The enforcement challenge of cap-and-trade regulation.

AuthorMcAllister, Lesley K.
PositionSymposium
  1. INTRODUCTION II. THE IMPERATIVE OF ACCURATE EMISSIONS DATA A. The Compliance Equation B. Market and Environmental Integrity C. Incentives for Fraud III. OBTAINING ACCURATE EMISSIONS DATA A. Emission Monitoring Methods 1. Direct Measurement 2. Estimation Using Emissions Factors B. Self-Monitoring and Reporting 1. Self-Monitoring and Reporting in Environmental Law 2. Self-Monitoring and Reporting Rules in Cap-and-Trade: A Reprise of Best Available Technology 3. Enforcement of Self-Monitoring and Reporting Rules C. The Additional Burdens of Verifying Offsets IV. ENFORCEMENT THROUGH COOPERATIVE FEDERALISM A. Federal Role B. The Role of States C. Citizen Enforcement D. Third Party Verification V. CONCLUSION I. INTRODUCTION

    Cap-and-trade regulatory programs present a significant enforcement challenge. To administer a cap-and-trade program, a regulatory agency needs a full accounting of the emissions from each regulated facility in the program. (1) Assembling such data is costly and resource intensive. In the Clean Air Act's (2) Title IV Acid Rain Program (Title IV)--the hallmark cap-and-trade program of the United States Environmental Protection Agency (EPA) to control sulfur dioxide (SO2) emissions from power plants--"measuring and monitoring have been the most complex and costly components" of the trading program. (3) The Los Angeles agency that administers the Regional Clean Air Incentives Market (RECLAIM), another longstanding cap-and-trade program, states that "an unanticipated consequence of RECLAIM was the enormous amount of resources it takes to adequately monitor and enforce compliance." (4)

    Cap-and-trade regulation remains the likely instrument of choice for a national program in the United States to regulate the greenhouse gas emissions that cause climate change. (5) The cap-and-trade program set forth in the American Clean Energy and Security Act (ACES Act), (6) passed by the House of Representatives in June 2009, would have capped about 85% of all greenhouse gas emissions in the United States and applied to about 7500 entities. (7) Although the ACES Act did not become law due to Senate inaction, (8) a similarly comprehensive cap-and-trade system seems likely to be considered again in the future. (9)

    This Article draws on the experience of past cap-and-trade programs to describe and analyze the enforcement challenges that will confront a future U.S. cap-and-trade program for greenhouse gases. (10) Part II of the Article describes why accurate emissions data are so critical to the functioning of a cap-and-trade program. Part III discusses how emissions data are obtained. Part IV argues that a comprehensive cap-and-trade program to reduce greenhouse gas emissions should not be enforced by the federal government alone. (11) Rather, a relatively decentralized cooperative federalism approach is called for. Significant roles should also be played by state enforcers, citizen enforcers, and possibly third party verification entities. (12)

  2. THE IMPERATIVE OF ACCURATE EMISSIONS DATA

    In a cap-and-trade program, accurate emissions data are essential to determining each regulated facility's compliance. Accurate emissions data also support the market value of the program's tradable allowances and create confidence in the program's attainment of its environmental objectives. Yet, at the same time, incentives for facilities to have their emissions undercounted clearly exist, particularly when allowance prices are high.

    1. The Compliance Equation

      A threshold question in determining whether cap-and-trade is a suitable regulatory approach is whether emissions can be monitored accurately. (13) To determine whether a regulated facility has complied, the agency must be able to ascertain that the facility has enough allowances to "cover" its emissions at the end of the compliance period. (14) To do so, it must have an accurate count of the facility's "mass" emissions--the whole quantity of its emissions over the given reporting period. (15)

      Existing cap-and-trade programs in the United States, such as Title IV (16) and RECLAIM, (17) have set the date for the compliance decision to be several weeks to several months after the reporting period ends. (18) In this so-called reconciliation period, (19) the facility has time to conduct trading to buy or sell permits as it deems necessary or advantageous. On the compliance date, the facility must surrender the number of permits representing the amount of pollution that it has emitted over the reporting period, or be deemed to be out of compliance. (20)

    2. Market and Environmental Integrity

      In the absence of accurate monitoring data, the integrity of the allowance market is compromised. If regulated facilities need fewer allowances to satisfy compliance because their emissions are undercounted, then there will be less demand for allowances in the allowance market, and the value of allowances will be lower. (21) The monitoring data are critical because they determine the number of allowances that a facility has to surrender for compliance, and in turn, the number of allowances that it must buy or that it can sell. (22)

      If any portion of a regulated facility's emissions is not included in the mass emissions count that is used to determine compliance, then the emissions reduction incentives created by the program are reduced. Most directly, the emissions reduction incentives for the facility that is able to avoid reporting some of its emissions are reduced; the facility has less incentive to spend money on emissions reductions if it can simply report lower emissions. This is also the case in a traditional environmental regulatory program. (23) Poorly monitored facilities will not be subject to the types of agency actions that would have otherwise given those facilities the incentive to reduce their emissions.

      In a cap-and-trade program, however, the ability of one participating facility to cheat affects not just its own incentives but also the incentives of all other facilities in the program. (24) In a traditional environmental regulatory program, a poorly monitored facility's ability to avoid emissions reductions would have no effect on the incentives faced by a well monitored facility in the same traditional environmental regulatory program. In a cap-and-trade program, in contrast, the two become interrelated. The poorly monitored facility that falsely reports overcompliance can sell allowances to the well monitored facility, thereby enabling the well monitored facility to avoid emissions reductions. Because of the trading, weak enforcement for some facilities affects the emissions reduction incentives of all. (25)

      Accurate monitoring is also critical to whether the program's environmental goal--the overall cap imposed on all the regulated sources-is truly attained. (26) If sources are emitting at levels higher than they report and such violations are not discovered, the reported level of overall emissions for the program will be lower than actual emissions. In cases where reported emissions are close to the cap, actual emissions may be above the cap, and the environmental goal espoused by the program will falsely appear to be met.

      Where the banking of allowances is allowed, the negative impact on the environmental integrity of the program will be carried into the future. In a program with allowance banking, allowances issued in one compliance period do not expire at the end of that period. Rather, regulated facilities can hold on to allowances for use or sale in a future compliance period. (27) If emissions are undercounted in a program with banking, allowances that should have been surrendered will be available to legitimize emissions that may exceed the cap in a future compliance period. (28)

    3. Incentives for Fraud

      While a reliable accounting of all of each source's emissions is critical to success, a cap-and-trade scheme creates a clear incentive for fraud: the price of an allowance is the monetary reward for not reporting the amount of pollution that that allowance represents. So, at the same time that the allowance price creates an incentive to make emissions reductions that would cost less than that price, it also creates an incentive to find a loophole or commit fraud to avoid having to report emissions. (29) As explained by Professor Marjan Peeters in a study about the European Union Emissions Trading Scheme (EU ETS), the European Union's (EU's) innovative cap-and-trade program to reduce greenhouse gas emissions "[b]y introducing a financial incentive for reducing emissions, an incentive for not following the rules is in fact included." (30) In other words, the acclaimed virtue of cap-and-trade--its ability to put a price on pollutant emissions--is also a path to vice.

      Moreover, when allowance prices are high, there is a greater incentive for facilities to cheat than when allowance prices are low. (31) The rational polluter bases the decision whether to comply on a comparison of the expected benefits and expected costs of noncompliance. (32) If the benefits of noncompliance exceed the costs, it is not rational to comply. The expected benefit of not complying is a function of the permit price. By not complying (i.e., by underreporting emissions), the polluter saves the money that it would have had to spend on allowances. The expected cost of noncompliance depends in turn on the likelihood that a penalty will be imposed and the severity of that penalty.

      Therefore, when allowance prices are higher, the same level of enforcement requires that the probability of a penalty, the price of that penalty, or both, rise in a proportionate way. For the probability of violation detection to rise, the agency must become more vigilant in conducting inspections and other activities to identify violations. Penalty amounts can rise if agencies have the authority to impose higher penalties and choose to do so.

      The enforcement regimes of existing cap-and-trade programs have not...

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