The Skirmish Over Permits

PAECONOMY, page 7

ADAM SMITH's "Wealth of Nations" defined air and water as "free goods." That idea made sense in the 18th century. But in today's smoggy cities and shrinking reservoirs, clean air and water are scarce, not free.

"Given that we have to ration them, there are two alternatives: One is the command-and-control system, the other is to use the price system to allocate them," says Richard Sandor, executive managing director of Kidder, Peabody & Co. and author of a United Nations-sponsored study on the table at the Earth Summit in Rio de Janeiro.

The United States Environmental Protection Agency estimates that in 1990, just under $100 billion was spent on compliance with federally mandated environmental regulations. By the year 2000, these mandated expenditures will exceed $150 billion annually, the EPA estimates.

The trend is toward using market economics, rather than strict rules, in the hope of holding pollution-control costs in check. Though several market-based strategies to control the emission of greenhouse gases are being considered in Rio, the idea of tradeable permits is getting special attention.

Permits, or allowances, give the holder the right to emit a specified amount of a pollutant within a limited time frame. Pollution is curbed over time by reducing the total number of permits available. Prices of permits are set by buying and selling them on an open exchange.

Conference participants in Rio will consider Dr. Sandor's proposal for an international trading system to control emission of carbon dioxide. How this country-by-country permit system would accommodate the growth of developing nations is a major hurdle.

Carbon dioxide is responsible for more than 60 percent of the greenhouse effect, according to a 1990 report by the Intergovernmental Panel on Climate Change. The US currently produces 20 percent of the world's carbon emissions, but other nations are expanding their output more rapidly.

The EPA began experimenting with tradeable pollution permits in 1975 when it authorized regional air-quality regulators to allow individual companies to buy and sell permits. Exchanges have been limited, however, because it is difficult both to place a value on permits and to facilitate negotiations between buyers and sellers.

To remedy these problems, Congress built into the 1990 Clean Air Act Amendments a legal basis for setting up a tradeable permit system to control sulfur dioxide, the principal component of acid rain. Beginning in 1995, utilities will receive allowances to emit sulfur dioxide at the level they were producing in 1985. A power plant eligible for 100,000 allowances would actually receive only 97.2 percent of that number, however. The remaining 2.8 percent would be withheld to be auctioned annually to firms b uilding new plants.

Permits would be bought and sold by utilities and eventually manufacturers in amounts to match their fuel requirements.

US law requires that by 2000, sulfur dioxide emissions by the 110 most pollution-intensive plants must be reduced from the 19 million-ton level of 1985 to 9 million tons annually.

Supporters argue that tradeable permits give companies a financial incentive to eliminate pollution; companies with cleaner plants can sell excess allowances to firms that cannot reduce emissions as efficiently. Companies can choose among the cheapest technologies available. Upward pressure on electricity rates due to pollution-control costs is thereby minimized.

Several organizations, including the Chicago Board of Trade (CBOT), the New York Mercantile Exchange, and the New York brokerage Cantor Fitzgerald Inc. have applied to the EPA for permission to handle the annual auction of emission permits. The EPA may select one of them as soon as this month.

The CBOT has made a further proposal for a cash exchange, to be run on an electronic bulletin board where transactions would be listed and negotiated.

The Chicago exchange has already received approval from the Commodity Futures Trading Commission to set up a system to trade futures contracts for emission allowances.

Companies can hedge their investment in pollution control equipment by "locking in," or selling ahead of time, the pollution permits they plan to avoid using. By watching trading prices of futures contracts, regulators can evaluate the impact of regulations on companies and on overall economic growth. The CBOT hopes to start trading contracts in 1993.

Recent pollution-permit transactions, such as the sale by Wisconsin Power and Light Company of emission rights to the Tennessee Valley Authority and the Duquesne Light Company, indicate that sulfur dioxide futures contracts may start trading at prices between $150 and $500 per ton.

If the US experience in using permits proves to be persuasive to conferees in Rio, an agreement on the basis for establishing a carbon-control system may emerge from deliberations.

Sandor, who wrote CBOT's pollution permit futures contract, also wrote the first option contracts for treasury bonds and interest-rate futures in the 1970s. He points to a possible added benefit of trading permits internationally: If developing nations are provided with the electronic capability needed to participate in a worldwide carbon dioxide control scheme, the infrastructure put in place would revolutionize those nations' ability to market and trade commodities.

"Once one quantifies an environmental problem, I think that goes a long way" toward solving it, Sandor says. "It's about time we took all these financial engineering skills we've learned in handling capital markets and applied them to social problems."