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)..

National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead

Like any legislation, the Waxman‑Markey bill has its share of flaws, but its cap-and-trade system has medium and long‑term targets for reducing greenhouse gas emissions that are sensible, and the cap‑and‑trade system is — for the most part — well designed.  With some exceptions, the bill’s cap‑and‑trade system will achieve meaningful reductions of carbon dioxide and other greenhouse gas emissions at minimal cost to the economy.

There has been much lamenting about the corporate give-away in the bill, but this is unfounded, as I explained in detail in my May 27th post on The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey. Concerns have also been expressed — such as by a number of Republican members of Congress during last Friday’s floor debate in the House of Representatives — about negative impacts on the international competitiveness of U.S. firms.  The only real solution to the international competitiveness issue in the long term 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.)  But that solution is fundamentally outside of the scope of the domestic policy action of any individual nation, including the United States.

In the meantime, the Waxman‑Markey approach of combining output‑based updating allocations in the short term for select sectors with the option in the long term of a Presidential determination (under stringent conditions) for import allowance requirements for specific countries and sectors was sensible and pragmatic (see my June 18th post on Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal).

That’s the good news.  But the bad news is that last-minute changes in the bill changed what was a Presidential option regarding long-term back-up border adjustments (tariffs) to a requirement that the President put such tariffs in place under specified conditions.  This moved the legislation considerably closer to risky protectionism, as President Obama rightly noted in comments to the press on Sunday.

Also, the compromise amendments with the House agriculture committee that provide for generous numbers of potential offsets from the agricultural sector (regulated not by EPA, but by USDA!) are troubling — not in terms of driving up compliance costs, but in terms of reducing the real environmental performance of the system.  This is because of the general problem of limited additionality of claimed reductions under offset (or emission-reduction-credit) systems, as opposed to cap-and-trade systems, plus the well-known difficulties of measuring non-point emissions, let alone emissions reductions, from agriculture.

These and other design issues will be important topics when the Senate takes up its own climate legislation, although the debate in that body on some of these issues will likely be quite different.  For example, there is likely to be more interest in the Senate in the use of a “price collar,” a mechanism to constrain both the maximum and the minimum market price of allowances over time.  This would be a move beyond the safety-valve mechanism that is provided in the House legislation.

When the action moves to the Senate, the greatest attention and the greatest skepticism should be directed not to the cap‑and‑trade mechanism, which is — for the most part — well designed in Waxman‑Markey, but rather to other elements of the legislation, some of which are highly problematic. While the titles of Waxman‑Markey that create the cap‑and‑trade system are ‑‑ on balance ‑‑ sensible, and will result in meaningful emissions reductions cost effectively, the other titles of the bill include a host of conventional standards and subsidies, many of which (under the cap‑and‑trade umbrella) will have minimal or no environmental benefits, but will limit flexibility and thereby have the unintended consequence of driving up compliance costs. That’s the soft under‑belly of this legislation that needs to be selectively, surgically repaired.

It is the fault of economists — myself included — that we have given so much attention to the cap-and-trade system that we have ignored these other important elements of the legislation, elements that unfortunately can degrade significantly the cost-effectiveness of the package while providing little if any incremental benefits to the environment.  Even the Congressional Budget Office, in its excellent economic analysis of HR 2454, focused exclusively on the bill’s cap-and-trade program.  Going forward, CBO, EPA, and independent analysts need to examine the bill’s other elements, and assess what those elements provide at what incremental cost.

A broader question — also raised by House Republicans in the floor debate — is whether the United States should be moving towards the enactment of a domestic climate policy before a sensible, post‑Kyoto international agreement has been negotiated and ratified. Such an international agreement should include not only the countries of the industrialized world, but also the key, rapidly‑growing economies of the developing world ‑‑ China, India, Brazil, Korea, Mexico, South Africa, and Indonesia ‑‑ which are and will increasingly be major contributors to emissions.

It’s natural for such a question to be raised about the very notion of the U.S. adopting a policy to help address what is fundamentally a global problem.  The environmental benefits of any single nation’s reductions in greenhouse gas emissions are spread worldwide, unlike the costs. This means that for any single country, the costs of action will inevitably exceed its direct benefits, despite the fact that the global costs of action will be less than global benefits.  This is the nature of a global commons problem, and this is the very reason why international cooperation is required.

The U.S. is now engaged in international negotiations, and the credibility of the U.S. as a participant, let alone as a leader, in shaping the international regime is dependent upon our demonstrated willingness to take actions at home.

Europe has put its climate policy in place, and Australia, New Zealand, and Japan are moving to have their policies in place within a year. If the United States is to play a leadership role in international negotiations for a sensible post‑Kyoto international climate regime, the country must begin to move towards an effective domestic policy ‑ with legislation that is timed and structured to coordinate with the emerging post‑Kyoto climate regime.

Without evidence of serious action by the U.S., there will be no meaningful international agreement, and certainly not one that includes the key, rapidly‑growing developing countries. U.S. policy developments can and should move in parallel with international negotiations.

So, the Waxman‑Markey bill has its share of flaws, but it represents a reasonable starting point for Senate deliberation on what can become a national climate policy that will place the United States where it ought to be -‑ in a position of international leadership to help develop a global climate agreement that is scientifically sound, economically rational, and politically acceptable to the key nations of the world..

Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal

The potential impacts of proposed U.S. climate policies on the competitiveness of U.S. industries is a major political issue, and it was one of the key issues in the Energy and Commerce Committee of the House of Representatives in the design of Henry Waxman and Edward Markey’s H.R. 2454 (the American Clean Energy and Security Act of 2009). In the floor debate that will soon take place as the full House considers the bill, it will be an important issue. It promises to be an equally important topic when the Senate takes up its own climate legislation, although the debate in that body on this issue will likely be quite different.

The ultimate answer to the question of how best to address concerns about international competitiveness is to bring all countries – both the industrialized nations and the developing world’s large, rapidly-growing economies (China, India, Brazil, Korea, Mexico, South Africa, and Indonesia) – into a meaningful (post-Kyoto) international climate change agreement (a topic on which I’ve spent much time over the past several years).  But – for the most part — that long-term objective is outside of the reach of the domestic policy of any single nation, even the United States.

Can Domestic Climate Policy Address Competitiveness Concerns?

A range of approaches has been considered for implementing sound, domestic climate policy while seeking to “level the economic playing field” with other countries. While no approach is without its flaws (as I describe below), the approach taken in the Waxman-Markey legislation is sensible and pragmatic:  in the short term, output-based updating allocations of allowances are employed for a few energy-intensive, trade-sensitive sectors; and in the long term, the President is given the option to put in place (under specific, stringent conditions) import-allowance-requirements in selected cases.

In order to explain my reasoning for coming to this conclusion, let’s back up for a moment and reflect on the reasons for the high level of political attention and receptiveness in the United States toward employing a cap-and-trade system nationally to address emissions of greenhouse gases.

It is because of the significant economic and political advantages of cap-and-trade systems to address carbon dioxide and other greenhouse gas emissions that most (but not all) attention by policy makers has been focused on this policy approach. First, it provides a cost-effective means of achieving meaningful reductions in emissions over relevant time horizons. Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by virtually any climate policy. Third, it is less likely than alternative approaches (such as a carbon tax) to be degraded – in terms of environmental performance and cost-effectiveness – by political forces. Fourth, it has a history of successful adoption and implementation over two decades. And fifth, it provides a straightforward means to link and harmonize with other countries’ climate policies.

The Waxman-Markey bill, H.R. 2454, would establish such a U.S. cap-and-trade system to reduce emissions that contribute to global climate change. The bill would put a declining cap on emissions and create a corresponding number of emission permits. Regulated firms could trade these permits at a price determined by the market – creating powerful incentives to reduce emissions cost-effectively.

But imposing a price (cost) on carbon in the United States at a time when some other countries (in the developing world) are not taking comparable actions raises concerns about negative impacts on the competitiveness of U.S. industry, particularly in energy-intensive, trade-sensitive sectors. This heightens worries about possible job losses, a particularly troubling concern when the United States find itself in the worst global recession in a generation.

The environmental side of the same coin is “carbon leakage.” Again, imposing a cost on the production of carbon-intensive goods and services shifts comparative advantage in the production of those same goods and services in the direction of countries not taking on such costs.  Also, reduced demand in the United States for carbon-intensive fuels such as coal can be expected to reduce worldwide demand enough that the world price of coal would fall, thereby making it more attractive for use in countries that are not participating in a meaningful international climate agreement (or otherwise taking significant domestic climate actions).

Both routes can result in a shift of carbon-intensive production to countries without climate controls, and therefore an increase in their CO2 emissions. This is carbon leakage, which reduces the environmental benefits of mitigating emissions and reduces cost-effectiveness of any actions (properly measured in terms of net changes in CO2 atmospheric concentrations).  Given that the United States, the European Union, and Japan are net importers of embodied CO2, while China and India are net exporters, the environmental – as well as the economic – impacts of carbon leakage are a natural concern of lawmakers.

Despite the high levels of attention that international competitiveness therefore receives in debates about domestic climate policies, economic research has consistently found that the actual competitiveness impacts of proposed domestic climate policies would not — in quantitative terms — constitute a major economy-wide economic issue for the United States, partly because differences in other costs of production (including labor and energy costs, without accounting for carbon constraints) across countries swamp differences in costs due to environmental policies, including prospective climate policies.

On the other hand, this is a real issue for some specific sectors, in particular, energy-intensive industries subject to international competition, such as aluminum, cement, fossil fuels, glass, iron and steel, and paper. More importantly, it is in any event a major (economy-wide) political issue.  So, it needs to be addressed in any domestic climate policy which is to be both meaningful and politically pragmatic.

How About Free Allowance Allocations?

The approach frequently proposed by policy makers and the approach utilized in the European Union for its Emission Trading Scheme, and discussed in a number of other countries for their planned cap-and-trade programs is generous and free allocation of allowances to specific sectors and companies.  This makes the receiving companies happy, but has no effect on their international competitiveness. This is because such a free grant of allowances is no different than cash, that is, a fixed subsidy. The allowances can be sold by the receiving companies, are as good as cash, and represent a lump-sum transfer from the government, not tied to carbon abatement efforts or production (and hence, in the language of economics, are infra-marginal subsidies rather than marginal incentives).

Since the subsidy has no effect on the company’s marginal cost of production (its supply function), it has no effect on international competitiveness. The company will continue to find it as challenging as it did without the subsidy to produce cement, steel, or whatever at a price that can compete with companies located in countries without climate policies (apart from liquidity effects, which are minor in most cases). And the domestic company will have the same incentives as previously to locate its next production facility in a country without a climate policy.

A Potentially Effective Approach:  Output-Based Updating Allocations

With proper design, allowance allocations can be used effectively to address leakage and competitiveness.  If the free allocation of allowances is tied to the company’s production level, then it does affect marginal production costs, and therefore does affect competitiveness. Such a “home rebate” can thereby reduce leakage. This is, in fact, the approach taken in the Waxman-Markey legislation, and it is a potentially effective means to address concerns about international competitiveness for a select set of energy-intensive trade-sensitive sectors.

There are, however, some legitimate concerns about this approach of linking annual allowance allocations with production levels, as I wrote in my previous post, “The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey.” Such output-based updating allocations can provide perverse incentives and thereby drive up the costs of achieving a cap. This is because an output-based updating allocation is essentially a production subsidy. This distorts firms’ pricing and production decisions in ways that can increase the cost of meeting an emissions target.

Think of it this way. On the one hand, the cap-and-trade system is (sensibly) increasing the cost of using carbon-intensive fuels and emitting CO2 into the atmosphere. An aluminum producer, for example, is therefore paying more for the (fossil-fuel generated) electricity it uses, driving up its cost of production. At the same time, the government hands a subsidy to the company for each unit of aluminum it produces, working at cross-purposes with the energy-pricing incentive, and thereby driving up the aggregate social costs of achieving the cap. In addition, these home rebates do not distinguish between competition from countries with and without domestic climate policies.

The Key Question

So, there are problems with output-based updating allocations, but the key question in the real world of legislative design is whether better approaches are available?  The answer – in my view – is that there are several other available approaches, but they are not any better; and indeed, they appear to be significantly worse.

An Alternative Approach:  Import Allowance Requirements

One alternative approach is an import allowance requirement, whereby imports of highly carbon-intensive goods (in terms of their manufacture) must hold allowances for the U.S. cap-and-trade system, mirroring requirements on U.S. sources, if those imports come from countries which have not taken comparable climate policy actions. Note that this approach – which is referred to as a border adjustment, and is an implicit border tax – differentiates according to the country of origin.  In principle, this approach can maintain a level playing-field between imports and domestic production, reduce leakage, and possibly help induce key developing countries to take domestic action to avoid the implicit border tax on their products.

The import allowance requirement approach has its own problems, however. First, it focuses exclusively on imports into the United States, and has no effect on the competitiveness of U.S. exports. Second, it may not be compliant with World Trade Organization (WTO) rules, because it would discriminate among trading nations (I’ll leave that issue for trade economists and trade lawyers to analyze and debate).

Third, it is questionable whether it would be effective as an inducement for developing countries to join an international agreement to reduce emissions. Why is that? Think about China, for example. China is the largest producer of cement in the world, accounting for almost 50% of world output. It is also the world’s largest exporter of cement. This may sound as though the threat of import allowance requirements in the U.S. and European cap-and-trade systems would be a powerful incentive for China to undertake emission reductions at home in order to avoid the border tax on its cement exports.  But China consumes 97% of its cement domestically, exporting only 3%, and much of that to developing countries. So, would a country such as China be willing to increase the costs of producing 97% of its output in order to protect a market for 1% or 2% of its production?(To be fair, for small developing countries for which their exports of a given product are a large share of their total output, the message could potentially be quite different.)

Despite these three problems with the import-allowance-requirement approach, note that it was a key part of the Lieberman-Warner Climate Security Act in the U.S. Senate in 2008, and may re-appear when serious debate commences in the Senate on climate legislation later this year. Also, it should be noted that this approach of import-allowance-requirements is included as a long-term backstop in Waxman-Markey if the President determines by 2022 that the output-based allocation mechanism is insufficient for some of the energy-intensive trade-sensitive sectors (and if a number of stringent conditions are met; see the “International Reserve Allowance Program” in the bill).

Other Possible Approaches

Another potential approach is a border rebate for exports to level the playing field abroad, whereby the government rebates the value of emissions embodied in exports. Imports, however, would retain their competitive advantage at home, and there are problems with WTO compliance. Finally, there is full boarder adjustment, meaning a border (import) tax plus a border (export) subsidy. Here there are questions not only about consistency with international trade law, but also concerns about feasibility. In some cases, there are tremendous challenges of calculating the embodied emissions of foreign products, and more generally, there are difficulties of defining and enforcing reliable rules of origin.

The Good, the Bad, and the Ugly

Thus, none of these approaches are ideal, not home rebates as in Waxman-Markey, nor implicit border taxes on exports as in Lieberman-Warner, nor border rebates, nor full border adjustments.  As I said at the outset, the only real solution to the international competitiveness issue in the long term 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.) But that solution is fundamentally outside of the scope of the domestic policy action of any individual nation, including the United States.

So, among the feasible set of options to address international competitiveness concerns – if only imperfectly and at some cost – which is best? The two live political options appear to be the output-based updating allocation mechanism in the Waxman-Markey legislation and the import allowance requirement, typically associated with the former Lieberman-Warner bill. At this time, meaning in the short term, I would be more worried about the potential damage to the international trade regime that import allowance requirements could foster than about the incremental social costs that an output-based updating allocation mechanism will create.

This is a political problem without a perfect solution (other than bringing all key countries into a meaningful international climate agreement).  For now, the domestic political process has done a credible job of patching together a set of interim solutions. Among the range of possible approaches of trying to level the international economic playing field, none is without its flaws, but the approach taken in the Waxman-Markey legislation appears best.  Subject to possible improvements on the House floor or in the Senate, the Waxman-Markey approach of combining output-based updating allocations in the short term for select sectors with the option in the long term of a Presidential determination (under stringent conditions) for import allowance requirements for specific countries and sectors seems both sensible and pragmatic.

A Broader Question:  Should the U.S. Enact a Domestic Climate Policy without a New, Sound International Climate Agreement in Place?

Stepping back from the specific policy design question, the broader argument has been made (indeed until a few years ago I was among those making it) that there should be no serious movement on a U.S. domestic climate policy until a meaningful and sensible (post-Kyoto) international agreement has been negotiated and ratified.  It is natural for questions to be raised about the very notion of the U.S. adopting a policy to help address a global problem. The environmental benefits of any single nation’s reductions in greenhouse gas emissions are spread worldwide, unlike the costs. This creates the possibility that some countries will want to “free ride” on the efforts of others. It’s for this very reason that international cooperation is required.

That is the why the U.S. is now vigorously engaged in international negotiations, and the credibility of the U.S. as a participant, let alone as a leader, in shaping the international regime is dependent upon our demonstrated willingness to take actions at home. Europe has already put its climate policy in place, and Australia, New Zealand, and Japan are moving to have their policies in place within a year. If the United States is to play a leadership role in international negotiations for a sensible post-Kyoto international climate regime, the country must begin to move towards an effective domestic policy – with legislation that is timed and structured to coordinate with the emerging post-Kyoto climate regime.

Without evidence of serious action by the U.S., there will be no meaningful international agreement, and certainly not one that includes the key, rapidly-growing developing countries.  U.S. policy developments can and should move in parallel with international negotiations.

The Bottom Line

So, like any legislation, the Waxman-Markey bill has its share of flaws. But it represents a solid foundation for a domestic climate policy that can help place the United States where it ought to be – in a position of international leadership to develop a global climate agreement that is scientifically sound, economically rational, and politically acceptable to the key nations of the world..