Emissions Trading, Electricity Industry Restructuring and Investment in Pollution Abatement

appeal to public interest arguments (such as cleaner air or construction job creation)
to justify receiving higher prices for their electricity. Merchant plants and other gen-
erators that rely heavily on the wholesale electricity market to recoup their pollution
control investments will be particularly reluctant to adopt a compliance strategy that
involves large investments in abatement equipment. Unlike utilities, many merchant
plants had low credit ratings in the years leading up to the SIP Call (Senate Com-
mittee on Energy and Natural Resources). Highly leveraged plants would have more
difficulties securing financing for major pollution control retrofits, which can cost over
$50M per unit.

The objective of this paper is to estimate a discrete choice model of firms’ com-
pliance decision in order to test the hypothesis that the type of electricity market in
which a coal plant is operating has significantly affected the environmental compli-
ance strategy choice. Using unique data on unit-level compliance costs, a conditional
logit model and a random parameter logit model of the compliance choice are esti-
mated. Results indicate that electricity market regulation significantly affected how
coal plants made their environmental compliance choices.

For decades, economists have studied the relationship between economic regula-
tion and the investment decisions of regulated firms. In their seminal paper, Averch
and Johnson demonstrate how rate of return regulation⁷ provides firms with an incen-
tive to overintensively substitute capital for other production factors. A large share
of the regulation literature has been devoted to extending and testing Averch and
Johnson’s work. Empirical verification of this effect in the context of the electric-
ity industry has been attempted several times with mixed results: Courville, Spann,
and Hayashi and Trapani all find support for the Averch-Johnson effect in the U.S.
electricity industry, whereas Boyes does not.

With the creation of the Acid Rain Program (ARP) in 1990, researchers became

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