Chicago -- The Chicago Board of Trade plans to apply market principles to the U.S. Environmental Protection Agency's clean air allowance program by giving power plants and others the ability to trade their pollution emission allowances at the exchange.

The exchange, which submitted a plan in September to its regulator -- the Commodity Futures Trading Commission -- already has the support of the EPA. Dave Ryan, a press officer with the EPA, said, "We're behind it. We want [trading in allowances to be] market-based and run by the private sector."

But the Edison Electric Institute, which represents investor-owned utilities and favors the trading of allowances, has not advocated any approach to trading, a spokeswoman said.

The exchange's plan would create cash, forward, and futures markets in the allowances to meet requirements under the acid rain provisions of the Clean Air Act Amendments of 1990. those requirements, which are still in the formative stages, call for the trading of clean air allownaces. Each allowance permits a plant to emit one ton of sulphur dioxide a year.

Allocation Based on Emission

The allowance would be held initially by existing power plants, which would receive their allocation based on their emission rates and average levels of fuel consumption from 1985 to 1987. Plants would be prohibited from emitting more sulphur dioxide than their allowances.

But the EPA has made it possible for plants to transfer the allowances, opening up a free market in the emission permits. Therefore, a plant that has installed air pollution control equipment or so-called scrubbers since the late 1980s may not need its full allocation and could sell its leftover allowances.

On the other hand, a plant that has not installed the equipment may have a higher emission level and need to buy allowances to comply with the EPA's standards.

The legislation's goal is to cut annual sulphur dioxide emissions to 10 million tons by the year 2000, from the 1980 level of about 20 million tons. Phase one of the EPA's proposal targets 110 mostly large investor-owned, coal-burning plants in 21 eastern and midwestern states. The plan requires them to reduce their 1980 levels of sulphur dioxide emission about 60% by 1995. Phase two, which takes effect in 2000, reduces emissions to less than half the 1980 level for those plants and about 700 smaller plants.

Active Dates for Markets

According to Richard Sandor, an executive managing director at Kidder, Peabody & Co. and chairman of the exchange's clean air committee, the cash and forward markets in allowances could be up and running by the second half of 1992, and the futures market could be in operation sometime in 1993, pending regulatory approval.

The cash market would have an electronic bulletin board system in operation where cash transactions in the allowances could be listed and negotiated between iterested parties. The forward market would enable buyers and sellers of allowances to tailor deals for future delivery at a price determined at the time of the transaction. The futures market would allow any buyer and seller of a contract to lock in a future price, as well as provide a centralized and listed market for price discovery purposes.

Mr. Sandor estimated the size of the futures market in allowances to be about $2 billion to $5 billion a year. He said futures contracts might trade in the $100- to $1,000-per-ton range, adding that it is not likely the contracts would trade near the $2,000-per-ton penalty a plant would have to pay if its emisions exceed its allowances.

The presence of the markets in clean air allowances could have implications for both the timing and size of financings for polution control equipment, he said.

"The utilities are definitely taking these allowances into account as they are making decisions now," said Jeremy Gibson, a lawyer with Chapman & Cutler in Chicago.

While the Tax Reform Act of 1986 ended the tax-exempt financing of scrubbers for private power plants, it did allow th euse of tax-exempt bonds for solid waste facilities subject to private-activity cap allocations. And, according to Robert Ollis Jr., a partner at Chapman & Cutler, 25% to 30% of air pollution control equipment may qualify as a solid waste system, because the sludge produced by the scrubers is characterized as solid waste.

Jeff McHugh, a senior partner at Miller, Canfield, Paddock & Stone in Detroit, suggested that power plants may buy allowances to cover any time they wait to get an allocation under their state's private-activity cap.

Mr. Ollis said a plant could choose to install equipment that would allow it to sell its allowances, thereby reducing the overall cost of the equipment down the line. But he said the price of the allowances would have to be high enough to permit the utility to make a profit to help offset the equipment cost. If allowances are cheap, a plant may find buying allowances is more cost effective than installing a scrubber.

But Anthony Gordon, a principal at Aer*X, an air pollution advisory firm that is organizing an over-the-counter, or unlisted, market in allowances, cautioned that there could be more allowance sellers than buyers if more plants opt to install equipment or if states clamp down on plants' abilities to buy these permits to pollute.

Mr. Sandor called the exchange's plan for clean air allowance futures "the first attempt to really use market solutions for environmental and social problems." The exchange already lists futures contracts on numerous agricultural commodities and financial instruments, such as U.S. Treasury bonds.

The exchange's motivation for entering this new area, Mr. Sandor said, is the potential for "a whole new family of futures in the property rights area." That could include emissions of nitrous oxide as well as carbon, which is said to cause global warming. Mr. Sandor said water and its pollutants also could lend themselves to market solutions.

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