DC Circuit decision will affect NOx and SO2 allowance trading markets.

On July 11, 2008, the District of Columbia Court of Appeals issued an opinion in State of North Carolina v. Environmental Protection Agency, No. 05-1244, slip op. (2008). The court’s opinion vacated the Environmental Protection Agency’s (EPA) Clean Air Interstate Rule (CAIR) and the associated Federal Implementation Plan, finding that the program had several “fatal flaws.”

On March 10, 2005, the EPA issued CAIR, which regulates upwind states that, with respect to fine particulate matter (PM) and ozone, contribute significantly to non-attainment in, or interfere with maintenance by, any other state (generally referred to as “downwind states”). Sulfur dioxide (SO2) and nitrogen oxides (NOx) contribute to the formation of PM, and NOx contributes to the formation of ground-level ozone. The EPA adopted CAIR to provide a federal framework to limit the emission of these pollutants. The rule requires 28 eastern states and the District of Columbia to permanently cap SO2 and NOx, thereby significantly reducing emissions in the affected states.

Under CAIR, states must achieve required emission reductions using one of two compliance options: (1) meet the state’s emission budget by requiring power plants to participate in an EPA-administered interstate cap-and-trade system that caps emissions in two stages, or (2) meet an individual state emissions budget that is administered through measures of the state’s choosing. The EPA-administered interstate cap-and-trade system does not establish quotas on individual states with respect to SO2 or NOx, but instead creates a regional framework with regional caps. CAIR is phased in under a two part plan, with a Phase I cap for NOx and SO2 beginning in 2009 and 2010, respectively, and Phase II beginning with respect to both pollutants in 2015.

The DC Circuit invalidated the CAIR program for the following reasons:

  • The regional framework of the CAIR cap-and-trade program does not prohibit polluting sources within an upwind state from preventing attainment of national ambient air quality standards (NAAQS) in downwind states. Because of the interstate nature of the program, upwind states could conceivably buy large portions of emissions credits, thereby permitting upwind sources to emit pollutants in quantities sufficient to affect downwind states.
  • Although CAIR ostensibly creates a framework to prevent upwind states from contributing significantly to the non-attainment of downwind states, it does not have a mechanism to preclude upwind states from interfering with the maintenance of NAAQS. Although the EPA argued that the latter requirement is included in the former, the court determined that there is an independent statutory requirement for the EPA to ensure upwind states do not interfere with the maintenance of downwind states’ NAAQS.
  • Title I of the Clean Air Act requires states to attain particular NAAQS as expeditiously as practicable, but not later than five years from the date the area was designated for non-attainment (subject to an extension of five years at the discretion of the EPA Administrator), which is shorter than the 2015 implementation deadline for Phase II of the CAIR program. Although the EPA claimed that CAIR is subject to only the procedural requirements of Title I, the court held that, because CAIR must be consistent with both the procedural and substantive requirements of Title I, regulations governing PM must be in place before the 2015 deadline.

Because SO2 and NOx are precursors to the formation of PM, CAIR creates optional interstate trading programs for each pollutant. The practical effect of CAIR created an emissions trading market that added to and would eventually supplant the existing Title IV SO2 Acid Rain and NOx SIP Call trading programs. It also created a new annual NOx allowance product to address PM emissions in addition to the seasonal ozone NOx allowance. The DC Circuit invalidated the CAIR cap-and-trade programs for these pollutants for the following reasons:

  • With respect to SO2, the budget of emissions allowances is significantly lower (50 percent lower in Phase I and 65 percent lower in Phase II) than the allowances received under the Title IV SO2 program. To determine these caps, the EPA started with the Title IV caps and reduced them to a level that it considered “cost-effective and equitable.” However, because the EPA applied solely economic considerations in determining such caps (which are not statutorily mandated considerations for regulating PM), the court invalidated the CAIR SO2 cap-and-trade program.
  • With respect to NOx, the EPA distributed emissions allowances based on each state’s heat input for the mix of fuels its power plants use. For example, a state that has a disproportionate amount of coal-fired plants receives a larger proportion of emissions allowances than an otherwise similarly situated state that relies on oil or natural gas. The EPA’s stated reason for allocating emissions allowances in such a way is a sense of fairness and efficiency. However, because, according to the court, such factors do not relate to the EPA’s obligations to prohibit significant contributions to downwind non-attainment, the court invalidated the CAIR NOx cap-and-trade program.
  • In order to harmonize the CAIR SO2 cap-and-trade program and the Title IV program, the EPA requires the participating state to have provisions to retire or to reduce allowances under the Title IV program. According to the court, the EPA does not have the authority to reduce the amount of Title IV compliant credits.

Although the court’s ruling eliminates the CAIR program, including the related SO2 and NOx cap-and-trade programs, the court noted that, in the absence of CAIR, the Title IV SO2 trading program and the NOx SIP Call program will continue as originally intended. However, by eliminating these programs, the CAIR-promulgated annual NOx product has been eliminated, leaving the validity of the states’ regulations regarding these allowances in question. Notwithstanding the court’s assurances that its decision will not impact emissions allowances trading markets, it throws into disarray the trading regime that has been developed for NOx and SO2, which covers currently traded emissions products that do not otherwise exist. This decision will dramatically affect implemented compliance and financing strategies of those companies subject to CAIR caps and will have a broad ripple effect throughout the allowance trading market. Trading publications reported drastic price reductions of SO2 and NOx allowances on July 11, 2008, following the publication of the opinion. Similar volatility is expected to continue as companies struggle to evaluate their compliance needs going forward.

Although the EPA claims that it is reviewing the decision and analyzing its effects, prospects for immediate action to re-promulgate a CAIR-like rule that preserves some vestiges of the old regime look dim because of the imminent election of a new administration and the current political climate. In addition, many market participants already are urging Congress to step in and revise the Clean Air Act in order to create replacement regulation.