vintage differentiated regulation Archives - An Economic View of the Environment

Cap-and-Trade versus the Alternatives for U.S. Climate Policy

Let’s credit Senator Lisa Murkowski (R-Alaska) for raising questions in the National Journal about the viability of cap-and-trade versus other approaches for the United States to employ in addressing CO₂ and other greenhouse gas emissions linked with global climate change.

Senator Murkowski says that only one approach – cap-and-trade – has received significant attention in the Congress. Let’s put aside for the moment the fact that most of the 1,428 pages of H.R. 2454 – the American Clean Energy and Security Act of 2009 (otherwise known as the Waxman-Markey bill) – are not about cap-and-trade at all, but about a host of other regulatory approaches (several of which are highly problematic, as I’ve discussed in a previous post). We can also put aside the fact that both conventional regulatory approaches and carbon taxes have been discussed repeatedly in numerous House and Senate committees over the past decade, and received detailed attention from a succession of U.S. administrations.

So, let’s not quibble about the Senator’s claim that cap-and-trade is the only approach that has received serious attention. Instead, let’s address the key substantive questions which Senator Murkowski raises, because they are important questions: Is cap-and-trade the most effective way of addressing climate change? And are there other approaches capable of achieving the same results at lower cost? From my perspective, as a card-carrying environmental economist, these are indeed the key questions.

While political leaders in the European Union, Canada, Australia, New Zealand, Japan, and the United States (Congress) move toward cap-and-trade systems as their preferred approach for achieving meaningful reductions in emissions of CO₂ and other greenhouse gases, many people – including some of my fellow economists — have been critical of the cap-and-trade approach in the climate context and have endorsed the use of carbon taxes. The Senator is correct that we should reflect on the merits of that alternative approach.

But, first, what about conventional regulatory approaches, that is, performance standards and technology standards?

Conventional Regulatory Standards

In short, experience has shown that such standards cannot ensure achievement of emissions targets, create problematic unintended consequences, and are very costly for what they achieve.

Why can conventional standard not ensure achievement of reasonable emissions targets? First, standards typically focus on new emissions sources, and do not address emissions from existing sources. Think about greenhouse gas standards for new cars and new power plants, for example. Second, standards cannot possibly address all types of new sources, given the ubiquity of energy generation and use (and hence CO₂ emissions) in a modern economy. Third, emissions depend upon many factors that cannot be addressed by standards, such as: emissions from existing sources and unregulated new sources; how quickly the existing capital stock is replaced; the growth in the number of new emissions sources; and how intensively emissions-generating plants and equipment are utilized.

Next, what about those unintended consequences? First, by reducing operating costs, energy-efficiency standards – for example — can cause more intensive use of regulated equipment (for example, air conditioners are run more often), leading to offsetting increases in emissions — the “rebound effect.” Second, firms and households may delay replacing existing equipment if standards make new equipment more costly. This is the well-known problem with vintage-differentiated regulations or “New Source Review.” Third, standards may encourage counterproductive, unintended shifts among regulated activities (for example, from purchasing cars to purchasing SUVs under the CAFE program). All of these unintended consequences result from the problematic incentives that standards can create, compared with the efficient incentives created by a cap-and-trade system (or a carbon-tax, for that matter).

If you favor a regulatory approach, then you may welcome what’s coming from EPA as a result of the Supreme Court ruling of a few years ago combined with the Administration’s endangerment finding. For my part, I don’t welcome it; I worry about it, because the set of regulatory approaches that could be forthcoming will accomplish relatively little, do so at an unnecessarily high cost, and hence play into the hands of opponents of progressive climate policy. (More about that in some other, future post.)

Putting a Price on Carbon

To virtually all participants in the policy world, it has become increasingly clear that the only approach that can do the job and do it cost-effectively is one which involves at its core putting a price on carbon. That leaves cap-and-trade and carbon taxes. Let me take these in turn.

Cap-and-Trade

Let’s step back from the debate regarding the details of the Waxman-Markey House bill or the new Senate proposal by Senators Boxer and Kerry, and think about the essence of the cap-and-trade approach. (For some of those details, however, please see my previous posts, where I have commented on various aspects of Waxman-Markey and described a proposal I developed for The Hamilton Project of an up-stream, economy-wide CO₂ cap-and-trade system to cost-effectively achieve meaningful greenhouse gas emissions reductions.)

Here are the basics. First, aggregate emissions from regulated sources are capped, and the cap is enforced through a requirement for affected firms to hold emissions allowances. Importantly, allowance trading minimizes costs of meeting the cap. It does this because allowances migrate to the highest-valued uses, covering emissions that are the most costly to reduce. So, the emission reductions undertaken are those that are least costly to achieve. In essence, the uniform market price of allowances creates incentives for all covered sources to reduce all emissions, and do so cost-effectively.

A cap-and-trade system can be more environmentally-effective and more cost-effective than standards. First, in terms of environmental-effectiveness, a cap-and-trade system can ensure achievement of emissions targets. Cap-and-trade allows policymakers to set specific overall emissions targets. And a well-enforced system guarantees achievement of those targets, because emissions will not exceed available allowances. An economy-wide, upstream cap-and-trade system on the carbon content of fossil fuels can cover all fossil-fuel-related CO₂ emissions without needing to regulate each emissions source individually.

In terms of cost-effectiveness, a well-designed cap-and-trade system minimizes emission reduction costs. Unlike NO_x, SO₂, and other pollutants, GHG emission reductions have the same effect no matter how, where, or when they are achieved. This makes the climate change problem unique in the degree to which compliance flexibility can be used to lower costs without compromising environmental integrity. Hence, a cap-and-trade system can minimize costs while still meeting environmental objectives by offering three forms of flexibility: what flexibility; where flexibility; and when flexibility.

In regard to “what flexibility,” many types of actions offer low-cost emission reductions, and a cap-and-trade system allows emission reductions through whatever measures are least costly. By contrast, standards can target only certain identified emission reduction measures, leaving other cost-effective opportunities untapped. Furthermore, predictions of what measures are cost-effective may be wrong.

In regard to “where flexibility,” the costs of emission reductions vary widely across industries, across facilities, and even across users of the same equipment. A cap-and-trade system exploits this variation in costs by achieving reductions wherever they are least costly. By contrast, standards would only be cost-effective if they accounted for all of the variation in costs across sectors, technologies, and regulated entities — but it is completely infeasible for standards to do this. Emission reduction costs across sectors and technologies change over time, making the flexibility offered by a cap-and-trade system even more valuable. Also, lower-cost opportunities to reduce emissions may exist in other countries. Importantly, a cap-and-trade system creates a common currency (emissions allowances) that makes it possible to link with other systems.

A cap-and-trade system also minimizes costs through “when flexibility.” Costs can be reduced through flexibility in the timing of emission reductions by avoiding: premature retirement of capital stock or lock-in of existing technologies; and unnecessarily costly reductions in one year due to unusual circumstances when less-costly offsetting reductions can be achieved in other years. A cap-and-trade can incorporate “when flexibility”
without compromising cumulative emissions targets through: allowance banking and borrowing; and multi-year compliance periods.

Beyond such “static cost-effectiveness,” cap-and-trade creates incentives for technology innovation, and thereby lowers long-run costs. By rewarding any means of reducing emissions, a cap-and-trade system provides broad incentives for any innovations that lower the cost of achieving emissions targets. Although standards may encourage development of lower cost means of meeting the standards’ specific requirements, they do not encourage efforts to exceed those standards.

Several cap-and-trade systems have been successful at achieving environmental goals and cost savings: the phase-out of leaded gasoline in the 1980s; the phase-out of ozone depleting substances; and the Clean Air Act amendments of 1990 SO₂ allowance trading program to cut acid rain by 50%. Perceived shortcomings in other cap-and-trade systems reflect design choices, not problems with the policy instrument itself. This applies both to California’s RECLAIM program, and the pilot phase of the EU Emissions Trading Scheme (which is operating successfully in its real, Kyoto phase).

In summary, compared with conventional standards, a cap-and-trade system can be more environmentally-effective and more cost-effective. As with any policy instrument, however, careful design is important.

Taxing Carbon

As I mentioned, it is clear that the only approach that can do the job and do it cost-effectively is one that involves putting a price on carbon. So, what about the other carbon-pricing approach — a carbon tax?

I am by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years. Indeed, both cap-and-trade and carbon taxes are good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences. I am opposed, however, to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.

While there are tradeoffs between these two principal market-based instruments targeting CO₂ emissions — a cap-and-trade system and a carbon tax – the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system. I say this based on three criteria: environmental effectiveness, cost effectiveness, and distributional equity. So, my position is not capitulation to politics. On the other hand, sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should surely be made in the real-world political context.

The key merits of the cap-and-trade approach I have described above are, first, the program can provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels. Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by a climate policy. Third, it provides a straightforward means to harmonize with other countries’ climate policies. Fourth, it avoids the current political aversion in the United States to taxes. Fifth, it is unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach has a history of successful adoption and implementation in this country over the past two decades.

Having said this, there are some real differences between taxes and cap-and-trade that need to be recognized. First, environmental effectiveness: a tax does not guarantee achievement of an emissions target, but it does provides greater certainty regarding costs. This is a fundamental tradeoff. Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly a cost-containment mechanism. On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and this is why environmental NGOs are opposed to the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same. But the key difference is that political pressures on a carbon tax system will most likely lead to 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. But political pressures on a cap-and-trade system lead to different allocations of allowances, which affect distribution, but not environmental effectives, and not cost-effectiveness.

Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful: reducing environmental achievement and driving up costs.

The Bottom Line

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects. Hence, they said, the two primary questions to use in deciding between them should be: which is more politically feasible; and which is more likely to be well-designed?

The answer to the first question is obvious; and I have argued here that given real-world political forces, the answer to the second question also favors cap-and-trade. In other words, it is important to identify and design policy that will be “optimal in Washington,” not just from the perspective of Cambridge, New Haven, or Berkeley.

In “policy heaven,” the optimal instrument to address climate-change emissions may well be a carbon tax (largely because of its simplicity), but in the real world in which policy is developed and implemented, cap-and-trade is the best approach if one is serious about addressing the threat of climate change with meaningful, effective, and cost-effective policies.

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.

Moving Beyond Vintage-Differentiated Regulation

A common feature of many environmental policies in the United States is vintage-differentiated regulation (VDR), under which standards for regulated units are fixed in terms of the units’ respective dates of entry, with later vintages facing more stringent regulation. In the most common application, often referred to as “grandfathering,” units produced prior to a specific date are exempted from a new regulation or face less stringent requirements.

As I explain in this post, an economic perspective suggests that VDRs are likely to retard turnover in the capital stock, and thereby to reduce the cost-effectiveness of regulation in the long-term, compared with equivalent undifferentiated regulations. Further, under some conditions the result can be higher levels of pollutant emissions than would occur in the absence of regulation. Thus, economists have long argued that age-discriminatory environmental regulations retard investment, drive up the cost of environmental protection, and may even retard pollution abatement.

Why have VDRs been such a common feature of U.S. regulatory policy, despite these problems? Among the reasons frequently given are claims that VDRs are efficient and equitable. These are not unreasonable claims. In the short-term, it is frequently cheaper to control a given amount of pollution by adopting some technology at a new plant than by retrofitting that same or some other technology at an older, existing plant. Hence, VDRs appear to be cost-effective, at least in the short term. But this short-term view ignores the perverse incentive structure that such a time-differentiated standard puts in place. By driving up the cost of abatement with new vintages of plant or technology relative to older vintages, investments (in plants and/or technologies) are discouraged.

In terms of equity, it may indeed appear to be fair or equitable to avoid changing the rules for facilities that have already been built or products that have already been manufactured, and to focus instead only on new facilities and products. But, on the other hand, the distinct “lack of a level playing field” – an essential feature of any VDR – hardly appears equitable from the perspective of those facing the more stringent component of an age-differentiated regulation.

An additional and considerably broader explanation for the prevalence of VDRs is fundamentally political. Existing firms seek to erect entry barriers to restrict competition, and VDRs drive up the costs for firms to construct new facilities. And environmentalists may support strict standards for new sources because they represent environmental progress, at least symbolically. Most important, more stringent standards for new sources allow legislators to protect existing constituents and interests by placing the bulk of the pollution control burden on unbuilt factories.

Surely the most prominent example of VDRs in the environmental realm is New Source Review (NSR), a set of requirements under the Clean Air Act that date back to the 1970s. The lawyers and engineers who wrote the law thought they could secure faster environmental progress by imposing tougher emissions standards on new power plants (and certain other emission sources) than on existing ones. The theory was that emissions would fall as old plants were retired and replaced by new ones. But experience over the past 25 years has shown that this approach has been both excessively costly and environmentally counterproductive.

The reason is that it has motivated companies to keep old (and dirty) plants operating, and to hold back investments in new (and cleaner) power generation technologies. Not only has New Source Review deterred investment in newer, cleaner technologies; it has also discouraged companies from keeping power plants maintained. Plant owners contemplating maintenance activities have had to weigh the possible loss of considerable regulatory advantage if the work crosses a murky line between upkeep and new investment. Protracted legal wrangling has been inevitable over whether maintenance activities have crossed a threshold sufficient to justify forcing an old plant to meet new plant standards. Such deferral of maintenance has compromised the reliability of electricity generation plants, and thereby increased the risk of outages.

Research has demonstrated that the New Source Review process has driven up costs tremendously (not just for the electricity companies, but for their customers and shareholders, that is, for all of us) and has resulted in worse environmental quality than would have occurred if firms had not faced this disincentive to invest in new, cleaner technologies. In an article that appeared in 2006 in the Stanford Environmental Law Journal, I summarized and sought to synthesize much of the existing, relevant economic research.

The solution is a level playing field, where all electricity generators would have the same environmental requirements, whether plants are old or new. A sound and simple approach would be to cap total pollution, and use an emissions trading system to assure that any emissions increases at one plant are balanced by offsetting reductions at another. No matter how emissions were initially allocated across plants, the owners of existing plants and those who wished to build new ones would then face the correct incentives with respect to retirement decisions, investment decisions, and decisions regarding the use of alternative fuels and technologies to reduce pollution.

In this way, statutory environmental targets can be met in a truly cost-effective manner, that is, without introducing perverse incentives that discourage investment, drive up costs in the long run, and have counter-productive effects on environmental protection.

It is not only possible, but eminently reasonable to be both a strong advocate for environmental protection and an advocate for the elimination of vintage differentiated regulations, such as New Source Review. That is where an economic perspective and the available evidence leads.