FTC Staff Comment Before the EPA Concerning the Protection of Stratospheric Ozone

V880061
BEFORE THE
ENVIRONMENTAL PROTECTION AGENCY
Washington, D.C.
COMMISSION AUTHORIZED
Protection of
Stratospheric Ozone
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40 CFR Part 82
[AMS-FRL-3226-2]
COMMENTS OF THE STAFF OF THE BUREAU OF ECONOMICS
OF THE FEDERAL TRADE COMMISSION
Washington, D.C. 	20580
November 1, 1988
• 	These comments 	represent the views of 	the staff of 	the Bureau of
Economics of the Federal Trade Commission. 	They do not necessarily reflect
the views of the Commission or any individual Commissioner.

I. INTRODUCTION
The staff of the Bureau of Economics of the Federal Trade Commission
("the staff") submits the following comments l 	in response to the request of
the 	Environmental 	Protection 	Agency 	(EPA) 	for 	comments 	on 	possible
modifications 	to 	its 	program 	for 	the 	trading 	of 	allocated 	quotas 	for
producers of certain chlorofluorocarbons (CFCs) and brominated compounds
(halons).2 	The EPA is the agency designated to implement the terms of the
Montreal Protocol,3 under which several nations have agreed to reduce their
output of CFCs and halons in order to protect the stratospheric ozone layer.
CFCs and halons are produced by five domestic and several foreign firms and
are 	used 	in 	computers, 	automobile 	air 	conditioners, 	refrigerators, 	aerosol
cans, 	and 	various 	other goods. 	The 	EPA 	has decided 	to comply 	with 	the
Montreal 	Protocol 	by 	creating 	a 	system 	of 	marketable 	permits, 	to 	be
allocated to each of the five domestic producers of these chemicals as well
as to each of the several importers in proportion to their 1986 production.·
1 These comments 	represent 	the 	views of 	the staff of 	the 	Bureau of
Economics of the Federal Trade Commission. 	They are not necessarily the
views 	of 	the 	Commission 	or 	of 	any 	individual 	Commissioner. 	Inquiries
regarding these comments should be directed to staff economist Andrew N.
Kleit, 	Bureau 	of 	Economics, 	Federal 	Trade 	Commission, 	Washington, 	DC
20580, (202) 326-3481.
2 Advance Notice of Proposed Rulemaking (ANPRM) 53 Federal Register
30604, August 12, 1988.
3 Protection 	of 	Stratospheric 	Ozone, 	Final 	Rule, 	53 	Federal 	Register
30566. 	The rule amends 40 CFR Part 82 by adding several subsections.
• EPA has chosen to implement its emission abatement program through
producers 	instead 	of 	users 	of CFCs and 	halons. 	The 	EPA 	plan 	calls 	for
"prOduction" permits to be issued granting the firms the right to produce the
restricted chemicals in the U.S., and "consumption" permits which gives firms
the 	right 	to 	seIl 	those 	chemicals 	for 	consumption 	in 	the 	U.S. 	Domestic
producers will be issued all of the production permits and almost all of the

In its recent ANPRM, EPA has suggested amending its CFC and halon
program in several ways. 	In particular, EPA has proposed supplementing its
marketable permit system with regulatory fees or using auctions to allocate
those 	permits 	in 	order 	to 	capture 	the 	value 	of 	those 	permits 	for 	the
government. 	EPA has also suggested implementing engineering-based control
mechanisms or outright bans for particular industries that are slow to reduce
their usage of the controlled substances.
We encourage the EPA to implement the Montreal Protocol in a manner
that 	enhances competition and 	economic efficiency. 	Toward 	that end, 	we
support 	the 	EPA's 	adoption 	of 	an 	economic 	incentive-based 	approach 	to
implementing CFC and halon reductions. 	This comment offers advice only as
to the mechanism of implementing whatever level of domestic production EPA
sets on 	the basis of the non-economic factors 	it must consider, specifically
the 	need 	to 	implement 	the 	Montreal 	Protocol, 	including 	its 	provision
requiring consideration of emerging scientific evidence. 	The staff offers no
opinion as to what the level of CFC and halon production should be.
Marketable 	permits 	represent 	a 	low 	cost, 	pro-competitive 	method 	of
reaching the output levels mandated by the Montreal Protocol. 	Allocation of
marketable permits without compensation to the government, however, could
I
grant a windfa1l 5 to those firms that receive the permits and thereby reduce
important incentives to innovate. 	These concerns can be addressed either by
consumption permits. 	Because the two types of permits are allocated in very
similar manners, our analysis will assume there is only one type of permit.
This assumption does not affect the validity of our analysis.
5 "Windfall" 	in 	this 	context 	refers 	to 	a 	valuable 	right 	which 	the
government grants to a firm without receiving compensation in return.
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auctioning off permits or by attaching a regulatory fee to the allocation of
these 	permits. 	Setting 	the 	proper fee, 	however, could 	be 	a 	difficult 	task.
Indeed, we 	believe that auctions have all 	of the advantages, and fewer of
the disadvantages, that regulatory fees have. 	We therefore suggest that the
EPA 	adopt 	auctions 	as 	the 	mechanism 	for 	capturing 	the 	windfall 	for 	the
government.
The 	benefits 	from 	an 	incentive-based 	approach 	may 	be 	reduced 	if
producers exert market power through control of a large number of permits,
which would allow producers to limit production and raise prices above the
competitive level. 	To alleviate this problem we suggest that EPA consider
retaining the right to reassign the permits of those producers who exercise
market power by hoarding permits.
In any case, all of the market-based approaches that permit the resale
of 	production 	or 	usage 	rights 	to 	CFCs 	and 	halons 	appear 	more 	likely 	to
achieve 	the 	goals 	of 	the 	Montreal 	accord 	at 	lower 	cost 	than 	engineering-
based regulations or bans, either in general or in particular industries. 	We
therefore 	recommend 	against 	any 	efforts 	to 	impose 	direct 	controls 	on 	an
industry by industry basis.
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II. FEDERAL TRADE COMMISSION EXPERIENCE
The 	FTC 	is 	an 	independent 	regulatory 	agency 	charged 	with 	the
responsibility to foster competition and safeguard the interests of consumers.
In discharging that responsibility, the staff of the FTC submits comments to
federal, state, and local regulatory agencies to suggest the most competitive
and 	efficient 	methods of 	achieving regulatory 	policy 	goals consistent 	with
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consumer welfare interests. 	These comments will therefore address (and be
limited to) the competitive and consumer issues raised by the EPA's proposal.
The staff has studied and commented upon similar innovative proposals
for regulatory flexibility. 	For example, we forwarded comments last year to
the EPA concerning the proposed program for trading or banking of credits
of particulate matter emitted by heavy duty engines.6 	Comments have also
been made by the staff to the Federal Aviation Administration concerning
the 	allocation 	of 	airport 	landing 	slots,7 	to 	the 	National 	Highway 	Traffic
Safety Administration on Corporate Average Fuel Economy Standards,8 and
to the Federal Communications Commission concerning the auctioning of the
radio spectrum.9
6 Comments of 	the 	Bureaus of Competition, Consumer 	Protection 	and
Economics 	of 	the 	Federal Trade Commission 	on 	Certification Program 	for
Trading 	and/or 	Banking 	of 	Oxides 	of 	Nitrogen 	and 	Diesel 	Particulate
Emission 	Credits 	for 	Heavy 	Duty 	Engines 	before 	the 	Environmental
Protection Agency, Docket No. A-85-22, February 23, 1987.
7 Comments of the Bureaus of Competition, Consumer Protection, and
Economics 	of 	the 	Federal 	Trade 	Commission 	on 	Charges 	for 	Use 	of
Metropolitan 	Washington 	Airports, 	Before 	the 	Federal 	Aviation
Administration, 	Docket 	No. 	25204, 	April 	13, 	1987, 	and 	Comments 	of 	the
Bureaus of Competition, Consumer Protection and Economics of the Federal
Trade Commission on Slots Transfer Methods, Before the Federal A via tion
Administration, Department of Transpor~ation, Washington, D.C., Docket No.
24105, Notice No. 84-6, July 25, 1984.
8 	Comments of the Bureaus of Competition, Consumer Protection, and
Economics of 	the Federal Trade Commission in 	Re: 	Passenger 	Automobile
Average Fuel Economy Standards Model Year 	1987-88, Before the National
Highway Traffic Safety Administration, Docket No. FE-85-01, March 26, 1986
and Comments of the Staff of the Bureau of Economics of the Federal Trade
Commission on 	Passenger Automobile Average Fuel Economy Standards for
Model 	Years 	1989 and 	1990, Before 	the 	National 	Highway 	Traffic Safety
Administration, Docket No. FE-88-01, September 15, 1988.
9 	Comments of the Bureaus of Competition, Consumer Protection, and
Economics 	of 	the 	Federal 	Trade 	Commission 	to 	Mark 	Fowler, 	Chairman,
Federal Communications Commission, October 29, 1986.
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_....
.III. THE BENE-'Frrs AND COSTS OF VARIOUS PROPOSALS TO RESTRICT
CFC AND HALON PRODUCTION
The EPA has the responsibility for ensuring that production and use of
CFCSlO does 	not 	exceed 	the 	levels 	set 	by 	the 	Montreal 	Protocols. 	These
treaty-determined 	levels can 	be achieved in several ways, and each method
will result in different costs and benefits to society. 	The methods that EPA
originally 	considered 	fell 	into 	two 	general 	categories: 	engineering 	controls
and economic incentive-based approaches. 	In its recently released rules, EPA
rejected 	engineering 	controls 	and 	decided 	to 	meet 	the 	protocol's 	limits
through 	the 	use 	of 	an 	allocated 	marketable 	permit 	scheme. 	Because 	EPA
now proposes to supplement its allocated market permit scheme with direct
engineering controls in particular industries,l1 both general methods remain
under consideration. 	We 	will discuss each category in 	general 	terms first,
and then specifically address the proposals outlined in the ANPRM
A. Engineering Controls
An obvious way of attempting to achieve the agreed-upon reductions in
CFCs 	is 	to 	implement 	a 	program 	of 	engineering 	con trois. 	The 	EPA 	has
discussed 	in 	the 	past12 	a 	plan 	under 	which 	it 	would 	examine 	the
technological capacity of each firm or individual factory, allocate to each a	I
fixed 	Quota of.CFCs to 	produce or 	use, and 	then 	approve a 	technological
plan for implementing the program. 	Such engineering controls, however, are
10 For 	convenience, 	"CFCs" 	will 	be 	used 	to 	refer 	to 	both 	CFCs 	and
halons.
11 ANPRM at 30615-6.
12 Notice 	of 	Proposed 	Rulemaking 	(NPRM) 	52 	Fed. 	Reg. 	47489
(December 14, 1987), EPA Docket No. A-87-20 at 47500.
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likely 	to 	be 	a 	very 	inefficient 	means 	of 	meeting 	the 	required 	standard.
Numerous studies have illustrated the high cost to society of these types of
controls relative to incentive-based approaches. 13
One of 	the reasons 	for 	the 	high costs of engineering controls is that
the cost of reducing the production or use of these chemicals is lower for
some firms than for others. 	Thus, a given reduction in CFC output could be
achieved 	at 	less 	cost 	to 	society 	if 	the 	bulk 	of 	the 	reductions 	came 	from
firms whose costs of reducing production or use are relatively low.
Another drawback of engineering controls is that they act to limit or
prohibit entry 	into 	the 	affected 	industry. 	While 	production or 	use 	rights
could 	be allocated to firms currently in the affected industry, it would be
difficult 	to devise a 	mechanism for 	reallocating 	those 	rights to firms 	that
may wish to enter the industry or expand their output, subject to the limits
of the Montreal Protocol or any other limits EPA may set. 	Under such a
system there would be no low-cost and easily available mechanism whereby
rivals 	could 	increase 	sales 	and 	new 	firms 	could 	enter 	in 	response 	to 	an
increase in price. 	Therefore, such limitations on entry or expansion have
the 	potential 	to 	encourage 	firms 	in 	an 	industry 	to 	raise 	price 	and 	lower
output, to the detriment of consumers.
13 See, 	for 	example, 	M 	L. 	Weidenbaum, 	Government-Mandated 	Price
Increases, 	American 	Enterprise 	Institute, 	1975; 	L. 	E. 	Ruff, 	"Federal
Environmental 	Regulations," in Case 	Studies in Regulation (L. W. 	Weiss and
Michael W. K. ed.), Little, Brown, and Company (1981) at 235-261; S. Breyer,
Regulation and 	Its 	Reform, 	Harvard, 	1982, at 261-276; L. J. 	Perl and 	F. C.
Dunbar, 	"Cost 	Effectiveness 	and 	Cost-Benefit 	Analysis 	of 	Air 	Quality
Regulations," 	American 	Economic 	Review, 	72:2, 	May 	1982, 	at 	208-213; 	R.
Crandall, Controlling Industrial Pollution, Brookings, 1983, and A. McGartland
and 	W. 	Oates, 	"Marketable 	Permits 	for 	the 	Prevention 	of 	Environmental
Damage," 	Journal 	of 	Em'ironmental 	Economics 	and 	Management, 	12:3,
September 1985, 207-228.
6

Engineering controls would also impose significant administrative costs
on the affected industries as well as on the EPA. 	Each 	facility 	would be
required to prepare a compliance plan demonstrating its ability to meet the
new abatement levels. 	All of these submissions would have to be reviewed
by EPA personnel. 	Facilities would also be required to submit performance
test analyses, as well as sample output of the controlled substances. 	Because
of 	the 	large 	number 	of 	producer 	and 	user 	facilities 	involved, 	the 	EPA
estimates that a general program of engineering controls would cost firms in
the industry a total of $227 million in the initial phase of the program and
$122 million for each year thereafter.I •
In 	the 	long 	term, 	engineering 	controls 	are 	also 	likely 	to 	discourage
innovation. 	The inability of firms to sell off their CFC Quotas will 	lower
their 	incentive 	to economize 	on 	the 	production 	or 	use 	of 	these 	chemicals.
Firms may also believe that if they generate new methods of reducing their
prod uction 	or use of CFCs below the levels set for 	them by the EPA, the
EPA 	is 	likely to reduce their allowable Quotas. 	Therefore, they may have
little or no 	incentive to lower the costs to themselves and society of CFC
output reduction. IS
The 	use 	of 	engineering 	controls 	could 	also 	grant 	a 	windfall 	to 	the
affected 	firms. I6 I
If 	engineering 	controls 	are 	employed, 	the 	government
14 Stratospheric 	Protection 	Program, 	Office 	of 	Program 	Development,
Office 	of 	Air 	and 	Radiation, 	U.S. 	Environmental 	Protection 	Agency,
"Protection 	of 	Stratospheric 	Ozone, 	Volume 	1: 	Regulatory 	Impact 	Analysis
Document," 	August 1, 1987 at 11·18. (Hereafter cited as "RIA".)
15 See 	D. 	Greer, 	Business, 	Government, 	and 	Society, 	MacMillan, 	1983,
at 482.
16 A 	reduction 	in 	the output of CFCs can 	be expected 	to lead 	to an
increase in the market price of these chemicals. 	Firms granted the right to
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grants to firms 	the right to use or produce a certain amount of chemicals.
Merely 	because 	these 	rights 	cannot 	be 	explicitly sold 	does 	not 	imply 	that
they 	are 	valueless 	to 	the 	firms 	holding 	them. 	Indeed, 	such 	rights 	could
significantly increase 	the 	profitability of 	these firms 	because 	the existence
and 	allocation 	of 	these 	rights 	precludes 	other 	firms 	from 	entering 	that
industry in response to a price increase.
In 	the short 	term, the granting of windfalls merely shifts a 	valuable
resource 	from 	the 	government 	to 	various 	parties. 	This 	windfall 	does 	not
have 	any 	immediate 	effects 	on 	efficiency 	or 	competition. 	In 	the 	longer
term, however, the granting of windfalls could encourage firms to attempt to
increase their share of output allotments through 	increased expenditures in
EPA 	proceedings. 	These 	"lobbying" 	efforts 	use 	resources 	and 	therefore
generate costs to society. 	However, because their effect would be merely to
transfer a right from one party to another, they do not create any benefits
for society. 	Therefore, they represent a net efficiency loss to the economy.
Under 	certain 	circumstances, 	the 	amount 	spent 	trying 	to 	obtain 	such
produce or use CFCs are likely to gain a windfall from the resulting higher
prices. 	This 	windfall 	may 	be 	reduced 	or eliminated 	for 	at 	least some of
these producers or users if: 1) average cost is higher at lower sales volumes
(economies of scale), so that some firms may be forced to leave the affected
industries if output is constrained; 2) there are substantial sunk costs in the
industry, so firms that are forced to end production of CFCs suffer financial
losses as manufacturers are unable to productively redeploy their assets; and
3) the demand for 	these chemicals is very sensitive to price (highly elastic)
so that producers cannot raise their prices significantly despite the mandated
reduction 	in 	output. 	We 	have 	no 	information 	to 	indicate 	whether 	the
conditions described above exist in the affected industries.
8

resources 	is 	equal 	to 	the 	value 	of 	the 	resource 	being 	allocated 	by 	the
government. 17
B. Economic Incentives
Another method by which the desired reductions in the production and
use of CFCs could be attained involves giving economic incentives to firms
to 	economize 	on 	the 	production 	or 	use 	of 	various 	chemicals. 	Economic
incentives could 	be created 	by 	auctioning off 	the right to 	produce or 	use
various chemicals, allocating such rights and then allowing the rights to be
traded, 	or 	charging firms 	fees 	for 	such 	rights. 	The 	potential 	benefits of
economic incentives and trading are well illustrated in the analysis of these
proposals done for the EPA's Regulatory Impact Analysis. 18
All of these incentive-based methods would create a market in 	which
the 	right 	to 	produce 	or 	use 	CFCs 	would 	cost 	each 	firm 	some 	price 	or
consideration. 	Firms 	that can 	inexpensively find 	substitutes for 	CFCs are
likely to do so. 	Firms for which it is expensive to reduce production or use
of these chemicals will likely opt to buy permits or invest in new equipment
that would lower their production or use of CFCs. 	The result is that the
required reductions would be achieved at the lowest cost to society.19
,
Another 	advantage 	of 	incentive-based 	approaches 	is 	that 	the
administrative costs appear to be quite small. 	Firms would be required only
17 See R. 	A. 	Posner, "The Social 	Costs 	of 	Monopoly 	and 	Regulation,"
Journal of Political Economy, August 	1975, 83:4, 807-827. 	In general, see J.
M. 	Buchanan, 	R. 	E. 	Tollison, 	and 	G. Tullock, eds., 	Towards 	a Theory of a
Rent-Seeking Society, Texas A&M University, 1980.
18 See RIA, Chapter I I.
19 See, 	for 	example, 	J. 	J. 	Seneca 	and 	M. 	K. 	Taussig, 	Environmental
Economics, Prentice Hall, 1979, at 60-90.
9

to 	report 	their 	output 	of 	CFCs 	and 	not 	be 	forced 	to 	provide 	extensive
engineering 	detail. 	This 	is 	in 	addition 	to 	the 	enforcement 	costs 	of 	the
program, which would occur under any output reduction system. 	EPA staff
has 	estimated 	that 	implementation 	costs 	for 	firms 	under 	incentive-based
approaches would be around $1.0 to $1.9 million for the start of the output
reduction program and from $1.0 million to $23.6 million on an annual basis,
depending on which incentive-based 	program is used. 2o 	This is well 	below
the comparable costs for the EPA's engineering control alternative.
Economic 	incentive-based 	approaches 	may 	also 	(in 	the 	absence 	of
possible anticompetitive conduct, as discussed below in Section VI) have few
of the entry-inhibiting effects of engineering controls. 	Should a firm wish
to enter the market or expand its output by lowering prices to consumers, it
will be able to buy the right to produce or use CFCs from other firms in
the 	industry 	without 	increasing 	the 	aggregate 	output 	level 	of 	these
chemicals. 	This is in contrast to engineering controls, which have no such
mechanism.
In 	the 	long 	run, 	incentive-based 	approaches 	give 	firms 	important
reasons 	to 	innovate 	to 	reduce their 	use or 	production of CFCs. 	Unlike a
regime 	of 	engineering 	controls, 	the 	incentive 	approach 	allows 	firms 	to
I
capture the gains from innovation by selling off their unused production or
use permits, or by reducing the fees they pay for such rights. 	If innovation
does 	occur, 	it 	would 	lower 	the 	cost 	to 	society 	of 	CFC 	output 	reductions.
Should 	any 	further 	reduction 	in 	CFC 	and 	halon 	output 	be 	necessary 	or
desireable, 	innovation 	would 	also 	reduce 	the 	cost 	to 	society 	of 	such 	an
action. 	Put differently, use of an 	incentive-based approach would make it
20 RIA at 11-18.
10

less costly -- and 	therefore 	more likely -- to 	lower 	further 	the production
of CFCs in the future. 21
IV. ENGINEERING CONTROLS IN SPECIFIC INDUSTRIES
If EPA follows an economic-incentive system as we suggest, there will
be no need for direct controls on specific industries in order to achieve the
overall target domestic production figure. 	Therefore, we oppose engineering
controls 	in 	specific 	industries 	for 	the 	same 	reasons 	we 	oppose 	general
engineering controls. 	Such controls could reduce or eliminate incentives to
develop substitutes, 	reduce 	competition 	in 	the 	affected 	industries, 	increase
administrative 	costs, 	and 	be 	inflexible 	with 	regards 	to 	changing economic
conditions. 	Further, 	giving 	EPA 	authority 	to 	make 	industry-specific
decisions 	could 	greatly 	increase 	the 	"lobbying" 	costs 	of 	a 	CFC 	abatement
program. 	Firms 	could 	spend 	considerable 	resources 	on 	administrative
procedures to try to avoid being singled out by EPA for reductions. 	Each
firm and each industry could potentially be required to justify its behavior
to the EPA.
In 	general, 	EPA 	appears 	to 	believe 	that 	engineering controls 	may 	be
necessary in specific instances because some industries will react differently
than 	others 	to 	a 	system 	of 	economic 	incentives. 22 	However, 	this 	is 	the
precise reason why market incentives represent the most efficient means of
imposing 	an 	abatement 	program 	on 	the 	economy 	and 	why 	direct 	controls
should 	be 	avoided. 	Each 	firm 	and 	industry 	has 	a 	different 	ability 	to
substitute 	for 	its 	CFC 	consumption. 	Only 	by 	insuring 	that 	the 	costs 	of
21 Greer at 482-3.
22 ANPRM at 30615-6.
II ...

abatement fall on firms and industries that can most easily reduce their use
of CFCs can the costs to the economy be minimized. 	Governments have only
a 	limited 	ability 	to 	discern, 	let 	alone 	properly 	allocate 	these 	costs. 	A
market system, on the other hand, tends to allocate these costs across firms
with the lowest abatement costs automatically.
V. SPECIFIC INCENTIVE-BASED APPROACHES
EPA 	now 	has 	three 	different 	incentive-based 	approaches 	available 	to
reduce 	the 	production 	and 	use 	of 	CFCs: 	auctions, 	marketable 	permits, 	or
marketable 	permits 	with 	fees. 	Each 	method 	has 	been 	shown 	to 	be
administratively 	feasible 	in 	a 	variety 	of 	settings, 	although 	auctions 	and
allocation of marketable permits appear more workable in this case. 	As the
EPA has noted, auctions are regularly used by the federal government in the
areas of government procurement, leasing of mineral rights, and the sale of
Treasury 	bills.23 	The 	EPA 	has 	used 	marketable 	permits 	previously 	in 	its
"banking" 	and 	"offset" 	programs. 24 	The 	federal 	government 	has 	granted
marketable 	rights for 	other resources as 	well, such as airport landing slots
and 	radio 	and 	television 	frequencies. 	Fees 	for 	the 	right 	to 	pollute 	have
been 	imposed 	by 	the 	EPA 	and 	several 	states 	on 	various 	hazardous 	waste
streams. 25 i
This 	section 	will 	review 	particular 	aspects 	of 	each 	incentive-
based approach as it applies to CFCs.
23 NPRM at 47507.
24 Michael 	H. 	Levin, 	"Building 	a 	Better 	Bubble 	at 	EPA," 	Regulation,
Marchi April 1985, 33-42.
25 See, 	for 	example, 	Congressional 	Budget 	Office, 	Hazardous 	Waste
Management: 	Recent 	Changes 	and 	Policy 	Alternatives, 	U.S. 	Government
Printing Office, Washington, D.C., May 1985.
12

A. Auctions
The 	EPA 	could 	implement 	it:.; 	program 	of 	output 	reductions 	by
auctioning off CFC production or use permits and then allowing the permits
to 	be 	subsequently 	bought 	and 	sold.26
advantages 	over 	other 	approaches.
Auctions 	have 	a t 	least 	three
Auctions 	are 	likely 	to 	be 	an
administratively 	simple 	and 	low-cost 	way 	to 	allocate 	production 	rights
rei a ti ve to fees, since the EPA would 	not have to estimate the correct fee
to 	charge 	producers 	or 	users. 27 	Also, 	firms 	would 	not 	be 	as 	inclined 	to
spend 	resources 	lobbying 	the 	EPA 	to 	increase 	their 	share 	of 	output
allotments, as firms might under engineering controls or under a system that
made initial allocations to incumbent firms. 	In addition, by making firms
buy 	the 	rights 	to 	produce 	or 	use 	CFCs, 	the 	EPA 	will 	capture 	for 	the
Treasury 	the 	full 	value 	of 	these 	rights. 	For 	these 	reasons, 	auctions 	are
probably 	the 	best 	of 	the 	incentive-based 	methods 	for 	allocating 	output
rights. 28
EPA 	has 	stated 	that 	any 	auction 	and 	subsequent 	market 	transactions
26 There 	are 	numerous 	types 	of 	auctions 	the 	EPA 	could 	employ 	in
administering its output reduction program (NPRM at 47507 and ANPRM at
30611). 	We do not comment on the medts of these various auction designs,
as EPA has indicated that if its adopts auctions, any specific details will be
addressed in a further rulemaking (ANPRM at 30610-11).
27 EPA 	has 	indicated 	that 	it 	believes 	auctions 	to 	be 	feasible. 	See
ANPRM at 30611.
28 EPA has expressed concern that it may not have the legal authority
to conduct such auctions. 	ANPRM at 30611-14. 	We note, however, that the
Department of Justice has stated its belief that EPA has this legal authority.
Comments of the Department of Justice on Proposed 	Rule on Protection of
Stratospheric Ozone, Before the Environmental Protection Agency, Docket A-
87-20, February 8, 1988, at 16-30.
13

should 	be 	open 	to 	all 	interested 	parties.29 	We 	support 	this 	position. 	In
general, 	markets 	work 	best 	when 	there 	are 	no 	unnecessary 	regulatory
restrictions on who can buy and sell. 	Participation in a CFC permit market
by 	entities 	besides 	producers 	can 	have 	important 	efficiency-enhancing
properties. 	Brokerage services may arise which can reduce the search costs
for 	would-be 	buyers and sellers of permits to find each other. 	Banks can
finance the purchase of permits and perhaps accept permits as collateral.
EPA 	has 	expressed 	concerns, 	however, 	that 	the 	use 	of 	auctions 	will
lead 	to 	uncertainty 	and 	speculation.3o 	However, 	to 	the 	extent 	middlemen
arise to handle these transactions, they can be expected to reduce, and not
increase, 	uncertainty 	and 	risk. 	Middlemen 	can 	be 	expected 	to 	invest 	in
permits when their price is below equilibrium value and sell permits when
the 	price 	is 	above 	equilibrium 	value. 	This 	type 	of 	trading 	also 	acts 	to
transfer 	risk 	to 	those 	parties 	who 	are 	better 	able 	to 	absorb 	it. 	These
actions would stabilize the market and send the proper signals to firms. 31
EP A 	has 	noted 	that 	there 	are 	concerns 	tha t 	an 	auction 	will 	lead 	to
permits not reaching those parties who are best able to use them. 	However,
it is to be expected that no matter how the permits are allocated, they will
29 ANPRM at 30611.
30 NPRM at 47500 and ANPRM at 30611.
31 For a discussion of the economics of speculation, see A. Alchian and
W. 	R. 	Allen, 	Exchange 	and 	Production: 	Competition. 	Coordination, 	and
Control, Wadsworth 	Publishing Company, 	1977, at 	132-137. 	Recent research
in economics indicates that there are certain unusual circumstances, such as
the 	October 	1987 	stock 	market 	crash, 	where 	speculation 	and 	other 	similar
activities 	may 	generate 	market 	distortions 	due 	to 	information 	externalities
and 	institutional 	constraints 	during 	large, 	rapid, 	price 	swings. 	See 	B.
Greenwald and J. Stein, "The Task Force Report: The Reasoning Behind the
Recommendations," 	The 	Journal of Economic Perspectives. Summer 	1988, 2:3,
pp. 3-23. 	However, it does not seem likely that these circumstances would
arise in a market for CFC permits.
14

eventually wind up with the firms that value them the most. 	All firms who
use permits will pay their scarcity value, either directly in payment, or in
"opportunity 	costs" 	by 	forgoing 	revenue 	that 	could 	be 	obtained 	by selling
them 	to 	another 	firm. 	This 	decision 	of 	the 	firm 	is 	not 	affected 	by 	the
manner in which permits are allocated.
EPA 	has 	also 	noted 	that 	there 	are 	concerns 	that 	large 	firms 	might
outbid 	small 	firms 	in 	an 	auction 	for 	permits.32 	This 	may 	indeed 	occur.
Firms of all sizes outbid each other in the marketplace all the time. 	If the
larger firms outbid the smaller firms in the absence of monopoly power, this
implies that larger firms are able to put the CFCs into a higher valued use.
Another 	objection 	to 	auctions 	has 	been 	the 	concern 	that 	unless
producers can keep the windfall from CFC permits, they will not have the
financial resources to develop substitute products for CFCs.33 	However, the
decision to create a new product depends on its expected costs and returns,
not solely on the cash flow of one part of a company. 	If a product will be
profitable, 	it 	can 	be 	expected 	that 	the 	capital 	markets 	(either 	internally
through 	a 	firm 	using cash on 	hand, or 	through 	increased 	borrowing from
banks or bondholders) will react by funding the project.
32 ANPRM at 30611.
33 See M 	Weiskopf, "Bidding Chlorofluorocarbons Farewell," Washington
Post, 	August 	2, 	1988 	at 	A-19. 	This 	concern 	is 	also 	noted 	(though 	not
supported) in Letter from James B. MacRae Jr., Deputy Administrator, Office
of Information and Regulatory Affairs, Office of Management and Budget to
Lee Thomas, Administrator, Environmental 	Protection Agency, February 	12,
1988.
15

B. Administrative Allocation of Marketable Permits to Producers
By 	allocating 	to 	producers 	a 	specific 	level 	of 	tradeable 	permits, 	the
EPA would ensure, in a competitive world, both the realization of the output
limits 	imposed 	by 	the 	Montreal 	Protocol 	and 	the 	economic 	benefits 	of
incentive-based systems. 	A system of tradeable permits would have most of
the 	desired 	efficiency 	and 	administrative 	properties 	of 	an 	incentive
mechanism. 	It would also, however, have some drawbacks. 	One drawback to
the allocation of marketable permits by themselves is that it may cause firms
to expend 	resources on 	otherwise nonproductive activities such as 	lobbying
to 	gain 	a 	windfall 	by 	receiving 	permits 	for 	which 	they 	do 	not 	pay.34
Marketable 	permits 	in 	a 	highly 	concentrated 	market 	may 	also 	lead 	to
hoarding of permits by producers and reduce incentives for innovation (See
discussion in Section VI below)
The 	EPA 	has 	suggested 	using 	regulatory 	fees 	in 	conjunction 	with
marketable 	permits. 35 	Under 	such 	a 	plan, 	the 	EPA 	might 	recover 	any
resulting 	windfall 	for 	the 	Treasury 	and 	reach 	the 	required 	output 	levels.
This proposal also presents some difficulties, however. 	If the EPA set the
regula tory fee too high, there would be more ou tpu t reduction than EPA set
out to achieve. 36 	If the EPA set the regulatory fee too low, the fee would
!
not 	capture 	all 	the 	windfall 	that 	could 	result 	from 	the 	allocation 	of
34 Of course, the initial allotment of tradeable permits need not be to
incumbent 	firms. 	In 	that 	case, 	other 	parties 	would 	gain 	any 	resulting
windfall.
35 ANPRM at 30608.
36 See discussion Section I, page 2 above.
16

•
marketable 	perri\its: 37
-~"
EPA's 	discussion 	of 	this 	proposal 	points 	out 	the
relevant problems the agency would face. 38
EPA 	has 	proposed 	to alleviate 	this 	problem 	by setting 	the regulatory
fee 	per CFC 	unit 	equal 	to 	the 	market 	price of a 	CFC consumption 	right.
EPA's 	preferred 	method 	for 	determining this fee 	would 	be to subtract the
production cost of the affected chemicals from the market price. 	However,
we believe that this approach contains great difficulties. 	EPA would need to
know 	not 	only 	what 	all 	of 	the 	chemicals 	sold 	for, 	but 	also 	what 	the
production 	costs 	were 	in 	each 	of 	the 	producing 	firms. 39 	EPA 	would 	also
have 	to 	account 	for 	whatever 	uncertainties 	and 	changes 	that 	would 	be
occurring in 	the marketplace. 	Further, producers could 	be expected to act
strategically in this situation in order to lower the fees they are required to
pay. 	Additionally, EPA would also be required to calculate a "fair" rate of
return for the producers. 	Obtaining such information could be quite costly
and difficult.4o 	This is in contrast to the use of an auction to garner the
windfall, 	which 	would 	have 	none 	of 	these 	problems 	while 	achieving 	the
desired goal of capturing the windfall for the Treasury.
EPA has suggested designing a fee that does not attempt to capture the
37 We have no comments on a proposal to use regulatory fees in order
to recover the administrative costs of an output reduction program.
38 ANPRM at 30609.
39 To properly calculate the windfall, EPA would be required to know
the marginal, not the average cost of production in the industry.
40 For 	a 	discussion 	of 	the 	difficulties 	of 	determining 	what 	a 	"fair"
price 	is 	in 	similar 	circumstances, 	see 	Franklin 	M 	Fisher 	and 	John 	J.
McGowan, "On the Misuse of Accounting Rates of Return to Infer Monopoly
Profits," American Economic Review, March 1983, 73:1, 82-97.
17
...

entire 	windfall 	gain 	to 	producers. 41 	By 	trying 	to 	set a 	fee 	less 	than 	the
amount 	of 	the 	windfall, 	EPA 	would 	be 	able 	to 	reduce 	or 	eliminate
"underproduction" 	of 	CFCs. 	However, 	the 	administrative 	problems 	noted
above would still exist, as well as the granting of some windfalls to firms
and possible resulting losses in innovation.
VI. POTENTIAL MARKET POWER PROBLEMS
In implementing its program for 	the allocation of marketable permits,
the EPA has chosen to direct its incentive plan at producers of CFCs. 	This
choice 	may 	lead 	to 	anti-competitive 	consequences. 	The 	markets 	for 	the
production 	of 	CFCs 	is 	highly 	concentrated. 	As 	Table 	I 	indicates, 	the
Herfindahl-Hirschman Index for CFCs is 2958 (3.38 equivalent sized firms)
and the Herfindahl for halons is 3648 (2.74 equivalent sized firms).42 	By any
measure, these markets are highly concentrated.
Given highly concentrated markets, producers might have an incentive
to hoard permits instead of using them for their own production or selling
them to rivals or potential entrants. 	This would occur if the gain to firms
from 	withholding 	is 	greater 	than 	the 	price 	they 	could 	receive 	for 	their
permits. 	Such behavior would increase prices above the level associated with
I
competition.43 	The 	existence 	of 	this 	type 	of 	entry 	or 	expansion 	barrier
41 ANPRM at 30609.
42 The Herfindahl Index is the measure generally used for determining
market concentration for antitrust purposes. 	It is calculated by summing the
squares of the market shares of all the firms in the relevant markets. 	See
Department 	of 	Justice, 	"Merger 	Guidelines," 	Antitrust 	and 	Trade 	Regulation
Report, Special Supplement, June 17, 1982, at S-6.
43 A similar outcome could occur with an auction of permits to producers.
18

could 	act 	to 	reduce 	(though 	not 	eliminate 44) 	the 	advantages 	of 	incentive-
based 	output 	reduction 	programs 	over 	the 	engineering 	controls 	discussed
above. 45 	To alleviate this problem, EPA may wish to consider retaining the
right to reassign the permits of producers who hoard them. 	As with other
options, the administrative costs of monitoring such potential conduct should
be considered when deciding whether to enact such a reassignment provision.
Market 	power 	problems 	could 	also 	act 	to 	slow 	down 	the 	pace 	of
innovation in the adoption of CFC alternatives. 	Since market shares are so
high, producers will be aware that if they innovate to reduce their need for
CFCs, they will also act to lower the price of permits on 	the open market
and 	hence 	the 	windfall 	to 	themselves.46 	This 	will 	not 	completely 	reduce
incentives 	for 	innovation, 	however. 	Firms will 	desire to innovate to gain
income 	from 	selling 	off 	permits 	made 	surplus 	to 	them 	by 	the innovation.
44 One 	commentator 	has 	argued 	that 	in 	certain 	circumstances 	(where
firms 	face 	highly 	disparate 	cost 	conditions 	and 	where 	the 	market 	is
extremely concentrated) the use of marketable permits may reduce welfare
slightly as compared to the use of engineering controls. 	See D. A. Malueg,
"Welfare 	Consequences 	of 	Emission 	Credit 	Trading 	Programs," 	Economic
Analysis Group Discussion Paper 87-11, Department of Justice, November 17,
1987. 	The cost conditions described by Malueg, however, do not seem to be
applicable 	to 	any 	industry, 	and, 	while 	the 	market 	structure 	in 	CFCs 	and
halons 	is highly concentrated, 	it does not 	appear 	to approach 	the 	extreme
level 	of 	concentration 	required 	to 	obtain 	Malueg's 	conclusions. 	Further,
Malueg's results should be adjusted to account for the important incentives
for innovation that would still exist in a highly concentrated industry under
a program of marketable permits, as well as the lower administrative costs
of a permit program.
45 R. 	W. 	Hahn, 	"Market 	Power 	and 	Transferrable 	Rights," 	Quarterly
Journal of Economics, 1984, 99, 753-765.
46 This situation 	would only 	be a problem 	if the firms 	that have the
ability 	to develop substitutes for 	CFCs are also the 	firms 	that 	receive the
windfalls on permits. 	Firms that do not receive windfalls do not have any
reason to desire high prices on permits. 	However, there is reason to believe
that the firms that currently produce CFCs are also the firms that have the
ability 	to create CFC substitutes. 	See M. Gladwell, "DuPont Plans to Make
CFC Alternative," Washington Post, September 30, 1988 at F-5.
19

Firms 	will 	also 	desire 	to 	innovate 	in 	order 	to 	protect 	themselves 	against
technological 	innovation 	by 	other 	firms 	(which 	would 	put 	them 	at 	a
comparable competitive disadvantage). 	Thus, firms would still have greater
reasons 	to 	innovate 	than 	they 	would 	under 	a 	program 	of 	engineering
controls.
Problems with innovation incentives can be alleviated by eliminating the
windfalls 	associated 	with 	permits. 	Thus, auctioning off permits or setting
the proper regulatory fee 	would serve to reduce the costs to society in the
long term of a CFC abatement program.
VI. CONCLUSION
Market-based incentive plans, like the one EPA has adopted, appear to
represent 	the 	lowest cost, 	most efficient, and 	most 	pro-competitive 	method
of 	implementing 	CFC and 	halon 	output 	reduction 	under 	the 	terms 	of 	the
Montreal 	Protocol. 	Further, 	by 	reducing 	the 	costs 	of 	abatement 	through
encouraging 	innovation, 	market-based 	incentive 	plans 	can 	make 	further
reductions in CFC and halon output more likely, because such reductions will
impose less economic burden on society.
In addition to supporting adoption of an economic incentive-based plan,
we support EPA's goal 	of capturing the 	windfall resulting from allocating
permits. 	However, 	we 	believe 	that 	the 	best 	way 	to 	gain 	this 	windfall 	is
through 	auctions, 	not 	through 	regulatory 	fees. 	Regulatory 	fees 	appear 	to
present substantial administrative problems that would not be encountered 10
an auction system.
The gains 	from 	an 	incentive-based 	program, however, can 	be reduced
20

somewhat 	if 	firms 	act 	to 	obtain 	market 	power 	through 	the 	hoarding 	of
permits. 	We urge the EPA to take actions to alleviate this problem.
Finally, we oppose any effort to adopt engineering controls or bans on
an 	industry 	by 	industry 	basis. 	Such 	actions 	would 	be 	contrary 	to 	the
market-based incentive plan that the EPA has adopted and would be likely to
increase the cost to society of CFC and halon abatement.
21

...
Table 1
Annual Consumption Allocations
(in millions of kilograms)
Group I ("CFCs")
Firm 	Allotment 	Market Share
Domestic
Foreign
DuPont
Allied-Signal
Pennwalt
Kaiser Chemical
Raicon
ICI Americas
Nat'l Refrig.
Kali-Chemie
Refricentro
Hoechet Celanese
Sumitomo
Holchem
Pharmachem
139.373
74.044
38.221
27.616
13.466
6.311
3.069
0.438
0.421
0.330
0.230
0.212
0.029
45.88%
24.38
12.58
9.09
4.43
2.08
1.01
0.14
0.14
0.11
0.08
0.07
0.01
Firm
Group II ("Halons")
Allotment 	Market Share
DuPont
Great Lakes
ICI Americas
Atochem Inc.
Kali-Chemie
27.731
19.855
6.348
2.126
1.534
48.15%
34.47
11.02
3.69
2.66
Herfindahl Index for Group I: 2958
Herfindahl Index for Group II: 3648
The 	Herfindahl Index 	is calculated by summing the squares of the market
shares of all the firms in the relevant markets.
Source: Final Rule at 30599
22