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A Golden Opportunity to Please Conservatives and Liberals Alike

The U.S. Environmental Protection Agency (EPA) has a golden opportunity to opt for a smart, low-cost approach to fulfilling its mandate under a Supreme Court decision to reduce carbon dioxide (CO₂) and other greenhouse gas (GHG) emissions linked with global climate change.

Such an approach would provide maximum compliance flexibility to private industry while meeting mandated emission reduction targets, would achieve these goals at the lowest possible cost, would work through the market rather than against it, would be consistent with the Obama Administration’s pragmatic approach to environmental regulation, and ought to receive broad political support, including from conservatives, who presumably want to minimize the cost burden of any policy on businesses and consumers.

Background and Context

By now, it is well known that the 2007 U.S. Supreme Court (5-4) decision in Massachusetts v. EPA found that EPA has the authority to regulate GHGs under the existing provisions of the Clean Air Act (CAA). This, combined with EPA’s “endangerment finding” in 2009 that GHGs threaten public health and the environment, led first in January, 2011, to new motor vehicle fuel efficiency standards, and soon will lead to regulations affecting new and modified stationary sources of emissions (under Section 111b of the CAA) via so-called New Source Performance Standards, and regulations for existing stationary sources (under Section 111d).

In quantitative terms, this last set of regulations – for existing stationary sources – will be key, and by far the most important affected sector will be electricity generation, which accounts for fully 40 percent of U.S. CO₂ emissions (and a third of national GHG emissions). Within this sector, coal-fired power plants will be the most drastically affected.

EPA could, in principle, promulgate a regulatory approach that incorporates compliance flexibility, such as through various types of credit, offset, or cap-and-trade mechanisms. It could do this, but may it do so under the legal authority of the Clean Air Act?

Call the Lawyers!

Over the past year, there has been a considerable amount of discussion and no small degree of hand-wringing over whether the relevant parts of the Clean Air Act authorize the use of such flexibility mechanisms. In the midst of this, a new report from Resources for the Future by Gregory Wannier (Columbia Law School) and others makes a compelling, but nuanced case in the affirmative. (See “Prevailing Academic View on Compliance Flexibility under §111 of the Clean Air Act”).

Their conclusion, in a nutshell: “EPA has the tools under §111 of the CAA to implement relatively flexible and efficient GHG regulation. The agency could use a range of compliance flexibility options itself, or facilitate state implementation plans that adopt such measures at the state or regional level.” Included are the market-based, economic-incentive instruments mentioned above.

We should take note, by the way, that Section 111d gives states considerable latitude when choosing their actions to follow EPA guidelines, an approach that is consistent with conservatives’ promotion of the primacy of state authorities in tailoring rules for individual state-by-state circumstances.

Now, for Some Economics

Even if the EPA has the legal authority to adopt a progressive, market-based approach to fulfilling this regulatory mandate, would it really make sense to do this? That is, what would be the consequences of adopting a flexible approach, compared with a conventional, inflexible regulatory scheme? Key issues include the implications for environmental performance, aggregate social cost, and consumer impacts via electricity prices.

Another new study, this one by Dallas Burtraw, Anthony Paul, and Matt Woerman (all at RFF), provides the analysis that is needed, using RFF’s well-regarded Haiku model of the U.S. electricity market, to examine the effect of alternative CAA policies on investment and operation of the nation’s electricity system over a 25-year time horizon in 21 interlinked regions. (See: “Retail Electricity Price Savings from Compliance Flexibility in GHG Standards for Stationary Sources”)

Four scenarios which would achieve the same environmental benefits are examined:

(1) a conventional approach in which the operating efficiency of individual coal-fired power plants would be regulated (labeled an “inflexible performance standard”).

(2) a “flexible performance standard,” under which plants that exceeded the standard could transfer a credit (in exchange for payment) to plants that found it more difficult to achieve the standard. The researchers call these “generation efficiency credit offsets.”

(3) cap-and-trade with auctioned CO₂ emission allowances, where the revenue generated for government simply displaces the need for other revenue sources on a one-for-one basis (that is, there is no assumption of a double-dividend through increased efficiency of the tax code).

(4) cap-and-trade with free allocation of allowances to Local Distribution Companies (LDCs), which are regulated and hence assumed to pass the benefits of the free allocation on to consumers.

The results are striking. In terms of aggregate social costs, the inflexible standard would bring with it total costs of about $5 billion per year, whereas – at the other extreme – cap-and-trade with free allocation would involve total costs of only $500 million annually, a 90 percent cost savings!

If – despite its legal authority – EPA believes it is politically unable to adopt a cap-and-trade approach (because of last year’s successful tarnishing of that phrase by Congressional conservatives), then it could opt for a second-best approach, the “flexible-performance standard,” above, which would involve total annual costs of about $1.4 billion, still a 70 percent cost savings compared with the conventional, inflexible standard.

Of course, political consideration of such policy alternatives is more frequently driven by estimates of consumer impacts than by overall social costs (which include consumer costs, industry costs, and costs to government). Here, the analysis is also striking. Consumer costs – due to higher electricity prices – under the inflexible standard would increase by 7 percent, while consumer costs under the flexible performance standard would increase by less than 2 percent. With the cap-and-trade regime with free allowances, consumer costs would actually fall by nearly 1 percent, due to lower electricity prices. [For complete numerical results with all of the scenarios, see the RFF discussion paper.]

The Bottom Line

Clearly, much is to be gained – and virtually nothing lost – by adopting a more flexible approach to meeting a court-ordered mandate that, one way or another, will have a regulation promulgated and eventually finalized. It would be foolish to turn away from a potential 90 percent cost savings for the country’s economy, particularly when the same approach yields lower electricity prices for consumers. All this, while meeting national obligations to reduce greenhouse gas emissions.

It’s too soon to forget that a year ago the Senate abandoned its attempt to pass climate legislation that would limit CO₂ emissions. In the process, conservative Republicans dubbed cap-and-trade “cap-and-tax.’’ But, as I’ve said before, regardless of what they think about climate change, conservatives should resist demonizing market-based approaches to environmental protection and reverting to pre-1980s thinking that saddled business and consumers with needless costs.

Market-based approaches to environmental protection should be lauded, not condemned, by political leaders, no matter what their party affiliation. Otherwise, there will be severe and perverse long-term consequences for the economy, for business, and for consumers.

Canada’s Step Away From the Kyoto Protocol Can Be a Constructive Step Forward

Canada confirmed this week that it will not take on a target under an extension of the Kyoto Protocol following the completion of the first commitment period, 2008-2012. Given that Canada is likely to miss by a wide margin its current target under the first commitment period, this decision may not be surprising, but it is nevertheless important. More striking, it may actually turn out to be a positive and constructive step forward in the drive to address global climate change through meaningful international cooperation. Why do I say that?

The Current Situation

The Kyoto Protocol, which essentially expires at the end of 2012, divides the world into two competing economic camps. Emission reductions are required for only the small set of “Annex I countries” (essentially those nations that used to be thought of as comprising the industrialized world). Such reductions will not reduce global emissions, and whatever is achieved would be at excessive cost, because of having left so many countries and so many low-cost emissions-reduction opportunities off the table. Furthermore, that dichotomous distinction is by no means fair: more than 50 non-Annex I countries now have higher per capita incomes than the poorest of the Annex I countries. (I have written about this and other issues surrounding the Kyoto Protocol in the past: Defining Success for Climate Negotiations in Cancun; Defining Success for Climate Negotiations in Copenhagen; Three Pillars of a New Climate Pact).

The United States did not ratify the Kyoto Protocol, and has made it clear that it will not take on a target under a second commitment period. The U.S. position continues to be that a considerably broader agreement is necessary – one that includes commitments not only from the Annex I (industrialized) countries, but also from the key emerging economies, such as China, India, Brazil, Korea, Mexico, and South Africa.

For much the same reason, Russia and Japan announced last year that they would not take on post-2012 commitments under the Kyoto Protocol. Further, it is unlikely that Australia will take on such a commitment under Kyoto, essentially leaving the European Union on its own.

On the other hand, the Kyoto Protocol is enthusiastically embraced by the non-Annex I countries (sometimes inaccurately characterized as the “developing countries”), because it holds out the promise of emissions reductions by the wealthiest nations without any responsibilities (costs) borne by others, including the emerging economies.

The Path from Copenhagen to Cancun to Durban

Year after year, the Conference of the Parties to the United Nations Framework Convention on Climate Change has failed to reach agreement on a second commitment period for the Kyoto Protocol. Most recently, in December, 2010, the issue was punted from the annual conference held in Cancun, Mexico, to the next conference, scheduled for December, 2011, in Durban, South Africa.

Because Durban provides the last opportunity to set up post-2012 targets (with time remaining for national ratification actions), it has been anticipated that the negotiations in Durban will re-ignite the divisiveness and recriminations that highlighted the Copenhagen negotiations in 2009 – with verbal hostilities between Annex I countries and non-Annex I countries dominating the discussions at the expense of any other considerations or meaningful actions.

A Positive and Constructive Step Forward

The decision just announced at meetings in Bonn, Germany, by the Canadian delegation that Canada will not take on a target in a second commitment period of the Kyoto Protocol can be a very constructive step forward. This is because it greatly reduces the risk that this year’s annual meeting of the Conference of the Parties in Durban will be dominated by acrimonious debates about a second commitment period for the Kyoto Protocol.

On the contrary, this announcement should encourage the non-Annex I (“developing”) countries, which have been insisting on a second commitment period, to begin to accept the reality that with the United States, Japan, Russia, and now Canada on record as not endorsing a second commitment period for the Kyoto Protocol, it is infeasible for the European Union to go it alone. (Indeed, one might suspect that Australia and most European nations are privately pleased by Canada’s announcement.)

The reality is that the world will be better off by focusing on sensible alternatives under the Long-Term Cooperative Action track of the UN negotiations and by “getting real” about post-Kyoto international climate policy architecture for the long term, such as by putting some additional meat on the Cancun Agreements and by considering any supplemental and sensible architectures the various parties wish to discuss. (For previous posts on the Cancun Agreements, see: Why Cancun Trumped Copenhagen; What Happened (and Why): An Assessment of the Cancun Agreements; Defining Success for Climate Negotiations in Cancun. For descriptions of a wide range of potential global climate policy architectures — ranging from top-down to bottom-up — see the diverse publications of the Harvard Project on Climate Agreements.)

Next Steps

At Cancun, it was encouraging to hear fewer people holding out for a commitment to another phase of the Kyoto Protocol, but it was politically impossible to spike the idea of extending the Kyoto agreement entirely. Instead, it was punted to the next gathering in Durban. Otherwise, the Cancun meeting could have collapsed amid acrimony and recriminations reminiscent of Copenhagen.

Usefully, the Cancun Agreements recognize directly and explicitly two key principles: (1) all countries must recognize their historic emissions (read, the industrialized world); and (2) all countries are responsible for their future emissions (think of those with fast-growing emerging economies). In important ways, this helps move beyond the old Kyoto divide.

The acceptance of the Cancun Agreements last December suggested that the international community may have begun to recognize that incremental steps in the right direction are better than acrimonious debates over unachievable targets. Canada’s announcement should help advance that recognition, and can thereby lead to vastly more productive talks this year in Durban.

What’s in a Name? Wine, Economics, and Terroir

Today, I’m pleased to offer a temporary respite from analysis of climate change policy (and other environmental policies, for that matter), while remaining well within the general province of environmental and natural resource economics. I do this through a merger of profession and avocation, in my case, economics and oenonomy (the study – as well as the enjoyment – of fine wine).

A Blend of Economy and Oenonomy

As some readers may know, in addition to having served as the founding Editor (and current Co-Editor) of the Review of Environmental Economics and Policy, I have had the distinct pleasure of being one of the founding Editors (along with Kym Anderson, Orley Ashenfelter, Victor Ginsburgh, and Karl Storchmann) of the Journal of Wine Economics. If you’re laughing, let me quickly note that the Journal consists of serious, refereed articles, many by leading economists, and has been referenced by the New York Times, The Economist, and The Financial Times. And – in what may be our high point or low point, depending upon your perspective – a discussion paper from the affiliated American Association of Wine Economists was referenced – and mocked – by Stephen Colbert on his “Colbert Report.”

A New Article

In an article that is forthcoming in the Journal of Wine Economics, Robin Cross, Andrew Plantinga (both of the Department of Agricultural and Resource Economics at Oregon State University), and I examine a concept that is central to the thinking of wine geeks around the world – terroir. The Journal article – “The Value of Terroir: Hedonic Estimation of Vineyard Sale Prices” – has not yet been published, but a brief version of our analysis – “What is the Value of Terroir?” – has just been published in the American Economic Review Papers and Proceedings 2011, and so I’m pleased to provide an even briefer summary here (quoting and paraphrasing from our AER P&P article) – both for wine geeks and for others. First, however, let me acknowledge Chuck Mason and other participants in a session at the 2011 American Economic Association meetings for having offered helpful comments on a previous version of the paper. Now, to the subject at hand.

Some Background

Wine producers and enthusiasts use the term “terroir,” from the French terre (meaning land), to refer to the special characteristics of a place that impart unique qualities to the wine produced. The Appellation d’Origine Contrôlée (AOC) system in France, and similar systems adopted in other wine-producing countries, are based upon the geographic location of grape production, predicated on this notion of terroir. Under the U.S. system, production regions are designated as American Viticultural Areas (AVAs), with finer geographical designations known as sub-AVAs. Such designations allow wineries to identify the geographical origin of the grapes used in producing their wines, and – equally important – seek to prevent producers outside an AVA from making false claims about the nature and origin of their wines.

Some Empirical Questions

“What is the value of terroir in the American context?” Does the “reality of terroir” – the location-specific geology and geography – predominate in determining the quality of wine? Does the “concept of terroir” – the location within an officially named appellation – impart additional value to grapes and wine? Does location within such an appellation impart additional value to vineyards?

The central question we sought to address in this work was whether measurable site attributes – such as slope, aspect, elevation, and soil type – or appellation designations are more important determinants of vineyard prices. We did this by conducting a hedonic price analysis to investigate sales of vineyards in Oregon’s Willamette Valley, one of the most important wine-producing regions in the United States.

Thinking About These Questions

How should site attributes and sub-AVA designations influence vineyard prices? If site attributes significantly affect wine quality and if consumers are able to discriminate such quality, then vineyard prices would depend on site attributes, and AVA designations might be redundant.

Alternatively, consumers might not be able to discriminate among wines perfectly and might use AVA designations as signals of average quality of wines from respective areas, and/or might derive utility directly from drinking wines which they know to be of particular pedigree. In this case, site attributes and AVA designations would influence vineyard prices, with parameters for site attributes indicating how producers value intra-AVA differences in vineyard characteristics. Presumably, producers attach premiums to site attributes that enhance wine quality, provided that consumers can perceive and are willing to pay for such quality differences.

What if, at the extreme, variation in vineyard prices were explained completely by AVA designations (that is, site attributes are irrelevant)? This would indicate that terroir matters economically – as a concept, though not as a fundamental reality. In other words, producers recognize the value of the AVA designation because they know that consumers will pay more for the experience of drinking wine from designated areas. (Likewise, producers might bid up the value of vineyards located in designated appellations because there is prestige associated with owning vineyards in these areas.) But if site attributes known to affect wine quality have no impact on vineyard prices, this would suggest that consumers cannot discern quality differences. Any appreciation they might express for an area’s terroir would essentially be founded on reputation, not reality.

Our Analysis

We estimated a hedonic model of vineyard prices in Oregon to examine whether such prices vary systematically with designated appellation, after controlling for site attributes. In other words, we carried out an econometric (statistical) analysis to examine the factors that appear to affect vineyard prices.

We employed a new data set we developed on vineyard sales with extensive information about respective properties, combined with GIS-based information on specific parcels. In our sample (actually, the universe of sales of vineyard – and potential vineyard – properties in the Willamette Valley between 1995 and 2007), the average price of vineyards was about $10,000 per acre, with prices ranging from $2,500 to $42,000 per acre.

We also carried out a check on our vineyard pricing analysis by examining price premiums paid by consumers for wines from related origins. If you’d like to read about either methodology, or see our quantitative results, please take a look at the article. But, for now, I will just summarize our results.

Some Answers

We found that vineyard prices are strongly determined by location within specific sub-AVAs, but not by site attributes. These appellations are supposed to reflect the area’s terroir, but our finding that the physical characteristics of vineyards are not priced implicitly in land markets raises questions about whether sub-AVA designations have a fundamental connection with terroir.

On the other hand, our results make clear that the concept of terroir matters economically, both to consumers and to wine producers. Buyers and sellers of vineyard parcels in the Willamette Valley of Oregon attach a significant premium to sub-AVA designations. One possibility is that buyers are less informed than sellers about how the attributes of a vineyard will affect wine quality and, therefore, rely on sub-AVA designations as quality signals.

In any event, consumers are evidently willing to pay more for the experience of drinking wines from these areas. While they may not discriminate among wines in terms of their intrinsic qualities, consumers are apparently responding to extrinsic qualities of wines, such as price and area of origin. So, terroir survives – as a concept, but somewhat less as a fundamental reality.