Emissions Trading, Electricity Industry Restructuring and Investment in Pollution Abatement

In some states, legislation has been passed to make it easier for regulated utilities to
recover their environmental compliance costs. ¹⁵

One approach to modeling the compliance decision in regulated markets assumes
that managers of regulated plants maximize shareholder profits subject to the con-
straint that they remain in compliance with environmental regulations (Fullerton et
al.). In this model, β∖ represents the portion of variable compliance costs (not includ-
ing the opportunity costs of using the permits it has been allocated) that the utility
is not permitted to pass on to its ratepayers through rate increases; ¹⁶ β^κ represents
the portion of capital investments in NOx control technology that is not included in
the rate base. If the regulated rate of return on capital exceeds the cost of capital,
the regulated firm will be biased towards capital intensive compliance options.

Alternatively, the compliance choice in regulated market can be modeled as a risk
(versus cost) minimizing choice (Rose). In this model, uncertainties regarding how
PUCs will treat future permit purchases could bias firms towards cleaner, more capital
intensive options (i.e. β^κ < β^v) (Bailey, Burtraw). Finally, several researchers found
that state environmental regulations and coal protection policies were an important
factor in ARP compliance decisions (Arimura, Coggins and Swinton, Keohane). If lo-
cal environmental quality or construction job creation concerns were a factor in PUCs’
rulings regarding cost recovery, costs associated with SCR technology (the compliance
alternative that delivers the most significant emissions reductions and requires more
substantial retrofits) may be treated more favorably in rate base calculations.

The Compliance Decision in Restructured Markets

Restructured electricity markets consist of buyers and sellers whose bids determine
a wholesale market price. Because the costs of storing electricity are prohibitively
high, supply and demand for electricity are balanced in real time. Trading occurs via

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