Pursuing Real Environmental Justice in California

California Governor Jerry Brown plans to move forward with the implementation of Assembly Bill 32, the Global Warming Solutions Act, under which California seeks to take dramatic steps to reduce its greenhouse gas emissions. Questions have been raised about the wisdom of a single state trying to address a global commons problem, but with national climate policy developments having slowed dramatically in Washington, California is now the focal point of meaningful U.S. climate policy action.

California’s Plan

A key element of the mechanisms to be used for achieving California’s ambitious emissions reductions will be cap-and-trade, a promising approach with a successful track record, despite its recent demonization as “cap-and-tax” by conservatives and other opponents in the U.S. Congress.

Under this approach, regulators restrict emissions by issuing a limited number of emission allowances, with the number of allowances ratcheted down over time, thus assuring ever-larger reductions in overall emissions. Pollution sources such as electric power plants and factories are allowed to trade allowances, and as a result, sources able to reduce emissions least expensively take on more of the pollution-reduction effort. Experience has shown that cap-and-trade programs achieve emissions reductions at dramatically lower cost than conventional regulation.

Concerns

Yet some groups in California have been very uneasy about the prospect of cap-and-trade. In particular, the Environmental Justice movement has opposed this approach, citing concerns that it would hurt low-income communities. Professor Lawrence Goulder of Stanford University and I addressed such concerns in an article in The Sacramento Bee.

One expressed concern has been that a cap-and-trade policy might increase pollution in low-income or minority communities. The apprehension is not about greenhouse gases (the focus of AB 32), since these gases spread evenly around the globe and thus would have no discernible impact in the immediate area. Rather, it’s about “co-pollutants,” such as nitrogen oxides, carbon monoxide, and particulates, which can be emitted alongside greenhouse gases.

Because a cap-and-trade system would reduce California’s overall greenhouse gas emissions, it would also lower the state’s emissions of co-pollutants. Still, it’s possible, though unlikely, that co-pollutant emissions would increase in a particular locality. But here it’s crucial to recognize that existing air pollution laws address such pollutants, and so any greenhouse gas allowance trades that would violate local air pollution limits would be prohibited.

If current limits for co-pollutants are thought to be insufficient, the best response is not to scuttle a statewide system that can achieve AB 32’s ambitious targets at minimum cost. Rather, the most environmentally and economically effective way to address such pollution is to revisit existing local pollution laws and perhaps make them more stringent.

While much attention has rightly been given to the effects of potential climate policies on environmental conditions in low-income communities, it’s also important to consider their economic impacts on these communities. Reducing greenhouse gas emissions will require greater reliance on more costly energy sources and more costly appliances, vehicles and other equipment. Because low-income households devote greater shares of their income to energy and transportation costs than do higher-income households, virtually any climate policy will place relatively greater burdens on low-income households. But because cap-and-trade will minimize energy-related and other costs, it holds an important advantage in this regard over conventional regulations.

Moreover, a cap-and-trade system gives the public a tool for compensating low-income communities for the potential economic burdens: If some emission allowances are auctioned, revenues can be used to mitigate economic burdens on these communities.

The Way Forward

All in all, cap-and-trade serves the goal of environmental justice better than the alternatives. This progressive policy instrument merits a central place in the arsenal of weapons California employs. Beyond helping the state meet its emissions-reduction targets at the lowest cost, it offers a promising way to reduce economic burdens on low-income and minority communities.

Renewable Energy Standards: Less Effective, More Costly, but Politically Preferred to Cap-and-Trade?

The new Congress is beginning to consider various alternative energy and climate policies in the wake of last year’s collapse in the U.S. Senate of consideration of a meaningful, economy-wide CO₂ cap-and-trade scheme. Among the options receiving attention are various types of renewable portfolio standards, also known as renewable electricity standards or clean energy standards, depending upon their specific design. These approaches, which focus exclusively on one sector of the economy, would be less effective than a comprehensive cap-and-trade approach, would be more costly per unit of what is achieved, and yet – ironically – appear to be much more attractive to some politicians who strenuously opposed cap-and-trade.

True enough, these standards can be designed in a variety of ways, some of which are better and some of which are worse. But the better their design (as a CO₂ reducing policy), the closer they come to the much-demonized cap-and-trade approach.

In an op-ed which appeared on November 24^th in The Huffington Post (click here for link to the original op-ed), Richard Schmalensee and I reflected on this irony. Rather than summarize (or expand on) our op-ed, I simply re-produce it below as it was published by The Huffington Post, with some hyperlinks added for interested readers.

For anyone who is not familiar with Dick Schmalensee, please note that he is the Howard W. Johnson Professor of Economics and Management at MIT, where he served as the Dean of the Sloan School of Management from 1998 to 2007. Also, he served as a Member of the President’s Council of Economic Advisers in the George H. W. Bush administration from 1989 to 1991. By the way, in a previous blog post, I featured a different op-ed that Dick and I wrote in The Boston Globe in July of last year (“Beware of Scorched-Earth Strategies in Climate Debates”).

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Renewable Irony

by Richard Schmalensee and Robert Stavins

The Huffington Post, November 24, 2010

One day after the election, the White House press secretary Robert Gibbs said that a national renewable electricity standard could be an area of bipartisan energy cooperation, after President Obama had said cap-and-trade was not the only way “to skin the cat.” It is ironic that while cap-and-trade — a sensible approach to reducing carbon dioxide emissions linked with climate change — is dead and buried in the Senate, considerable support has emerged for an approach that would be both less effective and more costly. A national renewable electricity standard would mandate that a given share of an electric company’s production come from renewable sources (most likely wind power), or, in the case of a “clean energy standard,” from an expanded list including nuclear and hydroelectric power.

One irony is that cap-and-trade is a market-based approach to environmental protection, which harnesses the power of the marketplace to reduce costs imposed on business and consumers, an approach championed by Republican presidents beginning with Ronald Reagan. Within its narrow domain, the renewable standard approach, which involves nationwide trading of renewable energy credits, is also market-based. Whereas cap-and-trade would raise the cost of fossil fuel, as its opponents have stressed so effectively, renewable standards would raise the cost of electricity, which its supporters seem reluctant to admit. If renewables really were cheaper, even with Federal subsidies, it wouldn’t take regulation to get utilities to use them.

A second source of irony is that renewable or clean electricity standards are a very expensive way to reduce carbon dioxide (CO₂) emissions — much more expensive than cap-and-trade. These standards would only affect electricity, thereby omitting about 60 percent of U.S. CO₂ emissions. And even then, the standards would provide limited incentives to substitute away from coal, the most carbon-intensive way to generate electricity. Even more problematic, renewable/clean electricity standards would provide absolutely no incentives to reduce CO₂ emissions from heating buildings, running industrial processes, or transporting people and goods. And unlike cap-and-trade, which would also affect oil consumption, the electricity standards would make no contribution to energy security. Only a very tiny fraction of U.S. oil consumption is used to generate electricity.

Increasing renewable electricity generation is no more than a means to an end for one part of the economy. Cap-and-trade keeps our eyes on the prize: moving the entire economy toward climate-friendly energy generation and use.

Those who believe that renewable electricity standards would create a huge number of green jobs have forgotten the lesson of Detroit: a large domestic market does not guarantee a healthy domestic industry. At the end of 2008, for instance, the U.S. led the world in installed wind generation capacity, but half of new installations that year were accounted for by imports. And a recent Lawrence Berkeley Laboratory study of the impacts of the economic stimulus package incentives for renewable electricity investments estimated that about 40 percent of the (gross) jobs created by new wind-energy investments were outside the United States, where many wind turbines are manufactured.

A sounder approach, for those concerned about green jobs, would focus on the long-term determinants of economic growth, such as technological innovation. That’s where cap-and-trade — which creates broad-based incentives for technology innovation — holds another edge over renewable electricity standards.

It is often argued that if cap-and-trade is dead, enacting renewable or clean electricity standards is better than doing nothing at all about climate change. While that argument has some merit, since the risks of doing nothing are substantial, there is a real danger that enacting these standards will create the illusion that we have done something serious to address climate change. Worse yet, it could create a favored set of businesses that will oppose future adoption of more efficient, serious, broad-based policies — like cap-and-trade.

If a national renewable electricity standard is nonetheless inevitable, it should not impose excess costs on businesses or consumers. It should pre-empt state renewable portfolio standards, since with a national standard in place, states’ programs simply impose extra costs on their citizens without affecting national use of renewables at all. And any national program should allow unlimited banking to encourage early investments. No environmental or economic purpose is served by limiting banking to two years, as current Senate legislation would do.

Carbon cap-and-trade has been killed in the Senate, presumably because of its costs. Renewable electricity standards or clean energy standards would accomplish considerably less and would impose much higher costs per ton of emissions reduction than cap-and-trade would. This does not sound like a step forward.

Richard Schmalensee is the Howard W. Johnson Professor of Economics and Management at the Massachusetts Institute of Technology; Robert N. Stavins is the Albert Pratt Professor of Business and Government at the Harvard Kennedy School.

Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy

For many years, there has been a great deal of discussion about carbon-pricing – whether carbon taxes or cap-and-trade – as an essential part of a meaningful national climate policy. It has long been recognized that although carbon-pricing will be necessary, it will not be sufficient. Economists and other policy analysts have noted that policies intended to foster climate-friendly technology research and development (R&D) will also be necessary, but likewise will not be sufficient on their own.

Some recent studies and press accounts, which I reference below, have identified these two approaches to addressing CO₂ emissions as substitutes, rather than complements. That is fundamentally inconsistent with decades of research, and so my purpose in this essay is to set the record straight.

Carbon Pricing: Necessary But Not Sufficient

First of all, why is there so much talk among policy analysts and policy makers – not simply among academics – about carbon‑pricing as the core of a meaningful strategy to reduce CO₂ emissions? Why, in fact, is this approach so overwhelmingly favored by the analytical community? The answer is simple and surprisingly pragmatic.

First, there is no other feasible approach that can provide meaningful emissions reductions, such as the 80 percent reduction in national CO₂ emissions by 2050 that was part of the legislation passed by the U.S. House of Representatives and proposed in the Senate and part of the Obama administration’s conditional pledge under the Copenhagen Accord. Because of the ubiquity and diversity of energy use in a modern economy, conventional regulatory approaches –standards of various kinds – simply cannot do the job. Only carbon pricing – either in the form of carbon taxes or cap-and-trade – can significantly tilt in a climate-friendly direction the millions of decentralized decisions that are made in our economy every day.

Second, carbon-pricing is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources. Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost.

Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time.

For these reasons, carbon-pricing is a necessary component of a truly meaningful national climate policy. [I’ve written about this in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”] However, although it is a necessary policy component, carbon-pricing is not sufficient on its own. This is because there are other market failures that dilute the impacts of price signals on decision makers.

Technology R&D Policies: Also Necessary, Also Not Sufficient

The most important of these “other market failures” is the public good nature of information. Companies carrying out research and development (R&D) incur the full costs of their efforts, but they do not capture the full benefits. This is because even with a perfectly-enforced system of intellectual property rights (such as patents), there are tremendous spillover benefits to other firms. Decades of economic research – much of it by my former colleague and co-author, Professor Adam Jaffe, now Dean of Arts and Sciences at Brandeis University – has analyzed with empirical (econometric) analysis the remarkable degree to which inventions and innovations by one firm provide valuable information that leads to new inventions and innovations by other firms.

So, firms pay the costs of their R&D, but do not reap all the benefits. The existence of this positive externality of firms’ R&D – or put differently, the public-good nature of the information generated by R&D – means that the private sector will carry out less than the “efficient” amount of R&D of new climate-friendly technologies in response to given carbon prices. Hence, other public policies are needed to address this “R&D market failure.”

New path-breaking technologies will be needed to address climate change, and public support for private-sector or public-sector R&D will be crucial to meet this need. But, at the same time, to address the climate-change market failure itself (that is, the externality associated with greenhouse gas emissions), carbon pricing will be necessary, for all of the reasons I gave above. This is an application of an important and fundamental principle in economics: two market failures require the use of two policy instruments.

Empirical analyses have repeatedly verified this crucial point – that combining carbon-pricing with R&D support is more cost-effective than adopting either approach alone. Included in this set of studies are the following: Carolyn Fischer (Resources for the Future) and Richard Newell (U.S. Energy Information Administration, on leave from Duke University), “Environmental and Technology Policies for Climate Mitigation”; Stephen Schneider (late of Stanford University) and Lawrence Goulder (Stanford University), “Achieving Low-Cost Emissions Targets”; and Daren Acemoglu (MIT), Philippe Aghion, Leonardo Bursztyn, and David Hemous (Harvard University), “The Environment and Directed Technical Change.”

Complements, Not Substitutes

An interesting, recent column, “Next Step on Policy for Climate,” by David Leonhardt in the New York Times (October 13, 2010, p. B1) might give some people the mistaken impression that technology policies are an adequate, even sensible substitute for carbon-pricing. That was not the intended message of the column. In fact, Leonhardt – perhaps the leading economic journalist writing today in the United States – indicates clearly in his column that he is skeptical of the notion of thinking of technology subsidies as an adequate substitute for carbon-pricing (in particular, cap-and-trade). And in a follow-up post at the New York Times’ Economix, he makes clear that “these two policies are not mutually exclusive.”

Nevertheless, Leonhardt’s original column (which included a very nice profile of my colleague, Professor Michael Greenstone of MIT) focused attention on a recent report – a report that could give the false impression that technology policies would be a sensible substitute for serious carbon-pricing. The report in question – “Post-Partisan Power” – received significant coverage, primarily because of its sponsorship: a combination of a prominent Republican-oriented Washington think tank, the American Enterprise Institute (AEI), and an equally prominent Democratic-oriented Washington think tank, the Brooking Institution (and a third partner, the Breakthrough Institute, a California-based environmental think tank).

The report may well garner some bi-partisan political support, because it promises a free lunch of painless, win-win solutions, a promise that will resonate with many elected officials. Indeed, the report’s sub-title is “how a limited and direct approach to energy innovation can deliver clean, cheap energy, economic productivity, and national prosperity.” What’s not to like? And the authors are presumably smart and politically shrewd. I know that’s the case with the AEI author, Steven Hayward, who I debated last year in the pages of the Wall Street Journal.

To its credit, the report lays out a menu of policies intended to stimulate carbon-friendly technological change, ranging from $500 million of Federal government funding of K-12 curriculum development and teacher training to $25 billion annually of direct Federal funding of energy innovation.

For the reasons I explained above (the “R&D market failure” and the “carbon emissions externality”), both direct technology R&D policies and serious carbon-pricing are necessary, but neither is sufficient on its own. Unfortunately, this new report – and some of the press coverage surrounding it – makes the claim that such direct government funding of technology innovation is a sufficient and sensible substitute for meaningful carbon-pricing. That claim is both unfortunate and wrong, as it is supported neither by sound reasoning nor empirical research, as I have described above.

Again, many of the individual technology policy recommendations offered by the AEI-Brookings-BI report are worthy of serious consideration (as a complement, not a substitute for an economy-wide carbon-pricing policy). But the specifics – indeed, much of the meat – are missing. “Reform the nation’s morass of energy subsidies” – yes, but exactly which subsidies (all of which have important political constituencies behind them) will be eliminated? “Recognize the potential for nuclear power” – yes, and both the House and Senate carbon-pricing schemes would have provided tremendous incentives for nuclear power investment.

Overall, there should be concern about how all of this will be funded. Where will the $25 billion per year come from? The report appropriately states that this should not come from general revenues, and thus add to the Federal debt. “Phasing out current subsidies for wind, solar, ethanol, and fossil fuels” could be meritorious on its own, but how much does this generate, and does it even pass a political laugh-test? Interestingly, beyond this, despite considerable rhetoric about moving beyond debates about carbon-pricing, the report recommends that in order to avoid adding to the Federal debt, it would be necessary to impose new taxes, including increased royalties for oil and gas extraction, a tax on imported oil, a tax on electricity sales, and a “very small carbon price” (presumably from a modest carbon tax or unambitious cap-and-trade system).

The actual numbers would be helpful, and the political feasibility remains a serious question. The political challenges that emerged in the effort to pass cap-and-trade climate legislation will not magically disappear if there’s an attempt to induce Congress to approve $25 billion in funding. As Tom Friedman noted on October 12^th in the New York Times, Congress has not come close to fully funding the outstanding requests for about $4 billion for ARPA-E (energy) research.

More broadly, despite the attraction of the AEI-Brookings-BI proposal as a potential complement to carbon-pricing (and I am serious that the proposal is of value in that context), one has to be very careful about comparing proposed new policies in idealized form (for example, precisely the right subsidies eliminated and precisely the right new subsidies introduced) with real policies with all their warts (for example, the cap-and-trade bill that was passed by the House last year). Making such comparisons can lead to flawed analysis and misleading results.

This is not a new issue. Robert Hahn and I wrote about this generic problem nearly 20 years ago in an article (“Economic Incentives for Environmental Protection: Integrating Theory and Practice”) which appeared the American Economic Review Papers and Proceedings (May 1992). At the time, our concern was that this mistake was being made not by the opponents but by the supporters of cap-and-trade and other (then essentially untested) market-based instruments. We worried that “many analysts use highly stylized benchmarks for comparison that ignore likely political realities,” and suggested that an appropriate “comparison would be between actual command-and-control policies and either actual trading [cap-and-trade] programs … or a reasonably constrained theoretical … program.”

Likewise today, when carrying out comparisons of policy alternatives, it is fine to compare two theoretical, idealized alternatives, or to compare two real-world policies, but it is problematic and usually misleading to compare a theoretical, idealized policy of one type with a real-world example of another type of policy.

The Bottom Line

Carbon-pricing – whether carbon taxes or cap-and-trade – will be an essential part of any truly meaningful national climate policy. Likewise, to address the “R&D market failure,” direct technology innovation policies will also be required. Both are necessary. Neither is sufficient. These are complements, not substitutes.

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Postscript: Four years ago, the U.S. Congressional Budget Office (CBO) — widely recognized for its non-partisan, first-rate research — produced a study on the same topic as the AEI-Brookings-BI report, but did so with rigor and without ideology. The CBO report — Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide Emissions (September 2006) — was prepared by Dr. Terry Dinan, a long-time, respected CBO economist, and was peer reviewed by an impressive set of academic and other experts. Sadly, the CBO paper received little press coverage, despite its high quality and its relevance. For anyone interested in the topic of this post, particularly those who disagree with my theme, I hope you will read the CBO report.

Also, a reader of this blog post sent me a paper by David Hart and Kadri Kallas (from MIT’s Energy Innovation working paper series) that examines “Alignment and Misalignment of Technology Push and Regulatory Pull.” It’s worth reading in the context of combining carbon pricing and technology R&D policies.