Market Effects of Environmental Regulation: Coal, Railroads, and the 1990 Clean Air Act

Abstract

Title IV of the 1990 Clean Air Act Amendments introduced a cap-and-trade system for sulfur dioxide emissions from electric power plants in the United States. This paper analyzes the effects of that regulatory change on the prices charged by the two railroads that hauled low-sulfur coal east from Wyoming. We estimate the effect of the tradeable permits regime by comparing prices at affected plants (called Table A plants) before and after the allowance market took effect, and by comparing prices at those plants to prices at unaffected plants. We show that after Title IV took effect, the delivered price of low-sulfur coal - controlling for the minemouth price of coal and the variable cost of transportation - rose at Table A plants within approximately 1000 miles of the Powder River Basin, and fell at Table A plants located further away. This shift in the delivered price schedule of PRB coal is consistent with a theoretical model of the effects of emissions regulation on demand for low-sulfur coal, and the corresponding optimal pricing strategy by a carrier with market power. Our results suggest that the railroads were able to price discriminate among power plants on the basis of the environmental regulations governing the plants.

Full text

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Working Paper Series ES
Economics


“Market Effects of Environmental Regulation:
Coal, Railroads, and the 1990 Clean Air Act”

Nathaniel O. Keohane, Yale School of Management



Working Paper # 37



This paper can be downloaded without charge from the
Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract=593449




Meghan R. Busse, Haas School of Business

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Market Effects of Environmental Regulation:
Coal, Railroads, and the 1990 Clean Air Act∗
Meghan R. Busse†
Nathaniel O. Keohane‡
First draft: July 26, 2003
This draft: September 17, 2004
Abstract
Title IV of the 1990 Clean Air Act Amendments introduced a cap-and-trade system for
sulfur dioxide emissions from electric power plants in the United States. This paper analyzes
the effects of that regulatory change on the prices charged by the two railroads that hauled
low-sulfur coal east from Wyoming.
We estimate the effect of the tradeable permits regime by comparing prices at affected plants
(called “Table A plants”) before and after the allowance market took effect, and by comparing
prices at those plants to prices at unaffected plants. We show that after Title IV took effect, the
delivered price of low-sulfur coal — controlling for the minemouth price of coal and the variable
cost of transportation — rose at Table A plants within approximately 1000 miles of the Powder
River Basin, and fell at Table A plants located further away. This shift in the delivered price
schedule of PRB coal is consistent with a theoretical model of the effects of emissions regulation
on demand for low-sulfur coal, and the corresponding optimal pricing strategy by a carrier with
market power. Our results suggest that the railroads were able to price discriminate among
power plants on the basis of the environmental regulations governing the plants.
JEL codes: Q28, L51, L92, L94.
∗We are grateful to Erin Mansur in particular for many comments that improved this paper. We also thank
Spencer Banzhaf, Severin Borenstein, Michael Greenstone, Jon Levin, Paul MacAvoy, Fiona Scott Morton, Sharon
Oster, Chris Timmins, Frank Wolak, Rob Williams, Florian Zettelmeyer, and seminar participants at Berkeley,
USC, UCF, Dartmouth, Harvard, Stanford, and the NBER Summer Institute for their comments and suggestions.
Daryl Newby of the Kentucky Public Service Commission and Jim Thompson of Energy Publishers provided helpful
assistance in gathering information on coal contracts.
†Haas School of Business, 2220 Piedmont Ave., Berkeley, CA 94720-1900; meghan@haas.berkeley.edu; tel (510)
642-9589; fax (510) 643-5180.
‡Yale Schoolof Management,P.O.Box208200,
nathaniel.keohane@yale.edu; tel (203) 432 6024; fax (203) 432 6974.
135ProspectSt.,NewHaven,CT06520-8200;

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1Introduction
Title IV of the 1990 Clean Air Act Amendments created a novel market in pollution allowances to
control sulfur dioxide emissions from large fossil-fired electric power plants in the United States.
This paper analyzes the effects of that new regulatory regime on the market for low-sulfur coal —
in particular, on the price schedules charged by the two railroads that haul low-sulfur coal from
Wyoming to power plants in the Great Plains and Midwest. The interaction of the allowance
market and the coal market sheds light on the degree of market power enjoyed by the railroads,
and on the unanticipated effects of market-based environmental regulation.
Because burning low-sulfur coal saves utilities the expense of buying allowances or of installing
and operating pollution control equipment, the tradeable permits regime made low-sulfur coal more
desirable relative to high-sulfur coal than it was before the regulation. In particular, the allowance
market increased the demand for coal from the Powder River Basin in Wyoming (henceforth the
“PRB”) — the largest deposit of low-sulfur coal in the United States. All coal from the PRB must
be carried on one of two railroads: the Burlington Northern Santa Fe (BNSF) and the Union Pacific
(UP). Moreover, several coal mines in the PRB are “captive shippers” to one railroad or the other,
and some power plants are located on rail lines served by only one of these two railroads. Although
railroad rates are overseen by regulators, this situation nonetheless creates the opportunity for
market power. We use detailed data on shipments of PRB coal to look for evidence that the two
railroads were able to take advantage of this opportunity, and to analyze how delivered coal prices
changed as a result.
We start by developing a simple theoretical model to analyze optimal spatial pricing policies
with market power. A key feature of the model is that the demand for low-sulfur coal is more
elastic under a tradeable permits regime than under an emissions standard, giving rise to price
discrimination by a profit-maximizing carrier. The optimal delivered price schedule pivots under
the permits regime: prices at nearby plants rise by more than they do at distant plants, and indeed
prices may even fall on the extensive margin.
With this model in mind, we estimate the response of delivered coal prices to the change in
regulation. The suddenness of the policy shift, and the fact that its first phase covered only a
subset of power plants, allow us to identify the effect of the new policy. We measure the effect of
the tradeable permits regime in two ways: by comparing prices at affected plants before and after
the allowance market took effect, and by comparing prices at affected plants to contemporaneous
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prices at plants that were not covered by the new regulatory regime. Both comparisons yield
similar results. Among plants that were subject to the new regime, delivered prices — controlling
for transportation costs and the minemouth price of coal — increased at plants relatively near to
the PRB (within approximately 1000 miles), and fell at more distant plants. As a result, the price
schedule for plants subject to the new regime shifted, relative to prices at those same plants prior
to the allowance market and relative to prices at plants that were not subject to the new regime.
These empirical findings suggest that the two railroads were able to exercise some degree of market
power, practicing price discrimination among power plants on the basis of regulatory regime. Our
results are robust to unobserved contract-level heterogeneity and nonlinear price schedules. We
also provide evidence in support of our contention that the emissions regulation affected demand
for low-sulfur coal. Finally, we show that no similar shift in prices occurred for low-sulfur coal from
Central Appalachia, where barge traffic makes coal transportation more competitive.
Although we lack the necessary data to estimate railroads’ profits directly, we are able to
perform a few “back-of-the-envelope” calculations to gauge the magnitude of their gains under the
new regulation. Those estimates suggest that the annual producer surplus enjoyed by the railroads
on deliveries to Table A plants increased by about 50% under the new regulation. These gains were
on the order of ten percent of the total value of the “regulatory rents” that were captured by the
regulated utilities as a whole, where those “rents” are defined as the difference between the market
value of the pollution allowances and the variable costs of emissions reductions.
In the next section, we describe the regulatory regimes governing sulfur dioxide emissions and
railroad transportation. Section 3 presents our theoretical model. We describe the data in Section
4, and in Section 5 present a series of maps to illustrate the geographic reach of PRB coal over the
course of the 1990s. We present our empirical results in Section 6. Section 7 concludes.
2 The regulatory context
2.1 Regulation of sulfur dioxide emissions
Burning coal to produce electricity produces sulfur dioxide (SO2) as a byproduct, because coal
contains sulfur. Propelled into the atmosphere by tall stacks, SO2returns to earth as sulfuric acid
in precipitation, and thus is a primary component of acid rain. In downwind urban areas, SO2
contributes to respiratory ailments and morbidity.
Federal regulation of SO2 emissions by coal-fired electric power plants has undergone three
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phases. Under the Clean Air Act Amendments (CAAA) of 1970, new generating units (those
built after August 17, 1971) were subject to New Source Performance Standards which imposed a
maximum allowable rate of SO2emissions of 1.2 pounds of SO2per million Btus. These “NSPS”
units were free to meet the emissions standard in whatever way they chose. Some managers chose
to install a flue gas desulfurization device, or “scrubber” — a building-sized piece of equipment that
removes sulfur dioxide from the flue gases, usually by reaction with a limestone solution. The main
alternative to scrubbing is to use low-sulfur coal.
In the second phase of federal regulation, under the Clean Air Act Amendments of 1977, new
sources were required to remove a certain percentage of SO2 from flue gases — tantamount to
requiring scrubbers. Because this technology-based regulation provided no incentives to burn low-
sulfur coal, this group of generating units will not figure in our analysis.
Finally, Title IV of the 1990 Clean Air Act Amendments introduced a novel market-based
policy to control SO2emissions from existing fossil-fueled electric generating units.1(Throughout
this paper, the terms “allowance market” and “tradeable permits regime” both refer to the Title IV
program.) Each generating unit in the program is given permits, or “allowances,” which allow it to
emit a certain amount of sulfur dioxide in a given year. A unit that emits more sulfur dioxide than
is covered by its allowance allocation can buy permits from other generating units. A generator
that emits less sulfur dioxide than its allocation, either by using low-sulfur coal or operating a
scrubber, may sell its surplus allowances or bank them for future use or sale.
Phase I of the allowance trading program started in 1995 and lasted through 1999. It applied
directly to the 263 largest, dirtiest existing generating units, located at 110 power plants — those
units that had been “grandfathered” out of prior federal standards on new sources. These units
are known as “Table A” units, after the table of the legislation that listed them. Phase II of the
program started in 2000 and extended the market to essentially every fossil-fired power plant of
reasonable size. Compliance with the program has been perfect, largely due to the presence of a
“truing-up” period in the first few months of each year (in which utilities had time to buy allowances
needed to cover the previous year’s emissions) and the threat of a $2000-per-ton fine for violations.
Coexisting with this federal regulatory structure is a patchwork of emissions standards imposed
by state governments, who must ensure that separately mandated ambient air quality standards
are met. Since power plants are a prominent source of air pollution, they are natural targets of
state regulation. In most cases, state regulations are less stringent than the NSPS standard. On
1Ellerman et al. (2000) provide a comprehensive analysis of Phase I of the tradeable permits program.
3