Emissions Trading, Electricity Industry Restructuring and Investment in Pollution Abatement

interested in the effect of economic regulation on electricity generators’ compliance
choice between SO2 pollution permits, fuel switching and a more capital intensive
compliance alternative- installing scrubbers. Using single agent models of the compli-
ance decision, Bohi and Burtraw conclude that the compliance choice will be distorted
if variable and compliance costs are treated asymmetrically in rate base calculations,
while Fullerton et al. show how state Public Utility Commission (PUC) rules that
distort investment incentives could more than double the cost of compliance. Other
researchers have used partial equilibrium models of the permit market to analyze the
effect of PUC regulation on permit market outcomes (Coggins and Smith, Cronshaw
and Kruse, Winebrake et al.). These studies predict that the performance of permit
markets will depend importantly on how rate of return regulation treats compliance
costs, and that rate of return regulation that favors capital intensive compliance op-
tions will limit permit market efficiency.

Once the Acid Rain Program came into effect in 1995, economists could em-
pirically analyze how generators respond to the incentives created by this emissions
trading program. In general, results have been mixed. Some studies find little or no
evidence that PUC regulations biased generators in favor of installing scrubbers (Bai-
ley, Keohane). Other researchers do find that cost recovery regulations significantly
discouraged participation in the permit market (Arimura, Rose); this effect is found
to be particularly strong in states where there was uncertainty about the extent to
which generators would pe permitted to recover costs of purchasing permits, and in
states with deposits of high sulfur coal.

This paper differs from previous studies of the relationship between economic
regulation and environmental compliance decision in two important ways. First,
to my knowledge, this is the first paper to use inter-state variation in electricity
industry restructuring activity to identify an effect of electricity market regulation on

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