The Effect of Fuel Contracting Constraints on SO2 Trading Program Compliance: Empirical Evidence

The U.S. SO2 Trading Program created by Title IV of the 1990 Clean Air Act Amendment led to lower compliance costs than what would have occurred under a Command-and-Control approach. However, all compliance cost savings were not realized. There have been several conjectures, including rigidities from fuel contracts, as to why the hypothetical outcome was not obtained. Kneifel (2008) shows how fuel contracts could alter a generating unit’s compliance decision in the U.S. SO2 Trading Program, but ignores any aggregate allowance market and industry-wide compliance cost impacts. This paper expands on Kneifel (2008) by looking at the allowance market equilibrium impacts and total industry compliance costs from fuel contracts both analytically and empirically. This paper also uses generating unit-level simulations to replicate results from previous studies and show that fuel contracts appear to explain a large portion of the previously unexplained compliance cost simulations. Based on the simulation results, actual total industry compliance costs were $1.17 billion compared to the least-cost outcome of $288.3 million, or $878.8 million in excess compliance costs. Once fuel contracts are introduced into the simulations, minimum total industry compliance costs increase to $939.4 million, which explains $651.1 million of the excess compliance costs, or 74%. Also, this paper considers a more appropriate level for compliance decisions. The literature has only considered compliance costs at the generating unit level up to this point. However, actual compliance decisions would be made at the plant level. This paper analytically analyzes the plant level decision-making process to show how costminimization at the more complex plant level may deviate from cost-minimization at the generating unit level. Choices may not minimize costs at the generating unit level, but should result in lower costs at the plant level and lead to lower costs overall.