The Sky's the Limit

How buying and selling pollutants could help clean up the Bay Area's air

In the third week of July, the Pacific Exchange held a commodity auction, both here and in Los Angeles, like no other in the world. Four million units changed hands, at an average price of 80 cents each, generating $3.2 million in sales. The commodity being bought and sold was dirt -- specifically, the chemical pollutants that pour into the atmosphere from tailpipes, exhaust vents, and smokestacks.

At the auction, anyone with the cash and the need could buy the right -- in 1-pound denominations -- to pollute the air. The buyers tended to be large businesses and industries, but there was nothing to stop an environmentally concerned parent from retiring a certain amount of air pollution permanently. "They can buy a smog certificate and hang it on the kid's wall," explains Dale Carlson, vice president for corporate affairs at the exchange.

For now, the only smog market in California deals with pollution generated in the Los Angeles Basin.

But some business and environmental groups say Northern California could best handle long-term pollution problems with a market-based approach. And a recent surprise action by the federal Environmental Protection Agency may push the Bay Area toward creating its own public smog market.

The Pacific Exchange smog auctions, which take place six times a year, are real-life expressions of the market-based incentive approach to reducing pollution, an economic theory of emission control first propounded more than 30 years ago. In this decade, the theory has moved from the academic fringe to mainstream reality and is now an accepted component of the EPA's regulatory arsenal.

What changes hands during the auctions are known as tradable emission credits. For now, the credits can be bought and sold only by Los Angeles Basin polluters that have joined the Regional Clean Air Incentives Market (RECLAIM).

The premise behind RECLAIM is simple: Use the marketplace itself to reward companies for reducing pollution.

To create RECLAIM, regulators established a base line of the amount of pollution being produced in the L.A. area and set long-term goals for reducing it. They then allocated credits for the existing pollution among the region's various industrial sources, based on their historic contribution to the total pollution load. As allowable pollution levels drop, the number of credits is reduced; this acts as a floor of sorts for the credits' market value.

Dale Carlson explains the dynamics: "As the supply of credits declines over time, the price goes up; the higher the price, the greater the incentive to come up with new [pollution control] technology; that will spin off excess credits and reduce the price of the credits."

Polluters registered with RECLAIM must reconcile their pollution accounts once a year. If a polluter finds it has emitted more pollution than it has been allocated, it must buy pollution credits at one of the Pacific Exchange's emission credit auctions. If it has reduced emissions below what was allocated, the firm sells the excess credits.

This market approach is a drastic departure from the prevailing "command and control" model for pollution regulation, which is used in most of the country, including the Bay Area. Under command and control, regulators set limits for polluters and impose sanctions in the forms of fines or shutdowns if those limits are not met.

But there is no reward for polluters who reduce emissions below those levels. Not only is there no incentive to pollute less than the legal limits; there's an economic disincentive for excessive cleanliness. The costs of pollution reduction beyond what is required by law cut into a company's competitiveness in the marketplace.

The Bay Area Air Quality Management District, which regulates air pollution here, is not a complete stranger to market-based theory. It established a credit-based program in 1984, but the plan has never been developed beyond a rudimentary "bank," which has languished largely unused. The bank mainly serves the region's handful of large polluters as a place to park excess polluting permits from facilities they've shut down; they get to tap the pollution credits for later expansions of production capacity. The bank registered a grand total of four transactions last year.

And Bill deBoisblanc, a spokesman for the district, says the agency has little interest in expanding its market-based program, either through banking or trading. He says that the relatively low emissions burden here offers little incentive to invest in the regulatory retooling required for a market-based approach.

But Roger Noll, a professor of environmental economics at Stanford University and one of the country's pre-eminent advocates for market-based emissions control, says the time to institute a market-based system is before the Bay Area faces a Los Angeles-level pollution problem.

Creating a market in which pollution credits have a low price, Noll says, would allow industry to reduce emissions gradually and at relatively low cost, rather than wait for a governmental edict -- a "hammer" that will cost businesses large amounts of money.

The federal government may already have picked up the "hammer" Noll refers to.

On Aug. 21, the EPA stunned local regulators and industry representatives by formally proposing to downgrade the official measure of the quality of the Bay Area's air. If that downgrade takes effect (a final decision is due by the end of the year), the Bay Area Air Quality Management District will have to come up with stricter limits on pollution produced here.

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