Category: Energy Economics

Reflections on Twenty Years of Policy Innovation

In 2009, the U.S. Congress considered but ultimately failed to enact legislation aimed at limiting U.S. greenhouse-gas (GHG) emissions.  The bill under consideration at that time, the American Clean Energy and Security Act of 2009, was the last in a series considered over several years.  Sponsored by Representatives Henry Waxman (D-California) and Edward Markey (D-Massachusetts), the bill passed the U.S. House of Representatives but failed to win sufficient support in the Senate.  No legislation was enacted, and by 2010, both Congress and the White House had abandoned efforts to pass federal climate legislation.

Over months of contentious debate, while the Waxman-Markey bill and subsequent Senate action were being considered, millions of Americans were introduced for the first time to the phrase “cap and trade,” a regulatory approach that first came to prominence in the 1990s as the centerpiece of a national program to address the threat of acid rain by limiting emissions of sulfur dioxide (SO2), primarily from electric power plants.

The 1990 SO2 cap-and-trade program was conceived by the administration of President George H. W. Bush and was widely viewed as a success.  Yet cap and trade became a lightning rod for congressional opposition to climate legislation from 2009 through 2010.

Some of that hostility reflected skepticism about whether climate change was real and, if it was, whether humans played a key role in causing it. A larger group of opponents in Congress worried about the proper role of government and the costs of combating climate change, particularly given the lack of commitments for action by the large emerging economies of China, India, Brazil, Korea, South Africa, and Mexico.  The congressional debate touched only lightly on the relative merits of various policy options to reduce greenhouse-gas emissions. Thus, cap and trade may not have been defeated on its merits (or demerits), but rather as collateral damage in the larger climate policy wars.

Congress (to the extent it did assess policy alternatives to cap and trade), as well as the broader community of analysts and observers in the late 2000s, raised a number of substantive questions about the merits of this policy instrument as a means for responding to a major environmental policy challenge of the sort posed by climate change:

  • How do the costs of a market-based approach, such as cap-and-trade, compare with traditional regulatory policies to reduce pollution?
  • Can market-based policies—and the markets they create—be trusted to reduce emissions? That is, are they environmentally effective?
  • What are the distributional impacts of market-based environmental policies; who are the winners and losers?
  • How well does a cap-and-trade system stimulate technological innovation, as compared with an environmental policy that sets performance standards, specifies technologies for reducing pollution, or both?

In May 2011, the Harvard Environmental Economics Program hosted a two-day research workshop and policy roundtable in Cambridge, Massachusetts, to reflect on these and other questions in light of twenty years of experience implementing the SO2 cap-and-trade program, established under Title IV of the Clean Air Act Amendments (CAAA) of 1990. Also known as the Acid Rain Program and the SO2 allowance-trading system, Title IV represented the first large-scale application of cap and trade to control pollution—in the United States or any other country.  (Of course, the largest emissions trading program in the world is now the European Union Emissions Trading System (EU ETS), a greenhouse-gas, cap-and-trade system that was implemented in 2005 and whose design was influenced by the U.S. SO2 program.)

A “policy brief” synthesizing the main conclusions and insights that emerged from the May 2011 Harvard workshop and roundtable has just been released, The SO2 Allowance Trading System and the Clean Air Act Amendments of 1990:  Reflections on Twenty Years of Policy Innovation.  The workshop and roundtable – sponsored by the Alfred P. Sloan Foundation – featured a dream team of economists and legal experts who had conducted extensive research on the SO2 allowance-trading system, as well as leaders of non-governmental organizations and former government officials who had guided the formulation and passage of the CAAA.

The new policy brief examines the design, enactment, implementation, and performance of the SO2 allowance trading system, with an eye toward identifying lessons learned for future efforts to apply cap and trade to other environmental challenges, including global climate change.  The first section provides background on the acid rain program and summarizes data and analysis on its benefits. Subsequent sections examine key questions regarding cost, environmental effectiveness, market performance, distributional implications, and effects on technology innovation.  The report also examines the political context of the formulation, enactment, and implementation of the SO2 allowance-trading system.  Finally, the conclusions feature some reflection on implications for climate change policy.

The participants in the research workshop were:  Joseph Aldy, Assistant Professor of Public Policy, Harvard Kennedy School; Dallas Burtraw, Darius Gaskins Senior Fellow, Resources for the Future; Denny Ellerman, Part-time Professor, European University Institute, Robert Schuman Centre for Advanced Studies; Michael Greenstone, 3M Professor of Environmental Economics, Massachusetts Institute of Technology; Lawrence H. Goulder, Shuzo Nishihara Professor of Environmental and Resource Economics, Stanford University; Robert Hahn, Director of Economics, Smith School, University of Oxford; Paul L. Joskow, President, Alfred P. Sloan Foundation; Erin T. Mansur, Associate Professor of Economics, Dartmouth College; Albert McGartland, Director, National Center for Environmental Economics, U.S. Environmental Protection Agency; Brian J. McLean, Former Director, Office of Atmospheric Programs, U.S. Environmental Protection Agency; W. David Montgomery, Senior Vice President, NERA Economic Consulting; Erich J. Muehlegger, Associate Professor of Public Policy, Harvard Kennedy School; Karen L. Palmer, Senior Fellow, Resources for the Future; John Parsons, Executive Director, Center for Energy and Environmental Policy Research, MIT Sloan School of Management; Forest L. Reinhardt, John D. Black Professor of Business Administration, Harvard Business School; Richard L. Schmalensee, Howard W. Johnson Professor of Economics and Management, MIT Sloan School of Management; Daniel Schrag, Sturgis Hooper Professor of Geology, Harvard University; Robert N. Stavins, Albert Pratt Professor of Business and Government, Harvard Kennedy School; Thomas Tietenberg, Mitchell Family Professor of Economics, Emeritus, Colby College; and Jonathan B. Wiener, William R. and Thomas L. Perkins Professor of Law, Duke University Law School.

The participants in the policy and politics roundtable were:  Robert Grady, General Partner, Cheyenne Capital Fund (1989–1991: Associate Director, Office of Management and Budget for Natural Resources, Energy & Science; 1991–1993 Executive Associate Director, OMB, and Deputy Assistant to the President); C. Boyden Gray, Principal, Boyden Gray & Associates (1989–1993: White House Counsel); Fred Krupp, President (1984–present), Environmental Defense Fund; Mary D. Nichols, Chairman, California Air Resources Board (1993–1997: Assistant Administrator for Air and Radiation, U.S. Environmental Protection Agency); Roger Porter, IBM Professor of Business and Government, Harvard Kennedy School (1989–1993: Assistant to the President for Economic and Domestic Policy); Richard L. Schmalensee, Howard W. Johnson Professor of Economics and Management, MIT Sloan School of Management (1989–1991: Member, President’s Council of Economic Advisers); and Philip Sharp, President, Resources for the Future (1975–1995: Member, U.S. House of Representatives, Indiana, and Chairman, Energy and Power Subcommittee, House Committee on Natural Resources).

I want to acknowledge the contributions of all of these participants in the research workshop and policy roundtable, as well as the comments and edits some provided on earlier drafts of the policy brief.  Their expertise and experience made this project possible. And, of course, I’m very grateful to the Alfred P. Sloan Foundation for having provided generous support for the workshop and for the preparation of the study.  I hope you find it of interest and value.

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Economics of the Environment

The Sixth Edition of Economics of the Environment: Selected Readings has just been published by W. W. Norton & Company of New York and London.  Through five previous editions, Economics of the Environment has served as a valuable supplement to environmental economics texts and as a stand-alone book of original readings in the field of environmental economics.  Nearly seven years have passed since the previous edition of this volume was published, and it is now more than three decades since the first edition appeared, edited by Robert and Nancy Dorfman.  The Sixth Edition continues this tradition.

Motivation and Audience

Environmental economics continues to evolve from its origins as an obscure application of welfare economics to a prominent field in its own right, which combines elements from public finance, industrial organization, microeconomic theory, and many other areas of economics.  The number of articles on the environment appearing in mainstream economics periodicals continues to increase, and more and more economics journals are dedicated exclusively to environmental and resource topics.

There has also been a proliferation of environmental economics textbooks for college courses.  Many are excellent, but none can be expected to provide direct access to timely and original contributions by the field’s leading scholars.  As most teachers of economics recognize, it is valuable to supplement the structure and rigor of a text with original readings from the literature.

Scope and Style

With that in mind, this new edition of Economics of the Environment consists of thirty-four chapters that instructors will find to be of great value as a complement to their chosen text and their lectures.  The scope is comprehensive, and the list of authors is a veritable “who’s who” of environmental economics, including:  Joseph Aldy, Kenneth Arrow, Trudy Cameron, Ronald Coase, Maureen Cropper, Peter Diamond, George Eads, Jeffrey Frankel, Rick Freeman, Don Fullerton, Lawrence Goulder, John Graham, Robert Hahn, Michael Hanemann, Jerry Hausman, Steven Kelman, Nathaniel Keohane, Alan Krupnick, Lester Lave, John Livernois, Eric Maskin, Leonardo Maugeri, Gilbert Metcalf, Richard Newell, Roger Noll, William Nordhaus, Wallace Oates, Sheila Olmstead, Elinor Ostrom, Karen Palmer, Ian Parry, Carl Pasurka, Robert Pindyck, William Pizer, Michael Porter, Paul Portney, Forest Reinhardt, Richard Revesz, Milton Russell, Michael Sandel, Richard Schmalensee, Steven Shavell, Jason Shogren, Kerry Smith, Robert Solow, Nicholas Stern, Laura Taylor, Richard Vietor, and myself.

The articles are timely, with more than 90 percent published since 1990, and half since 2005.  There are two completely new sections of the book, “Economics of Natural Resources” and “Corporate Social Responsibility,” and all of the chapters in the section on global climate change are new to the sixth edition.

In order to make the readings in Economics of the Environment accessible to students at all levels, one criterion I use in the selection process is that articles should not only be original and well written — and meet the highest standards of economic scholarship — but also be non-technical in their presentations.  Hence, readers will find virtually no formal mathematics in any of the book’s 34 chapters throughout its 733 pages.

The Path Ahead

Environmental economics is a rapidly evolving field.  Not only do new theoretical models and improved empirical methods appear on a regular basis, but entirely new areas of investigation open up when the natural sciences indicate new concerns or the policy world turns to new issues.  Therefore, this book remains a work in progress.  I owe a great debt to the teachers and students of previous editions who have sent their comments and suggestions for revisions.  Looking to future editions, I invite all readers — whether teachers, students, or practitioners — to send me any thoughts or suggestions for improvement.

In the meantime, if you’re interested finding out more about the book, immediately below is a chapter-by-chapter summary of the book.  Alternatively, you can check out the W. W. Norton or Amazon web sites.

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Appendix:  A Summary of Economics of the Environment, Sixth Edition

Part I of the volume provides an overview of the field and a review of its foundations.  Don Fullerton and I start things off with a brief essay about how economists think about the environment (Nature 1998).  This is followed by the classic treatment of social costs and bargaining by Ronald Coase (Journal of Law and Economics 1960), and a new article by Jason Shogren and Laura Taylor on the important, emerging field of behavioral environmental economics (Review of Environmental Economics and Policy 2008).

The Costs of Environmental Protection

Part II examines the costs of environmental protection, which might seem to be without controversy or current analytical interest.  This is not, however, the case.  This section begins with a survey article by Carl Pasurka that reviews the theory and empirical evidence on the relationship between environmental regulation and so-called “competitiveness” (Review of Environmental Economics and Policy 2008).

A somewhat revisionist view is provided by Michael Porter and Class van der Linde, who suggest that the conventional approach to thinking about the costs of environmental protection is fundamentally flawed (Journal of Economic Perspectives 1995).  Karen Palmer, Wallace Oates, and Paul Portney provide a careful response (Journal of Economic Perspectives 1995).

The Benefits of Environmental Protection

In Part III, the focus turns to the other side of the analytic ledger — the benefits of environmental protection.  This is an area that has been even more contentious — both in the policy world and among scholars.  Here the core question is whether and how environmental amenities can be valued in economic terms for analytical purposes.

The book features a provocative debate on the stated-preference method known as “contingent valuation.”  Paul Portney outlines the structure and importance of the debate, Michael Hanemann makes the affirmative case, and Peter Diamond and Jerry Hausman provide the critique (all three articles are from the Journal of Economic Perspectives 1994).

In the final article in Part III, the book turns to a concept that is both very important in assessments of the benefits of environmental regulations and is also very widely misunderstood — the value of a statistical life.  In an insightful essay, Trudy Cameron seeks to set the record straight (Review of Environmental Economics and Policy 2010).

There are two principal policy questions that need to be addressed in the environmental realm:  how much environmental protection is desirable; and how should that degree of environmental protection be achieved.  The first of these questions is addressed in Part IV and the second in Part V.

The Goals of Environmental Policy:  Economic Efficiency and Benefit-Cost Analysis

In an introductory essay, Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and I ask whether there is a role for benefit-cost analysis to play in environmental, health, and safety regulation (Science 1996).

Then, Lawrence Goulder and I focus on an ingredient of benefit-cost analysis that non-economists seem to find particularly confusing, or even troubling — intertemporal discounting (Nature 2002).  Next, Robert Pindyck examines a subject of fundamental importance — the role of uncertainty in environmental economics (Review of Environmental Economics and Policy 2007).  Steven Kelman provides an ethically-based critique of benefit-cost analysis, which is followed by a set of responses (Regulation 1981).

Part IV concludes with an up-to-date essay by John Graham on the critical role of the U.S. Office of Management and Budget in federal regulatory impact analysis (Review of Environmental Economics and Policy 2008).

The Means of Environmental Policy:  Cost Effectiveness and Market-Based Instruments

Part V examines the policy instruments — the means — that can be employed to achieve environmental targets or goals.  This is an area where economists have made their greatest inroads of influence in the policy world, with tremendous changes having taken place over the past twenty  years in the reception given by politicians and policy makers to so-called market-based or economic-incentive instruments for environmental protection.

Lawrence Goulder and Ian Parry start things off with a broad-ranging essay on instrument choice in environmental policy (Review of Environmental Economics and Policy 2008).  Following this, I examine lessons that can be learned from the innovative sulfur dioxide allowance trading program, set up by the Clean Air Act Amendments of 1990 (Journal of Economic Perspectives 1998).  Finally, Michael Sandel provides a critique of market-based instruments, with responses offered by Eric Maskin, Steven Shavell, and others (New York Times 1997).

Economics of Natural Resources

Part VI consists of three essays on a new topic for this book — the economics of natural resources.  First, John Livernois examines the empirical significance of a central tenet in natural resource economics, namely the Hotelling Rule — the proposition that under conditions of efficiency, the scarcity rent (price minus marginal extraction cost) of natural resources will rise over time at the rate of interest (Review of Environmental Economics and Policy 2009).

Essays by Leonardo Maugeri (Review of Environmental Economics and Policy 2009) and Sheila Olmstead (Review of Environmental Economics and Policy 2010), respectively, examine two particularly important resources:  petroleum and water.

The next four sections of the book treat some timely and important topics and problems.

Corporate Social Responsibility and the Environment

Part VII examines corporate social responsibility and the environment, discussion of which has too often been characterized by more heat than light.  Forest Reinhardt, Richard Vietor, and I provide an overview of this realm from the perspective of economics, examining the notion of firms voluntarily sacrificing profits in the social interest.  In a second essay, Paul Portney provides a valuable empirical perspective (both are from the Review of Environmental Economics and Policy 2008).

Global Climate Change

Part VIII is dedicated to investigations of economic dimensions of global climate change, which may in the long term prove to be the most significant environmental problem that has arisen, both in terms of its potential damages and in terms of the costs of addressing it.  First, a broad overview of the topic is provided in a survey article by Joseph Aldy, Alan Krupnick, Richard Newell, Ian Parry, and William Pizer (Journal of Economic Literature 2010).

Next, William Nordhaus critiques the well-known Stern Review on the Economics of Climate Change, and Nicholas Stern and Chris Taylor respond (both are from Science 2007).  In the final essay in this section, Gilbert Metcalf examines market-based policy instruments that can be used to address greenhouse gas emissions (Journal of Economic Perspectives 2009).

Sustainability, the Commons, and Globalization

Part IX begins with Robert Solow’s economic perspective on the concept of sustainability.  This is followed by Elinor Ostrom’s development of a general framework for analyzing sustainability (Science 2009), and my own historical view of economic analysis of problems associated with open-access resources (American Economic Review 2011).  Then, Jeffrey Frankel draws on diverse sources of empirical evidence to examine whether globalization is good or bad for the environment (Council on Foreign Relations 2004).

Economics and Environmental Policy Making

The final section of the book, Part X, departs from the normative concerns of much of the volume to examine some interesting and important questions of political economy.  It turns out that an economic perspective can provide useful insights into questions that might at first seem to be fundamentally political.

Nathaniel Keohane, Richard Revesz, and I utilize an economic framework to ask why our political system has produced the particular set of environmental policy instruments it has (Harvard Environmental Law Review 1998).  Myrick Freeman reflects on the benefits that U.S. environmental policies have brought about since the first Earth Day in 1970 (Journal of Economic Perspectives 2002).  Lastly, Robert Hahn addresses the question that many of the articles in this volume raise:  what impact has economics actually had on environmental policy (Journal of Environmental Economics and Management 2000)?

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Assessing the Climate Talks — Did Durban Succeed?

The 17th Conference of the Parties (COP-17) of the United Nations Framework Convention on Climate Change (UNFCCC) adjourned on Sunday, a day and a half after its scheduled close, and in the process once again pulled a rabbit out of the hat by saving the talks from complete collapse (which appeared possible just a few days earlier).  But was this a success?

The Durban Outcome in a Nutshell

The outcome of COP-17 includes three major elements:  some potentially important elaborations on various components of the Cancun Agreements; a second five-year commitment period for the Kyoto Protocol; and (read this carefully) a non-binding agreement to reach an agreement by 2015 that will bring all countries under the same legal regime by 2020.

Is This a Success?

If by “success” in Durban, one means solving the climate problem, the answer is obviously “not close.”

Indeed, if by “success” one meant just putting the world on a path to solve the climate problem, the answer would still have to be “no.”

But, I’ve argued previously – including in my pre-Durban essay last month – that such definitions of success are fundamentally inappropriate for judging the international negotiations on the exceptionally challenging, long-term problem of global climate change.

The key question, at this point, is whether the Durban outcome has put the world in a place and on a trajectory whereby it is more likely than it was previously to establish a sound foundation for meaningful long-term action.

I don’t think the answer to that question is at all obvious, but having read carefully the agreements that were reached in Durban, and having reflected on their collective implications for meaningful long-term action, I am inclined to focus on “the half-full glass of water.”  My conclusion is that the talks – as a result of last-minute negotiations – advanced international discussions in a positive direction and have increased the likelihood of meaningful long-term action.  Why do I say this?

The Significance of Durban

Let’s look at the three major elements of the Durban outcome.

     1.  Putting More Flesh on the Bones of the Cancun Agreements

First, the delegates agreed to a set of potentially important details on various components of the Cancun Agreements.  This progress may turn out to be very important indeed, and helps advance – at least for the interim – a workable bottom-up, pledge-and-review approach to international climate cooperation.  The progress on this front includes work done on the Green Climate Fund to help mobilize public and private funding of climate change mitigation and adaptation in developing countries; more specifics on technology transfer mechanisms; mechanisms to enhance the transparency of national commitments under the Cancun Agreements; and an international scheme to reduce deforestation, which – importantly – includes market mechanisms.

     2.  A Second Commitment Period for the Kyoto Protocol

Second, the delegates agreed to a second five-year commitment period for the Kyoto Protocol.  Without this element, the talks would have collapsed, because the key emerging economies of China, India, Brazil, South Africa, Korea, and Mexico (not to mention the much larger number of truly poor, developing countries) would have walked out.  Would this have been so bad?

I have long argued that the Kyoto Protocol – with its structure of relatively ambitious targets for a small set of industrialized countries (the Annex I countries) and no targets whatsoever for the much larger set of other nations in the world (the non-Annex I countries) – is fundamentally flawed as a basis for addressing the climate change problem in a meaningful way, that is, in a way that can eventually limit global temperature increases to no more than 2 or 3 degrees Centigrade above pre-industrial levels.  In the past, some observers have gone so far as to argue that such a collapse of the talks would be necessary to free the world to consider alternative and ultimately more productive routes going forward.  Eventually, that may turn out to be true, but extending the Kyoto Protocol at this time for another period does little mischief.

The major effect – in addition to keeping the emerging economies (and developing countries) from walking out of the room – was to place the European Union in a position of accepting a target (for a second five-year period) that is no more stringent than what it has already committed to do under the European Union Emission Trading Scheme (EU ETS).  The United States is not a party to the Kyoto Protocol, and Canada, Japan, and Russia have indicated that they will not take up targets in a second commitment period.  Europe (and New Zealand, and possibly Australia) will be doing what they would have done anyway.  In exchange for this, the major emerging economies agreed to the third key element.

     3.  The Durban Platform for Enhanced Action

Third and finally, the delegates reached a non-binding agreement to reach an agreement by 2015 that will bring all countries under the same legal regime by 2020.  That’s a strange and confusing sentence, but it’s what happened, and – in my opinion – it’s potentially important, although it’s much too soon to say for sure.

The anchor that has been preventing real progress in the international climate negotiations for the past fifteen years has been the Kyoto Protocol’s dichotomous distinction between Annex I and non-Annex I countries.  With 50 non-Annex I countries now having greater per capita income than the poorest of the Annex I countries, it is clearly out of whack.  But, much more than that, this dichotomous distinction means that the world’s largest emitter – China – is unconstrained, that half of global emissions soon will be from nations without constraints, it drives up costs to four times their cost-effective level, and it creates a structure that makes change and progress virtually impossible.

Fortunately, the Copenhagen Accord and the Cancun Agreements began the process of blurring the Annex I/non-Annex I distinction, which was an important accomplishment, although it was only in the context of the interim pledge-and-review system, not in the context of an eventual successor to Kyoto.  Now, the COP-17 decision for “Enhanced Action” completely eliminates the Annex I/non-Annex I (or industrialized/developing country) distinction.  It focuses instead on the (admittedly non-binding) pledge to create a system of greenhouse gas reductions including all Parties (that is, all key countries) by 2015 that will come into force (after ratification) by 2020.  Nowhere in the text of the decision will one find phrases such as “Annex I,” “common but differentiated responsibilities,” or “distributional equity,” which have – in recent years – become code words for targets for the richest countries and a blank check for all others.

We should not over-estimate the importance of a “non-binding agreement to reach a future agreement,” but this is a real departure from the past, and marks a significant advance along the treacherous, uphill path of climate negotiations.

The Path Ahead

In my previous essay at this blog, I expressed the fear that contentious debates over a possible second commitment period for the Kyoto Protocol might disrupt the Durban talks, divert them from making sound progress on the Cancun structure, and keep the delegates from moving toward a sound foundation for meaningful long-term action.  I worried, in essence, that Durban – despite the weather – might resemble Copenhagen more than Cancun.

My conclusion is that this did not happen.  Not only did Durban not undo the progress made in Cancun, it built upon it, and moved forward.  This won’t satisfy the 350.org crowd, and it must greatly annoy the opponents of sensible climate policy, but in the real world of international negotiations on this exceptionally difficult global commons problem, this is what success looks like.

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For an interesting and helpful assessment of “The Legal Aspects of the Durban Platform Text,” I recommend an insightful Q&A by Jacob Werksman of the World Resources Institute.

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