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What are the Benefits and Costs of EPA’s Proposed CO2 Regulation?

On June 2^nd, the Obama Administration’s Environmental Protection Agency (EPA) released its long-awaited proposed regulation to reduce carbon dioxide (CO₂) emissions from existing sources in the electricity-generating sector. The regulatory (rule) proposal calls for cutting CO₂ emissions from the power sector by 30 percent below 2005 levels by 2030. This is potentially significant, because electricity generation is responsible for about 38 percent of U.S. CO₂ emissions (about 32 percent of U.S. greenhouse gas (GHG) emissions).

On June 18^th, EPA published the proposed rule in the Federal Register, initiating a 120-day public comment period. In my previous essay at this blog, I wrote about the fundamentals and the politics of this proposed rule (EPA’s Proposed Greenhouse Gas Regulation: Why are Conservatives Attacking its Market-Based Options?). Today I take a look at the economics.

Cost-Effective, Perhaps – but Efficient?

The proposed rule grants freedom to implementing states to achieve their specified emissions-reduction targets in virtually any way they choose, including the use of market-based instruments (the White House has referenced cap-and-trade in this context, although somewhat obliquely as “market-based programs,” and state-level carbon taxes might also be acceptable – if any states were to include them in their plans to implement the regualtion). Also, the proposal allows for multistate proposals and for states and regions to establish linkages among their state and multi-state market-based instruments. Some questions remain regarding the temporal flexibility (banking and borrowing) that the proposed rule will allow, but it’s reasonable to conclude at this point that although EPA may not be guaranteeing cost-effectiveness, it is allowing for it, indeed facilitating it. As Dallas Burtraw of Resources for the Future has said, the proposed rule ought to be judged to be potentially cost-effective.

Cost-effectiveness (achieving a given target at the lowest possible aggregate cost) is one thing, but economists – and possibly some other policy wonks – may wonder if the proposal is likely to be efficient (maximizing the difference between benefits and costs). This is a much higher mountain to climb, and a particularly challenging one for a regional, national, or sub-national climate-change policy, given the global commons nature of the problem.

The Challenge of this Global Commons Problem

GHGs mix globally in the atmosphere, and so damages are spread around the world and are unaffected by the location of emissions. This means that any jurisdiction taking action – a region, a country, a state, or a city – will incur the direct costs of its actions, but the direct benefits (averted climate change) will be distributed globally. Hence, the direct climate benefits a jurisdiction reaps from its actions will inevitably be less than the costs it incurs, despite the fact that global climate benefits may be greater – possibly much greater – than global costs.

(An Aside: This presents the classic free-rider problem of this ultimate global commons problem: It is in the interest of no country to take action, but each can reap the benefits of any countries that do take action. This is why international, if not global, cooperation is essential. See the extensive work of the Harvard Project on Climate Agreements.)

On June 2^nd, EPA released its 376-page Regulatory Impact Analysis (RIA) of the proposed “Clean Power Plan” rule, the same day it released the 645-page proposed rule itself. An RIA is essentially a benefit-cost analysis, required for significant new Federal rules by a series of Executive Orders going back to the presidency of Jimmy Carter, and reaffirmed by every President since, including most recently President Obama.

Given the fundamental economic arithmetic of a global commons problem, it would be surprising – to say the least – if EPA were to find that the expected benefits of the proposed rule would exceed its expected costs, but this is precisely what EPA has found. Indeed, its central estimate is of positive net benefits (benefits minus costs) of $67 billion annually in the year 2030 (employing a mid-range 3% discount rate). How can this be?

Two Answers to the Conundrum

First, EPA does not limit its estimate of climate benefits to those received by the United States (or its citizens), but uses an estimate of global climate benefits.

Second, in addition to quantifying the benefits of climate change impacts associated with CO₂ emissions reductions, EPA quantifies and includes (the much larger) benefits of human-health impacts associated with reductions in other (correlated) air pollutants.

Of course, even if benefits exceed costs at the given level of stringency of the proposed rule, it does not mean that the rule is economically efficient, because it could be the case that benefits would exceed costs by an even greater amount with a more stringent or with a less stringent rule. However, if benefits are not greater than costs (negative net benefits), then the rule cannot possibly be efficient, so I will stick with the all-too-common Washington practice and simply ask whether the analysis indicates a winner or a loser at the proposed rule’s given level of stringency. In other words, the question becomes, “Is the proposed rule welfare-enhancing (even if it is not welfare-maximizing)?”

Now, let’s take a look at the numbers from these two key aspects of EPA’s economic analysis and the issues surrounding the calculations.

U.S. versus Global Damages

There are surely ethical arguments (and possibly legal arguments) for employing a global damage estimate, as opposed to a U.S. damage estimate, in a benefit-cost analysis of a U.S. climate policy, but until recently all Regulatory Impact Analyses over several decades had focused exclusively on U.S. impacts.

In a recent working paper, “Determining the Proper Scope of Climate Change Benefits,” Ted Gayer, Vice President and Director of Economic Studies at the Brookings Institution, and Kip Viscusi, University Distinguished Professor of Law, Economics, and Management at Vanderbilt University, review the history of RIAs, including their virtually exclusive focus on national impacts (defined by geography or U.S. citizenship) in benefit and cost estimates of regulations.

In the context of a conventional RIA, it does seem strange – at least at first blush – to use a global measure of benefits of a U.S. regulation. If this practice were applied in a consistent manner – that is, uniformly in all RIAs – it would result in some quite bizarre findings. For example, a Federal labor policy that increases U.S. employment while cutting employment in competitor economies might be judged to have zero benefits!

Another example, this one courtesy of Tim Taylor via Ted Gayer: Under global accounting, if a domestic climate policy had the unintended consequence of causing emissions and economic leakage (through relocation of some manufacturing to other countries), that would not be considered a cost of the regulation (and with diminishing marginal utility of income, it might be counted as a benefit)!

On the other hand, a counter-argument to this line of thinking is that the usual narrow U.S.-only geographic scope of an RIA is simply not appropriate for a global commons problem. Otherwise, we would simply restate in economic terms the free-rider consequences of a global commons challenge. In other words, a domestic-only RIA of a climate policy could have the effect of “institutionalizing free riding,” to quote my Harvard Kennedy School colleague, Professor Joseph Aldy. Of course, if global benefits are to be included in a regulatory assessment, it can be argued that global costs (such as leakage) should also be considered.

I leave it to legal scholars and lawyers to debate the law, and I defer to the philosophers among us to debate the ethics, but let’s at least ask what the consequences would be for EPA’s analysis if a U.S climate benefits number were used, rather than a global number. For this purpose, we can start with EPA’s estimates (from Table ES-7 on page ES-19 and Table ES-10 on page ES-23 of its Regulatory Impact Analysis of the proposed rule) for 2030 benefits and costs, using a mid-range 3% real discount rate. The estimated (global) climate benefits of the rule are $31 billion.

In order to think about what the domestic climate benefits might be, we can turn to the Obama administration’s original calculation of the Social Cost of Carbon in 2010, where the Interagency Working Group estimated a central global value for 2010 of $19 per ton of CO₂, and noted (and explained in more detail in a subsequent scholarly paper by several members of the Working Group) that U.S. benefits from reducing GHG emissions would be, on average, about 7 to 10 percent of global benefits across the scenarios analyzed with the one model that permitted such geographic disaggregation.

(The Interagency Working Group also suggested that if climate damages are simply proportional to GDP, then the U.S. share would be about 23%. However, given the IPCC’s prediction of highly unequal geographic distribution of climate change effects worldwide, combined with the exceptionally heterogeneous nature of climate sensitivity among the world’s economies, which vary from those with trivial reliance on agriculture to those dominated by their agricultural sectors, I find the argument behind this second approach unconvincing.)

Taking the midpoint of the Obama Working Group’s 7-10% range, U.S. damages (benefits) may be estimated to be 8.5% of global damages, which would reduce the $31 billion reported in the new RIA to about $2.6 billion, which is considerably less than the RIA’s estimated total annual compliance costs of $8.8 billion (assuming that the states facilitate cost-effective actions). This validates the intuition, explained above, that for virtually any jurisdiction, the direct climate benefits it reaps from its actions will be less than the costs it incurs (again, despite the fact that global climate benefits may be much greater than global costs).

There are plenty of caveats on both sides of this simple analysis. One of the most important is that if the proposed U.S. policy were to increase the probability of other countries taking climate policy actions (which I believe is probably the case), then the impacts on U.S. territory of such foreign policy actions would merit inclusion even in a traditional U.S.-only benefit-cost analysis. More broadly, although it has been traditional to use a U.S.-only benefits measure in RIAs, the current guidelines for carrying out these analyses from the Office of Information and Regulatory Affairs of the U.S. Office of Management and Budget (Circular A-4) requires that geographic U.S. benefit and cost estimates be provided, but also allows for the optional inclusion of global estimates.

Pending resolution (or more likely, discussion and debate) from lawyers and philosophers regarding the legal and ethical issue of employing domestic benefits versus global benefits in a climate regulation RIA, it is essential to recognize that there is an even more important factor that explains how EPA came up with estimates of significant positive net benefits (benefits exceeding costs) for the proposed rule (and would have even if a domestic climate benefits number had been employed), namely, the inclusion of (domestic) health impacts of other air pollutants, the emissions of which are correlated with those of CO₂.

Correlated Pollutants and Co-Benefits

The Obama Administration’s proposed regulation to reduce CO₂ emissions from the electric power sector is intended to achieve its objectives through a combination of less electricity generated (compared with a business-as-usual trajectory), greater dispatch of electricity from less CO₂-intensive sources (natural gas, nuclear, and renewable sources, instead of coal), and more investment in low CO₂-intensive sources. Hence, it is anticipated that less coal will be burned than in the absence of the regulation (and more use of natural gas, nuclear, and renewable sources of electricity). This means not only less CO₂ being emitted into the atmosphere, but also decreased emissions of correlated local air pollutants that have direct impacts on human health, including sulfur dioxide (SO₂), nitrogen oxides (NO_x), particulate matter (PM), and mercury (Hg).

It is well known that higher concentrations of these pollutants in the ambient air we breathe – particularly smaller particles of particulate matter (PM_2.5) – have very significant human health impacts in terms of increased risk of both morbidity and mortality. The numbers dwarf the climate impacts themselves. Whereas the U.S. climate change impacts of CO₂ reductions due to the proposed rule in 2030 are probably less than $3 billion per year (see above), the health impacts (co-benefits) of reduced concentrations of correlated (non-CO₂) air pollutants are estimated by EPA to be some $45 billion/year (central estimate)! (By the way, I assume that the co-benefits estimated by EPA are based upon a comparison with a business-as-usual baseline that includes the effects of all existing EPA and state regulations for these same local air pollutants. If not, the RIA will need to be revised.)

The Bottom Line

The combined U.S.-only estimates of annual climate impacts of CO₂ ($3 billion) and health impacts of correlated pollutants ($45 billion) greatly exceed the estimated regulatory compliance costs of $9 billion/year, for positive net benefits amounting to $39 billion/year in 2030. This is the key argument related to the possible economic efficiency of the proposed rule from the perspective of U.S. welfare. If EPA’s global estimate of climate benefits ($31 billion/year) is employed instead, then, of course, the rule looks even better, with total annual benefits of $76 billion, leading to EPA’s bottom-line estimate of positive net benefits of $67 billion per year. See the summary table below.

The Obama Administration’s proposed regulation of existing power-sector sources of CO₂ has the potential to be cost-effective, and if you accept these numbers, it can also be welfare-enhancing, if not welfare-maximizing.

That said, I assume that proponents of the Obama Administration’s proposed rule will take this assessment of EPA’s Regulatory Impact Analysis as evidence of the sensibility of the rule, and opponents of the Administration’s proposed actions will claim that my assessment of the RIA provides evidence of the foolishness of EPA’s proposal. So it is in our pluralistic system (not to mention, in the context of the political polarization that has gripped Washington on this and so many other issues).

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Benefits and Costs of EPA’s Proposed Clean Power Plan Rule in 2030

(Mid-Point Estimates, Billions of Dollars)

	Climate Change Impacts		Health Impacts (Co-Benefits) of Correlated Pollutants plus …
	Domestic	Global	Domestic Climate Impacts	Global Climate Impacts
Benefits
Climate Change	$ 3	$ 31	$3	$31
Health Co-Benefits			$45	$45
Total Benefits	$ 3	$ 31	$48	$76
Total Compliance Costs	$ 9	$ 9	$ 9	$ 9
Net Benefits (Benefits – Costs)	– $ 6	$ 22	$ 39	$ 67

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Climate Change, Public Policy, and the University

Over the past year or more, across the United States, there has been a groundswell of student activism pressing colleges and universities to divest their holdings in fossil fuel companies from their investment portfolios. On October 3, 2013, after many months of assessment, discussion, and debate, the President of Harvard University, Drew Faust, issued a long, well-reasoned, and – in my view – ultimately sensible statement on “fossil fuel divestment,” in which she explained why she and the Corporation (Harvard’s governing board) do not believe that “university divestment from the fossil fuel industry is warranted or wise.” I urge you to read her statement, and decide for yourself how compelling you find it, and whether and how it may apply to your institution, as well.

About 10 days later, two leaders of the student movement at Harvard responded to President Faust in The Nation. Andrew Revkin, writing at the New York Times Dot Earth blog, highlighted the fact that the students responded in part by saying, “We do not expect divestment to have a financial impact on fossil fuel companies … Divestment is a moral and political strategy to expose the reckless business model of the fossil fuel industry that puts our world at risk.”

I agree with these students that fossil-fuel divestment by the University would not have financial impacts on the industry, and I also agree with their implication that it would be (potentially) of symbolic value only. However, it is precisely because of this that I believe President Faust made the right decision. Let me explain.

The Value of Symbolic Action

If divestment would at best be a symbolic action, without meritorious direct financial impacts, can it not nevertheless be important and of great value? More broadly, can’t symbolic actions be valuable?

One major problem is that symbolic actions often substitute for truly effective actions by allowing us to fool ourselves into thinking we are doing something meaningful about a problem when we are not.

But even if there are such opportunity costs of symbolic actions, can they not still be merited as part of moral crusades (as the students would presumably argue)? The answer is, in my view, yes. The problem, however, is that climate change is fundamentally a scientific, economic, and political challenge. Viewing it as a moral crusade, I fear, will only play into and exacerbate the terrible political polarization that is already paralyzing Washington, a topic about which I have written previously at this blog.

The Climate Impacts of Divestment

Divestment of fossil fuel stocks would hurt, not help efforts to address global climate change. First, natural gas is the crucial transition fuel to address climate change. A major reason for the drop in U.S. CO₂ emissions is the increased use of natural gas to generate electricity, as documented in this recent report from the U.S. Energy Information Administration.

Second, even if divestment were to reduce the financial resources of coal, oil, and gas companies (which it would not do), this would only serve to reduce research and development at those same companies of carbon capture and storage (CCS) technologies, as well as other potential technological breakthroughs; and could reduce the development of some renewable sources of energy (which the fossil fuel companies are carrying out as part of their financially rational diversification strategies).

The University’s Comparative Advantage

Most important, as I have argued for years, Harvard’s real contributions to fight climate change and promote sound climate change policies will be through our products: research, teaching, and outreach. That is how this great university has made a difference on other societal challenges for decades and centuries, and it is how we will make a real difference on this one.

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Three and a half years ago, I posted an essay at this blog about what I saw to be the proper role of individuals and institutions in addressing climate change. Frequently I refer to my previous blog posts, but today I’m going a step further, and reproducing that one from March, 2010, because it applies so directly to the topic at hand (including its Epilogue at the very end):

What’s the Proper Role of Individuals and Institutions in Addressing Climate Change?

Posted on March 8, 2010 by Robert Stavins

This may seem like a trivial question with an obvious answer. But what really is the proper role for individuals and institutions in addressing climate change? An immediate and natural response may be that everyone should do their part. Let’s see what that really means.

Decisions affecting carbon dioxide (CO₂) emissions, for example, are made primarily by companies and consumers. This includes decisions by companies about how to produce electricity, as well as thousands of other goods and services; and decisions by consumers regarding what to buy, how to transport themselves, and how to keep their homes warm, cool, and light.

However, despite the fact that these decisions are made by firms and individuals, government action is clearly key, because climate change is an externality, and it is rarely, if ever, in the self-interest of firms or individuals to take unilateral actions. That’s why the climate problem exists, in the first place. Voluntary initiatives – no matter how well-intended – will not only be insufficient, but insignificant relative to the magnitude of the problem.

So, the question becomes how to shift decisions by firms and individuals in a climate-friendly direction, such as toward emissions reductions. Whether conventional standards or market-based instruments are used, meaningful government regulation will be required.

But where does this leave the role and responsibility of individuals and institutions? Let me use as an example my employer, a university. A couple of years ago, I met with students advocating for a reduced “carbon foot-print” for the school. Here is what I told them.

“I was asked by a major oil company to advise on the design of an internal, voluntary tradable permit systems for CO₂ emissions. My response to the company was ‘fine, but the emissions from your production processes — largely refineries — are trivial compared with the emissions from the use of your products (combustion of fossil fuels). If you really want to do something meaningful about climate change, the focus should be on the use of your products, not your internal production process.’ (My response would have been different had they been a cement producer.) The oil company proceeded with its internal measures, which – as I anticipated – had trivial, if any impacts on the environment (and they subsequently used the existence of their voluntary program as an argument against government attempts to put in place a meaningful climate policy).”

My view of a university’s responsibilities in the environmental realm is similar. Our direct impact on the natural environment — such as in terms of CO₂ emissions from our heating plants — is absolutely trivial compared with the impacts on the environment (including climate change) of our products: knowledge produced through research, informed students produced through our teaching, and outreach to the policy world carried out by faculty.

So, I suggested to the students that if they were really concerned with how the university affects climate change, then their greatest attention should be given to priorities and performance in the realms of teaching, research, and outreach.

Of course, it is also true that work on the “greening of the university” can in some cases play a relevant role in research and teaching. And, more broadly — and more importantly — the university’s actions in regard to its “carbon footprint” can have symbolic value. And symbolic actions — even when they mean little in terms of real, direct impacts — can have effects in the larger political world. This is particularly true in the case of a prominent university, such as my own.

But, overall, my institution’s greatest opportunity — indeed, its greatest responsibility — with regard to addressing global climate change is and will be through its research, teaching, and outreach to the policy community.

Why not focus equally on reducing the university’s carbon foot-print while also working to increase and improve relevant research, teaching, and outreach? The answer brings up a phrase that will be familiar to readers of this blog – opportunity cost. Faculty, staff, and students all have limited time; indeed, as in many other professional settings, time is the scarcest of scarce resources. Giving more attention to one issue inevitably means – for some people – giving less time to another.

So my advice to the students was to advocate for more faculty appointments in the environmental realm and to press for more and better courses. After all, it was student demand at my institution that resulted in the creation of the college’s highly successful concentration (major) in environmental science and public policy.

My bottom line? Try to focus on actions that can make a real difference, as opposed to actions that may feel good or look good but have relatively little real-world impact, particularly when those feel-good/look-good actions have opportunity costs, that is, divert us from focusing on actions that would make a significant difference. Climate change is a real and pressing problem. Strong government actions will be required, as well as enlightened political leadership at the national and international levels.

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Epilogue: After I posted the above essay, I was reminded of an incident that took place many years ago (before I came to Harvard for graduate school, in fact) when I was working full-time for the Environmental Defense Fund in Berkeley, California, under the inspired leadership of the late (and truly great) Tom Graff, the long-time guru of progressive California water policy. EDF was very engaged at the time in promoting better water policies in California, including the use of trading mechanisms and appropriate pricing schemes for scarce water supplies. A prominent national newspaper which was not friendly to EDF’s work sent a reporter to EDF’s Berkeley office to profile the group’s efforts on water policy in the State. A staff member found the reporter in the office bathroom examining whether EDF had voluntarily installed various kinds of water conservation devices in its plumbing. Our reaction at the time was that whether or not EDF had voluntarily installed water conservation devices was simply and purely an (intentional) distraction from the important work the group was carrying out. After several decades, my view of that incident has not changed.