regulation Archives - Page 18 of 20 - An Economic View of the Environment

Is Benefit-Cost Analysis Helpful for Environmental Regulation?

With the locus of action on Federal climate policy moving this week from the House of Representatives to the Senate, this is a convenient moment to step back from the political fray and reflect on some fundamental questions about U.S. environmental policy.

One such question is whether economic analysis – in particular, the comparison of the benefits and costs of proposed policies – plays a truly useful role in Washington, or is it little more than a distraction of attention from more important perspectives on public policy, or – worst of all – is it counter-productive, even antithetical, to the development, assessment, and implementation of sound policy in the environmental, resource, and energy realms. With an exceptionally talented group of thinkers – including scientists, lawyers, and economists – now in key environmental and energy policy positions at the White House, the Environmental Protection Agency, the Department of Energy, and the Department of the Treasury, this question about the usefulness of benefit-cost analysis is of particular importance.

For many years, there have been calls from some quarters for greater reliance on the use of economic analysis in the development and evaluation of environmental regulations. As I have noted in previous posts on this blog, most economists would argue that economic efficiency — measured as the difference between benefits and costs — ought to be one of the key criteria for evaluating proposed regulations. (See: “The Myths of Market Prices and Efficiency,” March 3, 2009; “What Baseball Can Teach Policymakers,” April 20, 2009; “Does Economic Analysis Shortchange the Future?” April 27, 2009) Because society has limited resources to spend on regulation, such analysis can help illuminate the trade-offs involved in making different kinds of social investments. In this sense, it would seem irresponsible not to conduct such analyses, since they can inform decisions about how scarce resources can be put to the greatest social good.

In principle, benefit-cost analysis can also help answer questions of how much regulation is enough. From an efficiency standpoint, the answer to this question is simple — regulate until the incremental benefits from regulation are just offset by the incremental costs. In practice, however, the problem is much more difficult, in large part because of inherent problems in measuring marginal benefits and costs. In addition, concerns about fairness and process may be very important economic and non-economic factors. Regulatory policies inevitably involve winners and losers, even when aggregate benefits exceed aggregate costs.

Over the years, policy makers have sent mixed signals regarding the use of benefit-cost analysis in policy evaluation. Congress has passed several statutes to protect health, safety, and the environment that effectively preclude the consideration of benefits and costs in the development of certain regulations, even though other statutes actually require the use of benefit-cost analysis. At the same time, Presidents Carter, Reagan, Bush, Clinton, and Bush all put in place formal processes for reviewing economic implications of major environmental, health, and safety regulations. Apparently the Executive Branch, charged with designing and implementing regulations, has seen a greater need than the Congress to develop a yardstick against which regulatory proposals can be assessed. Benefit-cost analysis has been the yardstick of choice

It was in this context that ten years ago a group of economists from across the political spectrum jointly authored an article in Science magazine, asking whether there is role for benefit-cost analysis in environmental, health, and safety regulation. That diverse group consisted of Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and myself. That article and its findings are particularly timely, with President Obama considering putting in place a new Executive Order on Regulatory Review.

In the article, we suggested that benefit-cost analysis has a potentially important role to play in helping inform regulatory decision making, though it should not be the sole basis for such decision making. We offered eight principles.

First, benefit-cost analysis can be useful for comparing the favorable and unfavorable effects of policies, because it can help decision makers better understand the implications of decisions by identifying and, where appropriate, quantifying the favorable and unfavorable consequences of a proposed policy change. But, in some cases, there is too much uncertainty to use benefit-cost analysis to conclude that the benefits of a decision will exceed or fall short of its costs.

Second, decision makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Removing statutory prohibitions on the balancing of benefits and costs can help promote more efficient and effective regulation.

Third, benefit-cost analysis should be required for all major regulatory decisions. The scale of a benefit-cost analysis should depend on both the stakes involved and the likelihood that the resulting information will affect the ultimate decision.

Fourth, although agencies should be required to conduct benefit-cost analyses for major decisions, and to explain why they have selected actions for which reliable evidence indicates that expected benefits are significantly less than expected costs, those agencies should not be bound by strict benefit-cost tests. Factors other than aggregate economic benefits and costs may be important.

Fifth, benefits and costs of proposed policies should be quantified wherever possible. But not all impacts can be quantified, let alone monetized. Therefore, care should be taken to assure that quantitative factors do not dominate important qualitative factors in decision making. If an agency wishes to introduce a “margin of safety” into a decision, it should do so explicitly.

Sixth, the more external review that regulatory analyses receive, the better they are likely to be. Retrospective assessments should be carried out periodically.

Seventh, a consistent set of economic assumptions should be used in calculating benefits and costs. Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

Eighth, while benefit-cost analysis focuses primarily on the overall relationship between benefits and costs, a good analysis will also identify important distributional consequences for important subgroups of the population.

From these eight principles, we concluded that benefit-cost analysis can play an important role in legislative and regulatory policy debates on protecting and improving the natural environment, health, and safety. Although formal benefit-cost analysis should not be viewed as either necessary or sufficient for designing sensible public policy, it can provide an exceptionally useful framework for consistently organizing disparate information, and in this way, it can greatly improve the process and hence the outcome of policy analysis.

If properly done, benefit-cost analysis can be of great help to agencies participating in the development of environmental regulations, and it can likewise be useful in evaluating agency decision making and in shaping new laws (which brings us full-circle to the climate legislation that will be developed in the U.S. Senate over the weeks and months ahead, and which I hope to discuss in future posts).

The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey

The headline of this post is not meant to be ironic. Despite all the hand-wringing in the press and the blogosphere about a political “give-away” of allowances for the cap-and-trade system in the Waxman-Markey bill voted out of committee last week, the politics of cap-and-trade systems are truly quite wonderful, which is why these systems have been used, and used successfully.

The Waxman-Markey allocation of allowances has its problems, which I will get to, but before noting those problems it is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems: the allocation of allowances – whether the allowances are auctioned or given out freely, and how they are freely allocated – has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs. (Well, there are some relatively minor, but significant caveats – those “problems” I mentioned — about which more below.) By the way, this independence of a cap-and-trade system’s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery in a path-breaking article in the Journal of Economic Theory (based upon his 1971 Harvard economics Ph.D. dissertation). It has been validated with empirical evidence repeatedly over the years.

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms’ production and emission reduction decisions. Firms face the same emissions cost regardless of the allocation method. When using an allowance, whether it was received for free or purchased, a firm loses the opportunity to sell that allowance, and thereby recognizes this “opportunity cost” in deciding whether to use the allowance. Consequently, the allocation choice will not influence a cap’s overall costs.

Manifest political pressures lead to different initial allocations of allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness. This means that ordinary political pressures need not get in the way of developing and implementing a scientifically sound, economically rational, and politically pragmatic policy. Contrast this with what would happen when political pressures are brought to bear on a carbon tax proposal, for example. Here the result will most likely be exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs (as some low-cost emission reduction opportunities are left off the table). Furthermore, the hypothetical carbon tax example is the norm, not the exception. Across the board, political pressures often reduce the effectiveness and increase the cost of well-intentioned public policies. Cap-and-trade provides natural protection from this. Distributional battles over the allowance allocation in a cap-and-trade system do not raise the overall cost of the program nor affect its environmental impacts.

In fact, the political process of states, districts, sectors, firms, and interest groups fighting for their share of the pie (free allowance allocations) serves as the mechanism whereby a political constituency in support of the system is developed, but without detrimental effects to the system’s environmental or economic performance. That’s the good news, and it should never be forgotten.

But, depending upon the specific allocation mechanisms employed, there are several ways that the choice to freely distribute allowances can affect a system’s cost. Here’s where the “caveats” and “problems” come in.

First, auction revenue may be used in ways that reduce the costs of the existing tax system or fund other socially beneficial policies. Free allocations to the private sector forego such opportunities. Below I will estimate the actual share of allowance value that accrues to the private sector.

Second, some proposals to freely allocate allowances to electric utilities may affect electricity prices, and thereby affect the extent to which reduced electricity demand contributes to limiting emissions cost-effectively. Waxman-Markey allocates allowances to local distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets. So, electricity prices would likely be affected by these allocations under existing state regulatory regimes. The Waxman-Markey legislation seeks to address this problem by specifying that the economic value of the allowances given to electricity and natural gas local distribution companies should be passed on to consumers through lump-sum rebates, not through a reduction in electricity rates, thereby compensating consumers for increases in electricity prices, but without reducing incentives for energy conservation.

Third, and of most concern in the context of the Waxman-Markey legislation, “output-based updating allocations” provide perverse incentives and drive up costs of achieving a cap. This merits some explanation. If allowances are freely allocated, the allocation should be on the basis of some historical measures, such as output or emissions in a (previous) base year, not on the basis of measures which firms can affect, such as output or emissions in the current year. Updating allocations, which involve periodically adjusting allocations over time to reflect changes in firms’ operations, contrast with this.

An output-based updating allocation ties the quantity of allowances that a firm receives to its output (production). Such an allocation is essentially a production subsidy. This distorts firms’ pricing and production decisions in ways that can introduce unintended consequences and may significantly increase the cost of meeting an emissions target. Updating therefore has the potential to create perverse, undesirable incentives.

In Waxman-Markey, updating allocations are used for specific sectors with high CO₂ emissions intensity and unusual sensitivity to international competition, in an effort to preserve international competitiveness and reduce emissions leakage. It’s an open question whether this approach is superior to an import allowance requirement, whereby imports of a small set of specific commodities must carry with them CO₂ allowances. The problem with import allowance requirements is that they can damage international trade relations. The only real solution to the competitiveness issue is to bring non-participating countries within an international climate regime in meaningful ways. (On this, please see the work of the Harvard Project on International Climate Agreements.)

Also, output-based allocations are used in Waxman-Markey for merchant coal generators, thereby discouraging reductions in coal-fired electricity generation, another significant and costly distortion.

Now, let’s go back to the hand-wringing in the press and blogosphere about the so-called massive political “give-away” of allowances. Perhaps unintentionally, there has been some misleading press coverage, suggesting that up to 75% or 80% of the allowances are given away to private industry as a windfall over the life of the program, 2012-2050 (in contrast with the 100% auction originally favored by President Obama).

Given the nature of the allowance allocation in the Waxman-Markey legislation, the best way to assess its implications is not as “free allocation” versus “auction,” but rather in terms of who is the ultimate beneficiary of each element of the allocation and auction, that is, how the value of the allowances is allocated. On closer inspection, it turns out that many of the elements of the apparently free allocation accrue to consumers and public purposes, not private industry.

First of all, let’s looks at the elements which will accrue to consumers and public purposes. Next to each allocation element is the respective share of allowances over the period 2012-2050 (measured as share of the cap, after the removal – sale — of allowances to private industry from a “strategic reserve,” which functions as a cost-containment measure.):

a. Electricity and natural gas local distribution companies (22.2%), minus share (6%) that benefits industry as consumers of electricity (note: there is a consequent 3% reduction in the allocation to energy-intensive trade-exposed industries, below, which is then dedicated to broad-based consumer rebates, below), 22.2 – 6 = 16.2%

b. Home heating oil/propane, 0.9%

c. Protection for low- and moderate-income households, 15.0%

d. Worker assistance and job training, 0.8%

e. States for renewable energy, efficiency, and building codes, 5.8%

f. Clean energy innovation centers, 1.0%

g. International deforestation, clean technology, and adaptation, 8.7%

h. Domestic adaptation, 5.0%

The following elements will accrue to private industry, again with average (2012-2050) shares of allowances:

i. Merchant coal generators, 3.0%

j. Energy-intensive, trade-exposed industries (minus reduction in allocation due to EITE benefits from LDC allocation above) 8.0% – 3% = 5%

k. Carbon-capture and storage incentives, 4.1%

l. Clean vehicle technology standards, 1.0%

m. Oil refiners, 1.0%

n. Net benefits to industry as consumers of lower-priced electricity from allocation to LDCs, 6.0%

The split over the entire period from 2012 to 2050 is 53.4% for consumers and public purposes, and 20.1% for private industry. This 20% is drastically different from the suggestions that 70%, 80%, or more of the allowances will be given freely to private industry in a “massive corporate give-away.”

All categories – (a) through (n), above – sum to 73.5% of the total quantity of allowances over the period 2012-2050. The remaining allowances — 26.5% over 2012 to 2050 — are scheduled in Waxman-Markey to be used almost entirely for consumer rebates, with the share of available allowances for this purpose rising from approximately 10% in 2025 to more than 50% by 2050. Thus, the totals become 79.9% for consumers and public purposes versus 20.1% for private industry, or approximately 80% versus 20% — the opposite of the “80% free allowance corporate give-away” featured in many press and blogosphere accounts. Moreover, because some of the allocations to private industry are – for better or for worse – conditional on recipients undertaking specific costly investments, such as investments in carbon capture and storage, part of the 20% free allocation to private industry should not be viewed as a windfall.

Speaking of the conditional allocations, I should also note that some observers (who are skeptical about government programs) may reasonably question some of the dedicated public purposes of the allowance distribution, but such questioning is equivalent to questioning dedicated uses of auction revenues. The fundamental reality remains: the appropriate characterization of the Waxman-Markey allocation is that 80% of the value of allowances go to consumers and public purposes, and 20% to private industry.

Finally, it should be noted that this 80-20 split is roughly consistent with empirical economic analyses of the share that would be required – on average — to fully compensate (but no more) private industry for equity losses due to the policy’s implementation. In a series of analyses that considered the share of allowances that would be required in perpetuity for full compensation, Bovenberg and Goulder (2003) found that 13 percent would be sufficient for compensation of the fossil fuel extraction sectors, and Smith, Ross, and Montgomery (2002) found that 21 percent would be needed to compensate primary energy producers and electricity generators.

In my work for the Hamilton Project in 2007, I recommended beginning with a 50-50 auction-free-allocation split, moving to 100% auction over 25 years, because that time-path of numerical division between the share of allowances that is freely allocated to regulated firms and the share that is auctioned is equivalent (in terms of present discounted value) to perpetual allocations of 15 percent, 19 percent, and 22 percent, at real interest rates of 3, 4, and 5 percent, respectively. My recommended allocation was designed to be consistent with the principal of targeting free allocations to burdened sectors in proportion to their relative burdens, while being politically pragmatic with more generous allocations in the early years of the program.

So, the Waxman-Markey 80/20 allowance split turns out to be consistent — on average, i.e. economy-wide — with independent economic analysis of the share that would be required to fully compensate (but no more) the private sector for equity losses due to the imposition of the cap, and consistent with my Hamilton Project recommendation of a 50/50 split phased out to 100% auction over 25 years.

Going forward, many observers and participants in the policy process may continue to question the wisdom of some elements of the Waxman-Markey allowance allocation. There’s nothing wrong with that.

But let’s be clear that, first, for the most part, the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost.

Second, questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.

Third, we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled. On the contrary, 80% of the value of allowances accrue to consumers and public purposes, and some 20% accrue to covered, private industry. This split is roughly consistent with the recommendations of independent economic research.

Fourth and finally, it should not be forgotten that the much-lamented deal-making that took place in the House committee last week for shares of the allowances for various purposes was a good example of the useful, important, and fundamentally benign mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled (without reducing the policy’s effectiveness or driving up its cost).

Although there has surely been some insightful press coverage and intelligent public debate (including in the blogosphere) about the pros and cons of cap-and-trade, the Waxman-Markey legislation, and many of its design elements, it is remarkable (and unfortunate) how misleading so much of the coverage has been of the issues and the numbers surrounding the proposed allowance allocation.

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.