rate of return on prudent investments in pollution abatement equipment, “deregulated” plants operating in restructured electricity markets are offered no such Emissions Trading, Electricity Restructuring, and Investment in Pollution Abatement