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Cap and Trade Markets

Cap and Trade

Allowance trading is the centerpiece of EPA's Acid Rain Program, and allowances are the currency with which compliance with the SO2 emissions cap is achieved.

The SO2 allowance trading component of the Acid Rain Program imposes a firm cap or limit on SO2 emissions but allows utilities to adopt the most cost-effective strategy to reduce SO2 emissions of units in their systems. Affected utilities are required to install systems that continuously monitor emissions of SO2, NOx, and other related pollutants in order to track progress, ensure compliance, and provide credibility to the trading component of the program. In any year that compliance is not achieved, excess emission penalties will apply, and sources either will have allowances deducted immediately from their accounts or they can submit a plan to EPA that specifies how they will offset the excess SO2.

Additional Reading

For more information on allowance markets related to the Acid Rain Program and the NOx Budget Trading Program, visit the Airmarkets Allowance Trading page.

2007 SO2 Allowance Market in Brief
Total Value of the SO2 Allowance Market $5.1 billion*
Average Nominal Price $325 per ton
Total Allowance Volume
(Allowable Emissions)
2007 Private Transactions 4,700 transactions moving 16.9 allowances

54 percent of allowances transferred between economically unrelated parties

* Total value of allowance market is a snapshot based on the average nominal price as of July 1, 2007 ($325) and 2007 total allowance volume.

Text excerpts of “SO2 and NOx Trading Markets: Providing Flexibility and Results”(PDF) (5pp., 1.2M, About PDF) by EPA’s Sam Napolitano, Dan Chartier, and Melanie LaCount, published in the June 2007 Environmental Manager, publication of the Air and Waste Management Association.

The allowance trading markets operating under the Acid Rain Program and NOx Budget Trading Program have demonstrated an increasing level of sophistication. While a regulated facility can choose to comply by installing controls with little or no reliance on these markets, the markets offer opportunities to reduce compliance costs, manage risk, and even turn a profit.

In the early years of the SO2 market, in addition to active “spot” and “forward” markets, many transactions were “in-system exchanges,” whereby allowances of different vintages were exchanged between parties. Also common was the bundling of allowances and fuel in a single contract. As the market began to mature, the spot (or cash) market expanded. Both programs also saw increases in transactions between economically distinct entities over time, and this provides a strong indicator of true market activity. In 2005, 30 percent of the transfers in the NOx market and 50 percent of the transfers in the SO2 market were economically significant (i.e., between economically distinct, or unrelated, organizations).

As participants grew in number and experience, activity moved beyond immediate settlement transactions to offer more flexibility and opportunities for risk management, including additional options and forward contracts. Options give the buyer the right to purchase allowances at a certain price by a certain date. Options provide a way to hedge risk against price fluctuations, but may also be used to maximize revenue on a portfolio of allowances. Forward contracts enable a purchaser to contractually agree to buy a number of allowances for delivery in the future at an agreed upon price, providing buyers with long-term planning capability and certainty.

Another indicator of the strength of the market has been the creation of futures exchanges. Both the Chicago Climate Futures Exchange (CCFE) Exit EPA Disclaimer and New York Mercantile Exchange (NYMEX) Exit EPA Disclaimer operate SO2 and NOx futures markets.

For all of these mechanisms, allowance prices are fluid and price information is readily available from a variety of sources. Private sector firms (e.g., Cantor Exit EPA Disclaimer, Evolution Markets Exit EPA Disclaimer) have stepped in to provide price indices for both the SO2 and NOx markets, which offer important information in structuring transactions.

See the Allowance Trading Basics page for more allowance trading information or the Buying Allowances page for more information on how to buy allowances.

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