FTC Staff Comment Before the EPA Concerning Certification Program for Trading and/or Banking of Emissions Credits for Heavy Duty Engine Repairs

BEFORE THE
ENVIRONMENTAL PROTECTION AGENCY
Washington, D.C.
COMMISSION~
APPROVED 	..
)
Certification Program for Trading 	)
and/or Banking of Oxides of 	)
Nitrogen and Diesel Particulate 	)
Emission Credits for Heavy Duty 	)
Engines 	)
------------)
40 CFR Part 86
[AMS-FRL-3J07-6]
COMMENTS OF THE BUREAUS
OF COMPETITION, CONSUMER PROTECTION, AND ECONOMICS
OF THE FEDERAL TRADE COMMISSION
Washington, D.C. 	20580
February 23. 1987
• 	These 	comments 	represent 	the 	views 	of 	the 	FTC's 	Bureaus 	of
Competition, 	Consumer 	Protection. 	and 	Economics 	and 	do 	not 	necessarily
reflect 	the 	views 	of 	the 	FTC 	or 	any 	individual 	Commissioner. 	The
Commission has. however. voted to authorize submission of these comments.

I. INTRODUCTION
The staff of the Federal Trade Commission (FTC) submits the following
comments 	in 	response 	to 	the 	proposal 	of 	the 	Environmental 	Protection
Agency 	(EPA) to establish a 	certification 	program 	for 	the trading and/or
banking of emissions credits for heavy duty engines. 	In making this choice,
we recommend that the EPA take into account the procompetitive effects of
allowing the broadest possible averaging and trading across engine classes.
On March 	IS, 	1985, the EPA issued a 	final rule promulgating revised
standards for oxides of nitrogen (NOx) emissions from heavy duty engines.
It also established standards for emissions of particulate matter from diesel
engines.1 	The 	EPA 	is 	now 	considering 	the 	most 	economical 	means 	of
attaining those standards. 	It has solicited comments on a proposal to allow
firms 	to average 	NOx and 	particulate matter emissions across their engine
production, 	to 	trade 	emissions 	credits 	between 	firms, 	and/or 	to 	bank
emissions 	credits 	for 	use 	in 	later 	years 	in 	order 	to 	reduce 	the 	cost 	to
society 	of 	meeting 	the 	standards 	while 	still 	achieving 	the 	regulatory
objectives.'
The 	strictest 	possible 	regulatory 	environment 	would 	require 	every
engine 	of 	each 	manufacturer 	produced 	in 	each 	model 	year 	to 	meet 	the
standards 	for 	NOx 	and 	particulate 	emissions. 	The 	EPA 	could, 	however,
establish a less restrictive alternative regulatory scheme involving averaging,
trading, and/or banking, while still achieving the desired pollution reduction.
Intrafirm averaging would permit a firm to produce some engines that exceed
the emissions standards provided that it also produces engines that are below
't 	-so F.R. It>606, "MarcD TS, ~S.
2 	51 F.R. 40986 (November 12, 1986), SI F.R. 31959 (September 8, 1986).

the standards and 	that the average level of emissions does not exceed 	the
standards. 	Interfirm trading would permit firms to earn credits for engines
producing less than the standard levels of emissions; these credits could then
be 	sold 	to 	manufacturers 	whose 	cngines 	exceed 	the 	emissions 	standards.
Banking would 	permit the averaging of emissions across model 	years. 	To
further increase the number of options. these regulatory approaches may be
applied to any of several different categories of engines. 	Averaging, trading
or 	banking could 	take 	place only within subclasses of engines (Le .• heavy
duty gasoline, light heavy duty diesel. medium heavy duty diesel. and heavy
heavy 	duty 	diesel). 	across combinations of subclasses (e.g .• all 	heavy duty
diesel engines). or across all heavy duty engines. 	The EPA is considering all
of these alternatives.'
II. FEDERAL TRADE COMMISSION EXPERIENCE
The 	FTC 	is 	an 	independent 	regulatory 	agency 	charged 	with 	the
responsibility 	for 	fostering 	competition 	and 	safeguarding 	the 	interests 	of
consumers. 	In discharging that responsibility the FTC staff appears before
regulatory agencies at the federal, state and local level to suggest the most
competitive 	and 	efficient 	methods 	of 	achieving 	regulatory 	policy 	goals
consistent with consumer welfare interests. 	These comments will therefore
address (and 	be 	limited 	to) the competitive and consumer issues raised 	by
the EPA's proposal.
The 	FTC 	staff 	has 	studied 	and 	commented 	upon 	similar 	innovative
proposals for regulatory flexibility. 	For example. comments have been made
, 	Since the EPA 	has not conducted an in-depth study of the effects
of banking, we will not discuss the issues raised by the banking of emissions
credits.
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to the Federal Aviation Administration concerning the auctioning of airport
landing slots.· to the 	National 	Highway 	Traffic Safety 	Administration 	on
Corporate 	Average 	Fuel 	Economy 	Standards.' 	and 	to 	the 	Federal
Communications 	Commission 	concerning 	the 	auctioning 	or 	the 	radio
spectrum. S
III. THE ECONOMIC BENEFITS OF AVERAGING AND TRADING EMISSIONS
CREDITS
The EPA 	has the responsibility to ensure that 	pollution from 	various
sources does not exceed the levels set by Congress. 	There are several ways
in which these legislatively-determined levels can be achieved. however. and
each method will result in different costs to society.
An obvious way of achieving these levels is to require that each engine
sold produce no more than the standard level of emissions. 	However. this is
likely to be a very costly means of meeting the Congressional standard. 	It
fails to recognize that the cost of reducing emissions of pollutants is lower
for some engines than for others. 	If society decided to reduce pollution by
one unit. and took 	that unit from 	an engine with a low cost of pollutant
abatement rather than from an engine with a high cost of abatement. the
• 	Comments of the Bureaus of Competition. Consumer Protection and
Economics 	of 	the 	Federal 	Trade 	Commission 	on 	Slots Transfer 	Methods--
Notice of Proposed Rulemaking. Before the Federal Aviation Administration.
Department of 	Transportation. Washington. D.C .• Docket 	No. 24105. 	Notice
No. 84-6. 14 C.F.R. Part 93. July 25. 1984.
5 	Comments of the Bureaus of Competition. Economics and Consumer
Protection 	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-8S-0J. March 26. 1986.,
S 	Comments 	of 	the 	Federal 	Trade 	Commission 	to 	Mark 	Fowler.
Chairman, Federal Communications Commission. October 29. J986.
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total amount of pollution would stiIJ be reduced by the desired amount. but
the cost to society of achieving this reduction would be less.
One way of reducing the societal cost of compliance would be to permit
firms to average emissions over their entire production of engines. 	For any
level of engine production. a firm will strive to achieve any given standard
of emissions at the lowest possible cost. 	The minimum level of cost will be
achieved when the marginal cost to the firm of reducing emissions by one
unit is the same 	for all the engines it produces. 	If engine manufacturers
are 	permitted 	to 	average 	the 	pollution 	over 	their 	entire 	production 	of
engines or over a subset of their production. they will design their engines
in 	such 	a 	way 	as 	to 	equalize 	the 	costs 	of 	additional 	units 	of 	pollution
reduction for each engine and so minimize their total cost. 	As a result. any
statutorily mandated reduction 	in total pollution can be achieved at lower
cost to society with averaging than if standards were set for each individual
engine.
A further reduction in cost can be achieved by allowing the averaging
of engine emissions across firms. 	This could be done 	by giving credits to
those firms whose engines emit less pollution than the standard, and allowing
them to sell these credits to other firms whose engines exceed the standard.
The 	trading of emissions credits in a competitive 	market 	would 	result 	in
equalization of the marginal costs of pollution reduction across all producers,
and a lower total cost to society of complying with the emissions standards
than if interfirm trading were not permitted.
To put this point another way, in a system where trading is allowed
the firms that can inexpensively reduce pollution ,..iIl do so, and the firms
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that cannot inexpensively reduce pollution will have an incentive and ability
to buy credits rather than having to redesign their heavy duty engines at
greater cost.
The potential benefits of averaging and trading are well illustrated in
the analysis of these proposals done for the EPA by Sobotka &. Co. T 	That
study indicates that the pollution standards will be achieved at lowest cost
to society by permitting the averaging and trading of credits over all heavy
duty engine production.
While 	the 	Sobotka 	study 	indicates 	substantial 	gains 	to 	society 	from
allowing the trading of emission credits. the FTC staff believes tbat it may
understate the relative benefits of trading across all engines. as opposed to
either 	intrafirm 	averaging 	or 	interfirm 	trading 	only 	witbin 	individual
subclasses of heavy duty engines. 	The calculations in the Sobotka study are
made on the assumption of that each firm will produce a fixed number of
engines. 	The methodology therefore does not allow for competitive effects
caused by 	the regulations. i.e .• an increase or a decrease in the number of
engines produced or in market shares. 	This causes the study to overlook
two reasons why it could be important to permit averaging across broader
classes 	of 	engines: 	(l) 	to 	avoid 	competitive 	problems 	in 	some 	highly
concentrated subclasses; and (2) to prevent artificial incentives for mergers.
These two points will be discussed in turn.
1 	Sobotka &. Company. Inc .• ·Savings from the Application or Trading
and Averaging to Heavy Duty Engine Regulation: August "'"23. ~61herein·
after ·Sobotka study·).
s

IV. THE TRADING OF CREDITS ACROSS ALL ENGINES WILL HELP AVOID
POTENTIAL 	COMPETITIVE 	PROBLEMS 	IN 	CERTAIN 	ENGINE
SUBCLASSES
Trading 	credits across 	subclasses 	will 	reduce 	the 	risk 	of competitive
harm. 	As the market share data in the Sobotka study shows, production of
engines 	in 	certain 	subclasses is now 	highly concentrated. 	As 	a 	result, 	if
trading 	is 	restricted 	to 	individual subclasses either 	the 	buyer 	or seller of
credits will be in a position to exercise market power. 	For example, there
are only 	three 	producers of heavy duty gasoline engines. 	If trading were
limited to this subclass, there would of necessity be either a single seller (3
monopolist) or a single buyer (a monopsonist) of credits. s 	This could cause
competitive problems in the buying and selling of those credits.
A 	monopolist 	seller 	would 	have 	an 	incentive 	to 	restrict 	sales 	of
emissions credits below the perfcctly competitive level. 	This is so for two
reasons. 	First, a monopolist can sell additional credits only by reducing the
price it charges for those credits, while perfectly competitive sellers can sell
additional credits without driving down the price. 	This negative impact of
additional 	credit sales on 	the price received 	by a 	monopolist provides the
monopolist with an incentive to sell fewer credits than would be desirable
from the viewpoint of society.
Second, 	the 	monopolist 	is 	selling 	credits 	to 	firms 	that 	are 	direct
competitors in the sale of engines. 	A higher price for credits would raise
• 	Since 	the 	number 	of 	credits sold 	by 	firms 	in 	the tradeable class
must 	equal 	the 	Dumber boug'llt, 	tbere could 	not be 	tbree buyers or lbree
seHers of credits.
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the rivals' cost of producing cngines. and so lead to lower output and higher
prices in thc cnginc markct to thc benefit of the credit seller.o
For similar rcasons, a monopsonistic buyer of crediu can buy additional
credits only by paying a higher price for credits. while perfectly competitive
buyers can purchase additional credits without driving up the price. 	This
adverse impact of additional credit purchases on the price the monopsonist
must 	pay 	for 	credits 	provides 	the 	monopsonist 	with 	an 	incentive 	to 	buy
fewer credits at a 	lower price than 	would 	be efficicnt. 	Since credits are
produced 	by 	producing 	cngines, 	this 	decreases 	the 	number 	of 	cngines
produced and raiscs their prices. to thc ultimate bcnefit of the monopsonistic
credit purchaser.
Any reduction in output and higher prices causcd by thcse unfavorable
competitive cffccts of 	restrictions 	on trading are undcsirable 	bccause they
reduce consumer welfarc. 	Furthermore, they may work against the goal of
reducing pollution, since higher prices for new engincs creatc an incentive
to kcep in service older engines with higher pollution levels.
This 	potential 	competitive 	problem 	can 	best 	be 	avoided 	by 	not
restricting 	trading 	to 	specific 	subclasses. 	With 	unrestricted 	trading 	there
would be 20 potential buyers or sellers in the markets for cmissions credits,
and so the ability of anyone firm to exercise market power is reduccd.
Of course. the potential competitive problem just discussed provides an
argument for allowing trading across all classes of heavy duty cngines rather
than restricting it within narrow subclasses. 	This potential problem is not
an argument for prohibiting trading altogether rather than allowing it within
9 	See S. "Salop and D. Scherrman,1OJlaising 'R.iva1s" Costs;- -n America n
Economic Review, May 1983, 267.
7

subclasses. 	Even restricted 	trading that is below the perfectly competitive
ievel is better than no trading at all.
V. THE TRADING OF CREDITS WILL HELP DISCOURAGE INEFFICIENT
MERGERS
As noted by the EPA staff- 1o trading is procompetitive in that it allows
the benefits from averaging across different types of cngines to be extended
to firms with specialized production that would not be able to benefit from
such averaging in the absence of trading. 	Trading. therefore, prevents the
necessity of merging in order for firms with specialized production to get
the benefit of averaging.
Trading might therefore prevent certain inefficient mergers. 	Suppose.
for 	example. 	that 	there 	were 	two 	firms 	with 	different costs of emissions
reduction under a regulatory system that permitted intra firm averaging but
not trading. 	If the two firms were to merge, they could reduce their joint
costs by SIO million through averaging. 	Suppose, however. that diseconomies
from the merger would offset S4 million of this gain. 	The firms would still
merge. since merger would give them a net gain of 56 million. 	However. the
firms could achieve the same 510 million of benefits if trading were possible.
and 	could 	do 	so 	without 	suffering 	the 	54 	million 	in 	diseconomies. 	The
trading approach would therefore be preferable as long as the transactions
costs of emissions credit trading were less than 54 million, as they surely
would be.
l000lssue Analysis: Trading and Banking of Heavy-Duty Engine NOx and
Particulate 	Emissions 	Credits: 	Staff 	Report. 	Standards 	Development 	and
Support 	Branch. 	Emission 	Control 	Technology' Division. 	Office 	of 	Mobile
Sources, Office of Air and Radiation. U,s. ~nvironmental "Protection Agency,
May, 1986.
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VI. CONCLUSIONS
We 	believe 	that 	the 	unrestricted 	averaging 	and 	trading 	of 	emissions
credits 	for 	all 	heavy 	duty 	engines 	is 	the 	most 	procompetitive 	means 	of
attaining 	emissions 	reductions. 	The 	EPA 	should 	consider 	these
procompetitive 	gains 	in 	determining 	the 	extent 	to 	which 	averaging 	and
trading of emissions credits will be allowed.
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