Robert Stavins, Author at An Economic View of the Environment

Climate Change, Public Policy, and the University

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

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

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

The Value of Symbolic Action

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

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

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

The Climate Impacts of Divestment

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

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

The University’s Comparative Advantage

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

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

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

Posted on March 8, 2010 by Robert Stavins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Remembering Ronald Coase’s Contributions

On September 2^nd, Ronald Coase, professor emeritus of economics at the University of Chicago Law School, Nobel laureate, and principal creator of the academic field of law and economics, passed away at the age of 102. Numerous, lengthy obituaries have appeared in the national and international press. And in an effective essay posted at the Energy Economics Exchange web site, Severin Borenstein, professor of economics at the University of California, Berkeley, wrote about the effect that Coase’s thinking had decades ago on his own intellectual development (while lamenting that the Wall Street Journal in its own tribute to Coase had twisted the implications of his work to fit the Journal’s view of the world).

The passing of Professor Coase brings to mind an essay I wrote for this blog in July of 2012, in which I recalled that a group of economists and legal scholars had gathered in December, 2010, at the University of Chicago to celebrate two notable events. One was the fiftieth anniversary of the publication of Ronald Coase’s “The Problem of Social Cost” (Coase 1960). The other was Professor Coase’s 100^th birthday. The conference resulted in a special issue of The Journal of Law and Economics.

Robert Hahn (of the University of Oxford) and I were privileged to participate in the conference (a video of our presentation is available here). We recognized that the fiftieth anniversary of the publication of Coase’s landmark study provided an opportunity for us to examine one of that study’s key implications, which is of great importance not only for economics but for public policy as well, in particular, for environmental policy.

The Coase Theorem and the Independence Property

In our article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” Hahn and I took as our starting point a well-known result from Coase’s work, namely, that bilateral negotiation between the generator and the recipient of an externality will lead to the same efficient outcome regardless of the initial assignment of property rights, in the absence of transaction costs, income effects, and third party impacts. This result, or a variation of it, has come to be known as the Coase Theorem.

We focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We called this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.

The Practical Political Importance of the Independence Property

We were interested in the independence property because of its great political importance. The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs. Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.

In Theory, Does the Property Always Hold?

Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice. In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

In Reality, Has the Property Held?

Of course, the fact that these factors can lead to the violation of the independence property does not mean that in practice they do so in quantitatively significant ways. Therefore, Hahn and I also carried out an empirical assessment of the independence property in past and current cap-and-trade systems: lead trading; chlorofluorocarbons (CFCs) under the Montreal Protocol; the sulfur dioxide (SO₂) allowance trading program; the Regional Clean Air Incentives Market (RECLAIM) in Southern California; eastern nitrogen oxides (NO_X) markets; the European Union Emission Trading Scheme (EU ETS); and Article 17 of the Kyoto Protocol.

I hope some of may find time to read our article, but a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).

Political Judgments

That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.

This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost. So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted. It is of real political importance and remarkable social value. It is just one of many lasting contributions of Ronald Coase.

Economics and Politics in California: Cap-and-Trade Allowance Allocation and Trade Exposure

In my previous essay at this blog – The Importance of Getting it Right in California – I wrote about the precedents and lessons that California’s Global Warming Solutions Act (AB 32) and its greenhouse gas (GHG) cap-and-trade system will have for other jurisdictions around the world, including other states, provinces, countries, and regions. This is particularly important, given the failure of the U.S. Senate in 2009 to pass companion legislation to the Waxman-Markey bill, passed by the U.S. House of Representatives, highlighting the absence of a national, economy-wide carbon pricing policy.

In my previous essay, I focused on three pending design issues in the emerging rules for the AB-32 cap-and-trade system: (1) the GHG allowance reserve; (2) the role of offsets; and (3) proposals for allowance holding limits. I drew upon a presentation I made on “Offsets, Holding Limits, and Market Liquidity (and Other Factors Affecting Market Performance)” at the 2013 Summer Issues Seminar of the California Council for Environmental and Economic Balance.

At the same conference, I made another presentation, which was on “Allowance Value Distribution and Trade Exposure,” a topic that is of great importance both economically and politically, not only in the context of the design of California’s AB-32 cap-and-trade system, but for the design of any cap-and-trade instrument in any jurisdiction. It is to that topic that I turn today. (For a much more detailed discussion, please see a white paper I wrote with Dr. Todd Schatzki of Analysis Group, “Using the Value of Allowances from California’s GHG Cap-and-Trade System,” August, 2012).

Why Does Anyone Care About the Allowance Value Distribution?

A cap-and-trade policy creates a valuable new commodity – emissions allowances. In a well-functioning emissions trading market, the financial value of these allowances (per ton of emissions, for example) is approximately equivalent to their opportunity cost, which is the marginal cost of emissions reductions. This is because of the existence of the overall cap, which – if binding – fosters scarcity of available allowances, and hence generates their economic value.

It should not be surprising, then, that the initial allocation of these allowances can have important consequences both for environmental and for economic outcomes.

Environmental Consequences of the Initial Allowance Allocation

No matter how many times I meet with policy makers around the world to talk about alternative policy instruments (for climate change and other environmental problems), I never cease to be struck by the confusion that abounds regarding the environmental (and the economic) consequences of the initial allocation of allowances in a cap-and-trade system. As I have written many times in the past at this blog, the initial allocation does not directly affect environmental outcomes. Regardless of the allocation method used, aggregate emissions are limited by the emissions cap. This is true whether the allowances are sold (auctioned) or distributed without charge. Furthermore, which firms or sources receive the initial allocation of allowances has no effect on either aggregate emissions or the ultimate distribution of emissions reductions among sources.

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. (More below about the initial allocation’s potential effects on economic performance.)

However, it is also true that the initial allocation method can indirectly affect emissions. In particular, emissions leakage can arise if economic activity shifts to unregulated sources – this risk is greatest with auctions or free fixed allocations. In contrast, an updating, output-based allocation (used in AB 32 for “industry assistance”) can reduce leakage risk by making the free allocation of allowances marginal, rather than infra-marginal (as is the case with a simple free allocation).

Economic Consequences of the Initial Allowance Allocation

A favorite topic of academic economists is that the allowance allocation method in a cap-and-trade system can affect the overall social cost of the policy if the allowances are auctioned (sold by government to compliance entities), and if the revenues are then used to reduce distortionary taxes (such as taxes on labor and investment), thereby eliminating some deadweight loss and cutting overall social cost. I discuss this a bit more below, but for now let’s recognize that the combination of two California propositions and subsequent court rulings means that the State is not permitted to use the auction proceeds to cut taxes (rather, any auction proceeds must be used to achieve the purposes of AB 32, that is, reducing GHG emissions).

So, within the set of feasible options, the initial allowance allocation will not directly affect the cost-effectiveness of actions taken by emission sources to reduce emissions. In other words, aggregate abatement costs will not be directly affected by the nature of the initial allocation.

I was careful to use the word, “directly,” because the initial allowance allocation can indirectly affect economic outcomes. In particular, the use of updating, output-based allocations can: (1) lower the costs seen by consumers, which can reduce incentives to conserve; (2) avoid reductions in economic activity within California, with associated distributional impacts; and (3) avoid potential shifts of production to less efficient, more distant producers.

Auction Revenue Use

Decisions about how auction revenues are used can have profound consequences for the potential benefits of auctioning. There are three basic options.

First, as I emphasized above, in theory, reducing distortionary taxes provides the greatest net economic benefit (by reducing the social cost of the policy). But California’s unique legal context takes this option off the table.

Second, funding programs to address other market failures that are not addressed by the price signals provided by the cap-and-trade system can be meritorious. For example, information spillovers can be addressed through financing of research and development activities, and the principal-agent problems that infect energy-efficiency adoption decisions in rental properties can be addressed — to some degree — through zoning and other local policies.

The third and final option, however, is highly problematic, if not completely without merit, and yet, ironically, there are strong incentives in place for policy makers to go this third route. This third option is to use auction revenues to fund programs to subsidize emission reductions. There is a strong incentive to do this, because of California’s legal constraint to employ any auction revenues in pursuit of the objectives of the statute, that is, reducing GHG emissions.

What’s the problem? The AB-32 cap-and-trade system will cover approximately 85% of the economy. In other words, the vast majority of sources are under the cap. As I have explained in detail in several previous essays at this blog, under the umbrella of a cap-and-trade mechanism, (successful) efforts to further reduce emissions of capped sources will have three consequences: (1) allowance prices will be supressed (take a look at the hand-wringing in Europe over allowance prices in its CO₂ Emissions Trading System); (2) aggregate compliance costs will be increased (cost-effectiveness is reduced because marginal abatement costs are no longer equated among all sources); and (3) nothing is accomplished for the environment, in the sense that there are no additional CO₂ emissions reductions (rather, the CO₂ emissions reductions are simply relocated among sources under the cap).

Economics, Policy, and Politics

As I concluded in my previous essay, the California Air Resources Board has done an impressive job in its initial design of the rules for its GHG cap-and-trade system. Of course, there are flaws, and therefore there are areas for improvement. A major issue continues to be the mechanisms used for the initial allocation of allowances. Because of the economics and politics of this issue, it will not go away. But, going forward, it would be helpful if those debating this issue could demonstrate better understanding of the allowance allocation’s real – as opposed to fictitious – environmental and economic consequences.