global climate policy Archives - Page 43 of 44 - An Economic View of the Environment

The New Auto Fuel-Efficiency Standards — Going Beyond the Headlines

On My 19^th, 2009, President Obama announced new Federal fuel-efficiency standards for motor-vehicles that would make the current standards — known as Corporate Average Fuel Economy — or CAFE — standards significantly more stringent. These CAFE standards measure compliance as the average of a company’s entire fleet of cars, and so are more flexible and less costly than model-by-model standards, better matching consumer preferences and lowering production costs.

Other good news is that the administration’s proposal will yield a single standard nationwide, rather than two fuel efficiency standards, one for California and the 13 other states that chose to follow its more stringent Pavley standards, and another standard for the rest of the country under the existing CAFE program. The result would have been that the states adopting the more stringent California standard would have brought about little incremental benefit for the environment beyond the national CAFE program, because auto manufacturers and importers would have largely undone the effects of the more stringent state-level fuel-efficiency requirements by selling more of the less fuel-efficient models in their fleets in the non-Pavley states. This has been validated in an interesting research paper by Lawrence Goulder (Stanford University), Mark Jacobsen (University of California, San Diego), and Arthur van Benthem (Stanford University). Thus, dual standards would have increased costs, but with little or no additional benefit to the environment.

These new Federal standards proposed by the Obama administration can therefore be one small step along the path to meaningful reductions in greenhouse gas emissions that cause climate change. That’s the good news. But it’s also true that the new standards are inferior to other possible approaches.

First of all, CAFE affects only the cars we buy, not how much we drive them, and so CAFE standards are less cost-effective than gasoline prices at reducing gasoline consumption, because gas prices (whether reflecting market conditions or government taxes) affect both which cars we buy and our choices about driving.

Some people may think that CAFE standards — unlike gas taxes — are costless for consumers. But according to the administration, the increases in CAFE standards (including both scheduled increases already on the books and the new Obama proposal) will add — on average — $1,300 to the cost of producing a new car.

Because CAFE standards increase the price of new cars, the standards have the unintentional effect of keeping older — dirtier and less fuel-efficient — cars on the road longer. This counterproductive effect is typical of any vintage-differentiated-regulation, a topic which I have addressed in a previous post. There is abundant empirical research on this issue.

Also, by decreasing the cost per mile of driving, CAFE standards — like any energy-efficiency technology standard — exhibit a “rebound effect,” namely, people have an incentive to drive more, not less, thereby lessening the anticipated reduction in gasoline usage. This has also been documented empirically.

The bottom line is that gasoline prices are a much more effective – and more cost-effective – means of cutting gasoline demand, both in the short term and the long term. But if increasing gasoline prices through gas taxes is politically impossible – which certainly appears to be the case in the current political climate – why raise all of these objections? Am I allowing the (infeasible) perfect to be the enemy of the good? Not at all, as I will explain.

There is, in fact, another policy instrument available that has the same desirable impacts as gas taxes on gasoline prices (and, more importantly, on all other fossil fuel prices, as well), but inspires dramatically less political opposition. And this instrument is not only politically feasible, but is right now achieving remarkable, broad-based political support in Washington. I’m talking about the economy-wide CO₂ cap-and-trade system in Congressmen Waxman and Markey’s legislation in the House of Representatives. Their cap-and-trade system will serve to increase the price of gasoline, cut demand, and reduce emissions. But, in addition, its impacts will go far beyond automobiles and trucks, and beyond the transportation sector, as well.

To seriously and cost-effectively address climate change, it is essential to put in place a single carbon price that affects all fossil fuels and all uses throughout the economy — not only in the transportation sector, but also electric power, and the manufacturing, commercial, and residential sectors. This is precisely what cap-and-trade does. A meaningful, upstream, economy-wide cap-and-trade system will serve to increase the price of gasoline, as well as other fuels, electricity, and all goods and services in proportion to their carbon-intensity in production, and it does this (as would a carbon tax) in the right proportions for each fuel, energy source, and product, so that the overall cap is achieved at the least possible cost. The real bottom line is that cap-and-trade is the cheapest, best, and only politically feasible approach that can achieve the significant reductions in CO₂ emissions that will be necessary to meet President Obama’s ambitious climate goals.

Back to the Obama administration’s CAFE proposal, a separate and distinct question is what will the effects be on the U.S. automobile industry? Will this be “good for the auto industry,” as the White House press release claimed? Doesn’t the presence of so many leading auto executives on the podium with the President clearly indicate that this regulatory change is good for the U.S. auto industry?

First, it is surely the case that a single national standard is better for the auto industry – and society more broadly – than the dual system that would have been brought about by the 14 Pavley states going forward with more stringent standards. There’s nothing new about the U.S. auto industry wanting a single national standard. Indeed, for this reason, the industry supported the enactment of Federal clean air legislation in the 1970s. We all prefer bad news to worse news, but that does not mean we welcome the bad news or that’s it good for us.

It’s also true that the U.S. auto industry has vastly less political clout now than it has had in decades, plus a much smaller share of the U.S. automobile market. The industry is in severe economic decline, indeed on the verge of bankruptcy, and it is depending now on massive government handouts. In this climate, it is hardly surprising that the U.S. auto industry is being exceptionally cooperative with the Federal government.

But is this policy in the long-term interest of the U.S. auto industry; is this “good for the U.S. auto industry?” The answer to that question is unknown. Keep in mind that for decades the U.S. auto manufacturers have just barely complied with CAFE standards each year, while Japanese manufacturers and importers have exceeded the standards. So, at first blush, it would appear that it may be easier — less costly — for Japanese companies than U.S. companies to meet the heightened fuel-efficiency standards. I’m not saying that the new standards will put the U.S. companies out of business, but simply that we don’t know at this point what the long-term impacts will be. In my view, one should be skeptical about claims to the contrary. As I’ve suggested in previous posts, the best reason to carry out environmental policies is that they are expected to be good for the environment.

Does economic analysis shortchange the future?

Decisions made today usually have impacts both now and in the future. In the environmental realm, many of the future impacts are benefits, and such future benefits — as well as costs — are typically discounted by economists in their analyses. Why do economists do this, and does it give insufficient weight to future benefits and thus to the well-being of future generations?

This is a question my colleague, Lawrence Goulder, a professor of economics at Stanford University, and I addressed in an article in Nature. We noted that as economists, we often encounter skepticism about discounting, especially from non-economists. Some of the skepticism seems quite valid, yet some reflects misconceptions about the nature and purposes of discounting. In this post, I hope to clarify the concept and the practice.

It helps to begin with the use of discounting in private investments, where the rationale stems from the fact that capital is productive – money earns interest. Consider a company trying to decide whether to invest $1 million in the purchase of a copper mine, and suppose that the most profitable strategy involves extracting the available copper 3 years from now, yielding revenues (net of extraction costs) of $1,150,000. Would investing in this mine make sense? Assume the company has the alternative of putting the $1 million in the bank at 5 per cent annual interest. Then, on a purely financial basis, the company would do better by putting the money in the bank, as it will have $1,000,000 x (1.05)³, or $1,157,625, that is, $7,625 more than it would earn from the copper mine investment.

I compared the alternatives by compounding to the future the up-front cost of the project. It is mathematically equivalent to compare the options by discounting to the present the future revenues or benefits from the copper mine. The discounted revenue is $1,150,000 divided by (1.05)³, or $993,413, which is less than the cost of the investment ($1 million). So the project would not earn as much as the alternative of putting the money in the bank.

Discounting translates future dollars into equivalent current dollars; it undoes the effects of compound interest. It is not aimed at accounting for inflation, as even if there were no inflation, it would still be necessary to discount future revenues to account for the fact that a dollar today translates (via compound interest) into more dollars in the future.

Can this same kind of thinking be applied to investments made by the public sector? Since my purpose is to clarify a few key issues in the starkest terms, I will use a highly stylized example that abstracts from many of the subtleties. Suppose that a policy, if introduced today and maintained, would avoid significant damage to the environment and human welfare 100 years from now. The ‘return on investment’ is avoided future damages to the environment and people’s well-being. Suppose that this policy costs $4 billion to implement, and that this cost is completely borne today. It is anticipated that the benefits – avoided damages to the environment – will be worth $800 billion to people alive 100 years from now. Should the policy be implemented?

If we adopt the economic efficiency criterion I have described in previous posts, the question becomes whether the future benefits are large enough so that the winners could potentially compensate the losers and still be no worse off? Here discounting is helpful. If, over the next 100 years, the average rate of interest on ordinary investments is 5 per cent, the gains of $800 billion to people 100 years from now are equivalent to $6.08 billion today. Equivalently, $6.08 billion today, compounded at an annual interest rate of 5 per cent, will become $800 billion in 100 years. The project satisfies the principle of efficiency if it costs current generations less than $6.08 billion, otherwise not.

Since the $4 billion of up-front costs are less than $6.08 billion, the benefits to future generations are more than enough to offset the costs to current generations. Discounting serves the purpose of converting costs and benefits from various periods into equivalent dollars of some given period. Applying a discount rate is not giving less weight to future generations’ welfare. Rather, it is simply converting the (full) impacts that occur at different points of time into common units.

Much skepticism about discounting and, more broadly, the use of benefit-cost analysis, is connected to uncertainties in estimating future impacts. Consider the difficulties of ascertaining, for example, the benefits that future generations would enjoy from a regulation that protects certain endangered species. Some of the gain to future generations might come in the form of pharmaceutical products derived from the protected species. Such benefits are impossible to predict. Benefits also depend on the values future generations would attach to the protected species – the enjoyment of observing them in the wild or just knowing of their existence. But how can we predict future generations’ values? Economists and other social scientists try to infer them through surveys and by inferring preferences from individuals’ behavior. But these approaches are far from perfect, and at best they indicate only the values or tastes of people alive today.

The uncertainties are substantial and unavoidable, but they do not invalidate the use of discounting (or benefit-cost analysis). They do oblige analysts, however, to assess and acknowledge those uncertainties in their policy assessments, a topic I discussed in my last post (“What Baseball Can Teach Policymakers”), and a topic to which I will return in the future.

The Making of a Conventional Wisdom

Despite the potential cost-effectiveness of market-based policy instruments, such as pollution taxes and tradable permits, conventional approaches – including design and uniform performance standards – have been the mainstay of U.S. environmental policy since before the first Earth Day in 1970. Gradually, however, the political process has become more receptive to innovative, market-based strategies. In the 1980s, tradable-permit systems were used to accomplish the phasedown of lead in gasoline (at a savings of about $250 million per year), and to facilitate the phaseout of ozone-depleting chloroflourocarbons (CFCs); and in the 1990’s, tradable permits were used to implement stricter air pollution controls in the Los Angeles metropolitan region, and – most important of all – a cap-and-trade system was adopted to reduce sulfur dioxide (SO₂) emissions and consequent acid rain by 50 percent under the Clean Air Act amendments of 1990 (saving about $1 billion per year in abatement costs). Most recently, cap-and-trade systems have emerged as the preferred national and regional policy instrument to address carbon dioxide (CO₂) emissions linked with global climate change (see my previous posts of February 6^th on an “Opportunity for a Defining Moment” and March 7^th on “Green Jobs”).

Why has there been a relatively recent rise in the use of market-based approaches? For academics like me, it would be gratifying to believe that increased understanding of market-based instruments had played a large part in fostering their increased political acceptance, but how important has this really been? In 1981, my Harvard colleague, political scientist Steven Kelman surveyed Congressional staff members, and found that support and opposition to market-based environmental policy instruments was based largely on ideological grounds: Republicans, who supported the concept of economic-incentive approaches, offered as a reason the assertion that “the free market works,” or “less government intervention” is desirable, without any real awareness or understanding of the economic arguments for market-based programs. Likewise, Democratic opposition was based largely upon ideological factors, with little or no apparent understanding of the real advantages or disadvantages of the various instruments. What would happen if we were to replicate Kelman’s survey today? My refutable hypothesis is that we would find increased support from Republicans, greatly increased support from Democrats, but insufficient improvements in understanding to explain these changes. So what else has mattered?

First, one factor has surely been increased pollution control costs, which have led to greater demand for cost-effective instruments. By the late 1980’s, even political liberals and environmentalists were beginning to question whether conventional regulations could produce further gains in environmental quality. During the previous twenty years, pollution abatement costs had continually increased, as stricter standards moved the private sector up the marginal abatement-cost curve. By 1990, U.S. pollution control costs had reached $125 billion annually, nearly a 300% increase in real terms from 1972 levels.

Second, a factor that became important in the late 1980’s was strong and vocal support from some segments of the environmental community. By supporting tradable permits for acid rain control, the Environmental Defense Fund seized a market niche in the environmental movement, and successfully distinguished itself from other groups. Related to this, a third factor was that the SO₂ allowance trading program, the leaded gasoline phasedown, and the CFC phaseout were all designed to reduce emissions, not simply to reallocate them cost-effectively among sources. Market-based instruments are most likely to be politically acceptable when proposed to achieve environmental improvements that would not otherwise be achieved.

Fourth, deliberations regarding the SO₂ allowance system, the lead system, and CFC trading differed from previous attempts by economists to influence environmental policy in an important way: the separation of ends from means, that is, the separation of consideration of goals and targets from the policy instruments used to achieve those targets. By accepting – implicitly or otherwise – the politically identified (and potentially inefficient) goal, the ten-million ton reduction of SO₂ emissions, for example, economists were able to focus successfully on the importance of adopting a cost-effective means of achieving that goal.

Fifth, acid rain was an unregulated problem until the SO₂ allowance trading program of 1990; and the same can be said for leaded gasoline and CFC’s. Hence, there were no existing constituencies – in the private sector, the environmental advocacy community, or government – for the status quo approach, because there was no status quo approach. We should be more optimistic about introducing market-based instruments for “new” problems, such as global climate change, than for existing, highly regulated problems, such as abandoned hazardous waste sites.

Sixth, by the late 1980’s, there had already been a perceptible shift of the political center toward a more favorable view of using markets to solve social problems. The George H. W. Bush Administration, which proposed the SO₂ allowance trading program and then championed it through an initially resistant Democratic Congress, was (at least in its first two years) “moderate Republican;” and phrases such as “fiscally responsible environmental protection” and “harnessing market forces to protect the environment” do have the sound of quintessential moderate Republican issues. But, beyond this, support for market-oriented solutions to various social problems had been increasing across the political spectrum for the previous fifteen years, as was evidenced by deliberations on deregulation of the airline, telecommunications, trucking, railroad, and banking industries. Indeed, by the mid-1990s, the concept (or at least the phrase), “market-based environmental policy,” had evolved from being politically problematic to politically attractive.

Seventh and finally, the adoption of the SO₂ allowance trading program for acid rain control – like any major innovation in public policy – can partly be attributed to a healthy dose of chance that placed specific persons in key positions, in this case at the White House, EPA, the Congress, and environmental organizations. The result was what remains the golden era in the United States for market-based environmental strategies.

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If you would like to read more about the factors that have brought about the changes that have occurred in the political reception given to market-based environmental policy instruments over the past two decades, here are some references:

Stavins, Robert N. “What Can We Learn from the Grand Policy Experiment? Positive and Normative Lessons from SO2 Allowance Trading.” Journal of Economic Perspectives, Volume 12, Number 3, pages 69-88, Summer 1998.

Keohane, Nathaniel O., Richard L. Revesz, and Robert N. Stavins. “The Choice of Regulatory Instruments in Environmental Policy.” Harvard Environmental Law Review, volume 22, number 2, pp. 313-367, 1998.

Hahn, Robert W. “The Impact of Economics on Environmental Policy.” Journal of Environmental Economics and Management 39(2000):375-399.

Hahn, Robert W., Sheila M. Olmstead, and Robert N. Stavins. “Environmental Regulation During the 1990s: A Retrospective Analysis.” Harvard Environmental Law Review, volume 27, number 2, 2003, pp. 377-415.