Revamped air quality regulations proposed by the US Environmental Protection Agency (EPA) will give power plant operators more flexibility to engage in interstate trading of sulphur dioxide (SO2) and nitrogen oxides (NOx) emissions allowances, but confusion about the rule is casting doubt on whether viable markets will emerge.

The re-named Cross-State Air Pollution Rule, formerly known as the Clean Air Transport Rule, requires reductions in emissions of NOx and SO2 - key ingredients in smog and soot pollution - from power plants in 27 states.

With this rule, the EPA is invoking the Clean Air Act’s “good neighbour” provision, which requires states to address the problem of ‘interstate transport’ of air pollution.

The new regulation replaces the Clean Air Interstate Rule (CAIR) programme struck down by the courts in July 2008. But, as expected, CAIR allowances will not be transitioned into the new programme.

Annual NOx allowances from the old system were trading at a bid-offer spread of $125-135 on Friday, slightly off the $135-150 spread on Thursday, after it became apparent that rumours that current allowances would transition into the new programme were unfounded. SO2 vintage 2009 allowances were trading at $3.25-$4.00, within their recent range, as traders did not expect them to be saved by the new rule.

From a trading perspective, the new regulation changes key aspects of the Transport Rule released last year, bringing forward the start of the assurance provisions to 2012 from 2014, meaning states will have to comply with their emissions caps earlier than expected.

But the EPA did increase the buffer used to account for yearly fluctuations in emission levels in the states’ annual budgets, known as ‘variability limits’, from 10% variability to 18% of annual NOx and SO2 emissions and 21% for ozone season NOx during the months of the year when ozone levels are at their highest levels.

“I see positive and negatives in both those changes,” said Paul Tesoriero, director of environmental markets for brokerage Evolution Markets.

The EPA changed a few key elements of the Transport Rule that traders liked, such as the 2014 start of the assurance provisions, which would have given traders two years of unlimited trading before the variability limits kicked in.

Such changes have created the impression that the new rule will make it even tougher to re-establish a functioning SO2 and NOx market, said Thaddeus Huetteman, Atlanta-based president of consultancy PEAR.

But upon closer examination, the EPA has added elements that could expand the level of trading, he said. Allowing all states to hit the maximum variability limits included in the new rule will not significantly contribute to pollution in downwind states, therefore states will have more opportunity to buy allowances from other states, Huetteman added.

“There is a bit more flexibility in the rule,” EPA administrator Lisa Jackson said. “The modelling showed you could allow a bit more trading. We believe you can increase the amount of trading, but without increasing the amount of the cap.”

The agency also increased the penalties that emitters will pay if they fail to comply with the rule, to two additional allowances for every tonne of emissions above the state’s cap.

Texas SO2 and NOx emissions capped

In a controversial move, the agency added Texas to the list of states to be controlled for SO2 and NOx pollution after only proposing to regulate the state’s ozone emissions in the Transport Rule. But the EPA removed several other states such as Florida and Louisiana from the list of states to be controlled for SO2 and NOx.

“When you have a limited number of states to trade with, you potentially have a liquidity problem,” noted Gary Hart, a senior market analyst at ICAP Energy in Birmingham, Alabama. “Trading is not by any means the centrepiece of this thing at all.”

To speed implementation, EPA is adopting federal implementation plans - which set out how to achieve air quality standards when a state does not or is unable to develop an adequate plan - for each of the states covered by the rule.

But the agency is encouraging the states to replace these plans with State Implementation Plans - their own blueprints for complying with the standards - starting as early as 2013.

This provision creates uncertainty because regulators may have to revise the allocations for individual emitters if the states replace the federal plans with their own, Tesoriero said.

“I don’t know why EPA wrote that because it does cause a little bit of a problem,” he said. “To me, that’s not the cleanest approach.”

The annual cost of compliance will be about $2.4 billion, compared to the $120 billion-$280 billion in annual benefits, according to EPA.