At the auction, anyone with the cash and the need could buy the right -- in 1-pound denominations -- to pollute the air. The buyers tended to be large businesses and industries, but there was nothing to stop an environmentally concerned parent from retiring a certain amount of air pollution permanently. "They can buy a smog certificate and hang it on the kid's wall," explains Dale Carlson, vice president for corporate affairs at the exchange.
For now, the only smog market in California deals with pollution generated in the Los Angeles Basin.
But some business and environmental groups say Northern California could best handle long-term pollution problems with a market-based approach. And a recent surprise action by the federal Environmental Protection Agency may push the Bay Area toward creating its own public smog market.
The Pacific Exchange smog auctions, which take place six times a year, are real-life expressions of the market-based incentive approach to reducing pollution, an economic theory of emission control first propounded more than 30 years ago. In this decade, the theory has moved from the academic fringe to mainstream reality and is now an accepted component of the EPA's regulatory arsenal.
What changes hands during the auctions are known as tradable emission credits. For now, the credits can be bought and sold only by Los Angeles Basin polluters that have joined the Regional Clean Air Incentives Market (RECLAIM).
The premise behind RECLAIM is simple: Use the marketplace itself to reward companies for reducing pollution.
To create RECLAIM, regulators established a base line of the amount of pollution being produced in the L.A. area and set long-term goals for reducing it. They then allocated credits for the existing pollution among the region's various industrial sources, based on their historic contribution to the total pollution load. As allowable pollution levels drop, the number of credits is reduced; this acts as a floor of sorts for the credits' market value.
Dale Carlson explains the dynamics: "As the supply of credits declines over time, the price goes up; the higher the price, the greater the incentive to come up with new [pollution control] technology; that will spin off excess credits and reduce the price of the credits."
Polluters registered with RECLAIM must reconcile their pollution accounts once a year. If a polluter finds it has emitted more pollution than it has been allocated, it must buy pollution credits at one of the Pacific Exchange's emission credit auctions. If it has reduced emissions below what was allocated, the firm sells the excess credits.
This market approach is a drastic departure from the prevailing "command and control" model for pollution regulation, which is used in most of the country, including the Bay Area. Under command and control, regulators set limits for polluters and impose sanctions in the forms of fines or shutdowns if those limits are not met.
But there is no reward for polluters who reduce emissions below those levels. Not only is there no incentive to pollute less than the legal limits; there's an economic disincentive for excessive cleanliness. The costs of pollution reduction beyond what is required by law cut into a company's competitiveness in the marketplace.
The Bay Area Air Quality Management District, which regulates air pollution here, is not a complete stranger to market-based theory. It established a credit-based program in 1984, but the plan has never been developed beyond a rudimentary "bank," which has languished largely unused. The bank mainly serves the region's handful of large polluters as a place to park excess polluting permits from facilities they've shut down; they get to tap the pollution credits for later expansions of production capacity. The bank registered a grand total of four transactions last year.
And Bill deBoisblanc, a spokesman for the district, says the agency has little interest in expanding its market-based program, either through banking or trading. He says that the relatively low emissions burden here offers little incentive to invest in the regulatory retooling required for a market-based approach.
But Roger Noll, a professor of environmental economics at Stanford University and one of the country's pre-eminent advocates for market-based emissions control, says the time to institute a market-based system is before the Bay Area faces a Los Angeles-level pollution problem.
Creating a market in which pollution credits have a low price, Noll says, would allow industry to reduce emissions gradually and at relatively low cost, rather than wait for a governmental edict -- a "hammer" that will cost businesses large amounts of money.
The federal government may already have picked up the "hammer" Noll refers to.
On Aug. 21, the EPA stunned local regulators and industry representatives by formally proposing to downgrade the official measure of the quality of the Bay Area's air. If that downgrade takes effect (a final decision is due by the end of the year), the Bay Area Air Quality Management District will have to come up with stricter limits on pollution produced here.
The EPA was prodded to act by an unlikely coalition that included local environmentalists and politicians from a section of the Central Valley that is downwind from the Bay Area's pollution. (One study claims that more than one-fourth of the air pollution in the northern Central Valley can be traced to the Bay Area.)
Denny Larson, the Northern California regional director of Communities for a Better Environment, was one of the lead actors in getting the EPA to consider downgrading the Bay Area's air pollution status. But he is calling for more command and control, rather than market-based incentives, to reduce air pollution here. In an interview last week, he denounced market-based incentives as "snake oil" dreamed up by polluters.
Actually, the market-based approach was created by environmental economists, many of whom consider themselves environmental liberals. And market-based incentives have been embraced by leading environmental groups, among them the Natural Resources Defense Council.
Pressure for reductions in Bay Area air pollution isn't coming just from the EPA. Newly issued ozone and particulate standards approved by the president earlier this summer will also require cuts in Bay Area emissions. And to comply with federal law, those reductions will probably need to continue for decades.
As air quality improves, the task of removing the final remnants of pollution grows exponentially more difficult. "It's like wringing water out of a rag," says Bill Quinn, vice president of the California Council for Environmental and Economic Balance, a San Francisco-based business and labor coalition. "As you go further it gets more difficult. California has already done all the easy stuff; what's left are the really tough things.
"For the most part, all the command and control that makes sense has been done. If you come up with tough command and control rules, there will be a big impact."
Supporters claim the market approach is designed to produce continuing, incremental improvements in air quality without saddling businesses with large, sudden, unexpected pollution control costs.
But regulators have an inherent resistance to moving away from command and control and to market-based incentives. If market-based regulation works as planned, economic pressure will edge out government regulation as the chief enforcement tool against polluters. Such a shift in approach reduces the political clout of regulatory agencies -- and the people who control them.
Setting up market-based incentive programs in the Bay Area would require an overhaul in pollution control procedures. The current system measures success by looking at the installation and maintenance of equipment to reduce pollution. The new approach would require regulators to track real-time, actual emissions of pollutants.
But Noll and other advocates of market-based pollution control say a reliance on command and control regulation will eventually mean huge and unnecessary economic shocks for Bay Area businesses and motorists.
And Carlson says the mechanisms for trading emission credits at the Pacific Exchange are fully operational -- and waiting for somebody to apply them to the Bay Area. "The market is there, the infrastructure is there, what's lacking is something to trade. It's like having a grocery store without any food on the shelves.