Tag Archives: acid rain

Reflections on Twenty Years of Policy Innovation

In 2009, the U.S. Congress considered but ultimately failed to enact legislation aimed at limiting U.S. greenhouse-gas (GHG) emissions.  The bill under consideration at that time, the American Clean Energy and Security Act of 2009, was the last in a series considered over several years.  Sponsored by Representatives Henry Waxman (D-California) and Edward Markey (D-Massachusetts), the bill passed the U.S. House of Representatives but failed to win sufficient support in the Senate.  No legislation was enacted, and by 2010, both Congress and the White House had abandoned efforts to pass federal climate legislation.

Over months of contentious debate, while the Waxman-Markey bill and subsequent Senate action were being considered, millions of Americans were introduced for the first time to the phrase “cap and trade,” a regulatory approach that first came to prominence in the 1990s as the centerpiece of a national program to address the threat of acid rain by limiting emissions of sulfur dioxide (SO2), primarily from electric power plants.

The 1990 SO2 cap-and-trade program was conceived by the administration of President George H. W. Bush and was widely viewed as a success.  Yet cap and trade became a lightning rod for congressional opposition to climate legislation from 2009 through 2010.

Some of that hostility reflected skepticism about whether climate change was real and, if it was, whether humans played a key role in causing it. A larger group of opponents in Congress worried about the proper role of government and the costs of combating climate change, particularly given the lack of commitments for action by the large emerging economies of China, India, Brazil, Korea, South Africa, and Mexico.  The congressional debate touched only lightly on the relative merits of various policy options to reduce greenhouse-gas emissions. Thus, cap and trade may not have been defeated on its merits (or demerits), but rather as collateral damage in the larger climate policy wars.

Congress (to the extent it did assess policy alternatives to cap and trade), as well as the broader community of analysts and observers in the late 2000s, raised a number of substantive questions about the merits of this policy instrument as a means for responding to a major environmental policy challenge of the sort posed by climate change:

  • How do the costs of a market-based approach, such as cap-and-trade, compare with traditional regulatory policies to reduce pollution?
  • Can market-based policies—and the markets they create—be trusted to reduce emissions? That is, are they environmentally effective?
  • What are the distributional impacts of market-based environmental policies; who are the winners and losers?
  • How well does a cap-and-trade system stimulate technological innovation, as compared with an environmental policy that sets performance standards, specifies technologies for reducing pollution, or both?

In May 2011, the Harvard Environmental Economics Program hosted a two-day research workshop and policy roundtable in Cambridge, Massachusetts, to reflect on these and other questions in light of twenty years of experience implementing the SO2 cap-and-trade program, established under Title IV of the Clean Air Act Amendments (CAAA) of 1990. Also known as the Acid Rain Program and the SO2 allowance-trading system, Title IV represented the first large-scale application of cap and trade to control pollution—in the United States or any other country.  (Of course, the largest emissions trading program in the world is now the European Union Emissions Trading System (EU ETS), a greenhouse-gas, cap-and-trade system that was implemented in 2005 and whose design was influenced by the U.S. SO2 program.)

A “policy brief” synthesizing the main conclusions and insights that emerged from the May 2011 Harvard workshop and roundtable has just been released, The SO2 Allowance Trading System and the Clean Air Act Amendments of 1990:  Reflections on Twenty Years of Policy Innovation.  The workshop and roundtable – sponsored by the Alfred P. Sloan Foundation – featured a dream team of economists and legal experts who had conducted extensive research on the SO2 allowance-trading system, as well as leaders of non-governmental organizations and former government officials who had guided the formulation and passage of the CAAA.

The new policy brief examines the design, enactment, implementation, and performance of the SO2 allowance trading system, with an eye toward identifying lessons learned for future efforts to apply cap and trade to other environmental challenges, including global climate change.  The first section provides background on the acid rain program and summarizes data and analysis on its benefits. Subsequent sections examine key questions regarding cost, environmental effectiveness, market performance, distributional implications, and effects on technology innovation.  The report also examines the political context of the formulation, enactment, and implementation of the SO2 allowance-trading system.  Finally, the conclusions feature some reflection on implications for climate change policy.

The participants in the research workshop were:  Joseph Aldy, Assistant Professor of Public Policy, Harvard Kennedy School; Dallas Burtraw, Darius Gaskins Senior Fellow, Resources for the Future; Denny Ellerman, Part-time Professor, European University Institute, Robert Schuman Centre for Advanced Studies; Michael Greenstone, 3M Professor of Environmental Economics, Massachusetts Institute of Technology; Lawrence H. Goulder, Shuzo Nishihara Professor of Environmental and Resource Economics, Stanford University; Robert Hahn, Director of Economics, Smith School, University of Oxford; Paul L. Joskow, President, Alfred P. Sloan Foundation; Erin T. Mansur, Associate Professor of Economics, Dartmouth College; Albert McGartland, Director, National Center for Environmental Economics, U.S. Environmental Protection Agency; Brian J. McLean, Former Director, Office of Atmospheric Programs, U.S. Environmental Protection Agency; W. David Montgomery, Senior Vice President, NERA Economic Consulting; Erich J. Muehlegger, Associate Professor of Public Policy, Harvard Kennedy School; Karen L. Palmer, Senior Fellow, Resources for the Future; John Parsons, Executive Director, Center for Energy and Environmental Policy Research, MIT Sloan School of Management; Forest L. Reinhardt, John D. Black Professor of Business Administration, Harvard Business School; Richard L. Schmalensee, Howard W. Johnson Professor of Economics and Management, MIT Sloan School of Management; Daniel Schrag, Sturgis Hooper Professor of Geology, Harvard University; Robert N. Stavins, Albert Pratt Professor of Business and Government, Harvard Kennedy School; Thomas Tietenberg, Mitchell Family Professor of Economics, Emeritus, Colby College; and Jonathan B. Wiener, William R. and Thomas L. Perkins Professor of Law, Duke University Law School.

The participants in the policy and politics roundtable were:  Robert Grady, General Partner, Cheyenne Capital Fund (1989–1991: Associate Director, Office of Management and Budget for Natural Resources, Energy & Science; 1991–1993 Executive Associate Director, OMB, and Deputy Assistant to the President); C. Boyden Gray, Principal, Boyden Gray & Associates (1989–1993: White House Counsel); Fred Krupp, President (1984–present), Environmental Defense Fund; Mary D. Nichols, Chairman, California Air Resources Board (1993–1997: Assistant Administrator for Air and Radiation, U.S. Environmental Protection Agency); Roger Porter, IBM Professor of Business and Government, Harvard Kennedy School (1989–1993: Assistant to the President for Economic and Domestic Policy); Richard L. Schmalensee, Howard W. Johnson Professor of Economics and Management, MIT Sloan School of Management (1989–1991: Member, President’s Council of Economic Advisers); and Philip Sharp, President, Resources for the Future (1975–1995: Member, U.S. House of Representatives, Indiana, and Chairman, Energy and Power Subcommittee, House Committee on Natural Resources).

I want to acknowledge the contributions of all of these participants in the research workshop and policy roundtable, as well as the comments and edits some provided on earlier drafts of the policy brief.  Their expertise and experience made this project possible. And, of course, I’m very grateful to the Alfred P. Sloan Foundation for having provided generous support for the workshop and for the preparation of the study.  I hope you find it of interest and value.

Cap-and-Trade: A Fly in the Ointment? Not Really

For more than two decades, environmental law and regulation was dominated by command-and-control approaches — typically either mandated pollution control technologies or inflexible discharge standards on a smokestack-by-smokestack basis.  But in the 1980s, policy makers increasingly explored market-based environmental policy instruments, mechanisms that provide economic incentives for firms and individuals to carry out cost-effective pollution control.  Cap-and-trade systems, in which emission permits or allowances can be traded among potential polluters, continue today to be at the center of this action.

Most recently, this has been in the context of deliberations regarding possible U.S. actions to reduced carbon dioxide and other greenhouse gas emissions linked with global climate change, as in HR 2454, the Waxman-Markey bill approved by the U.S. House of Representatives, as well as in proposals developing in the Senate.  (I have written a number of blog posts on this topic.  If you’re interested, please see:  “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade:  A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness?  Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy:  A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009).  For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

But the transition from command-and-control regulation to market-based policy instruments has not always been easy.  Sometimes policy can outrun basic understanding, and the claims made for the cost-effectiveness of cap-and-trade systems can exceed what can be reasonably anticipated.  Among the factors that can adversely affect the performance of such systems are transaction costs.

In general, transaction costs — those costs that arise from the exchange, not the production, of goods and services — are ubiquitous in market economies.  They can arise from any exchange:  after all, parties to transactions must find one another, communicate, and exchange information.  It may be necessary to inspect and sometimes even measure goods to be transferred, draw up contracts, consult with lawyers or other experts, and transfer title.

In cap-and-trade markets, there are three potential sources of transaction costs. The first source, searching and information-collection, arises because it can take time for a potential buyer of a discharge permit to find a seller, though — for a fee — brokers can facilitate the process.  Although less obvious, a second source of transaction costs — bargaining and deciding — is potentially as important.  A firm entering into negotiations incurs real resource costs, including time and/or fees for brokerage, legal, and insurance services.  Likewise, the third source — monitoring and enforcing — can be significant, although these costs are typically borne by the responsible governmental authority and not by trading partners.

The cost savings that may be realized through cap-and-trade systems depend upon active trading.  But transaction costs are an impediment to trading, and such impediments thereby can limit savings.  So, transaction costs reduce the overall economic benefits of allowance trading, partly by absorbing resources directly and partly by suppressing exchanges that otherwise would have been mutually (indeed socially) beneficial.  But when transaction costs can be kept to a minimum, high levels of trading — and significant cost savings – are the result.

Since David Montgomery’s path-breaking work in 1972, economists have asserted that the post-trading allocation of control responsibility among sources and hence the aggregate costs of control are independent from the initial permit allocation.  This is an extremely important political property, but does this still hold in the presence of transaction costs?  This is a question I investigated in an article titled, “Transaction Costs and Tradable Permits,” which was published in the Journal of Environmental Economics and Management in 1995 (and which the publisher lists as one of the ten most cited articles in the journal’s history, going back to 1974).

The answer to this question is: “it depends.”  If incremental transaction costs are independent of the size of individual transactions, the initial allocation of permits has no effect on the post-trading allocation of control responsibility and aggregate control costs.  But if incremental transaction costs decrease with the size of individual trades, then the initial allocation will affect the post-trading outcome.

This is of great political importance, because it means that in the presence of transaction costs, the initial distribution of permits can matter not only in terms of distributional equity, but in terms of cost-effectiveness or efficiency.  This can reduce the discretion of the Congress (or other legislature or agency) to distribute allowances as they please (in order to generate a constituency of support for the program), and may thereby reduce the political attractiveness and feasibility of a cap-and-trade system.

Empirical evidence, however, indicates that transaction costs have been minimal, indeed trivial, in enacted and implemented cap-and-trade systems, including the U.S. EPA’s leaded-gasoline phasedown in the 1980s, and the well-known SO2 allowance trading system, enacted as part of the Clean Air Act amendments of 1990.

That’s good news, surely.  But nevertheless, going forward, choices between conventional, command-and-control environmental policies and market-based instruments should reflect the imperfect world in which these instruments are applied.  Such choices are not simple, because no policy panacea exists.

On the one hand, even if transaction costs prevent significant levels of trade from occurring, aggregate costs of control will most likely be less than those of a conventional command-and-control approach.  A trading system with no trading taking place will likely be less costly than a technology standard (because the trading system provides flexibility to firms regarding their chosen means of control) and no more costly than a uniform performance standard.

But the existence of transaction costs may make the choice between conventional approaches and cap-and-trade more difficult because of the ambiguities that are introduced.  With transaction costs — as with other departures from frictionless markets — greater attention is required to the details of designing specific systems.  This is the way to lessen the risk of over-selling such policy ideas and ultimately creating systems that stand the best chance of being implemented successfully.

The Making of a Conventional Wisdom

Despite the potential cost-effectiveness of market-based policy instruments, such as pollution taxes and tradable permits, conventional approaches –  including design and uniform performance standards – have been the mainstay of U.S. environmental policy since before the first Earth Day in 1970.  Gradually, however, the political process has become more receptive to innovative, market-based strategies.  In the 1980s, tradable-permit systems were used to accomplish the phasedown of lead in gasoline ­(at a savings of about $250 million per year), and to facilitate the phaseout of ozone-depleting chloroflourocarbons (CFCs); and in the 1990’s, tradable permits were used to implement stricter air pollution controls in the Los Angeles metropolitan region, and –  most important of all – a cap-and-trade system was adopted to reduce sulfur dioxide (SO2) emissions and consequent acid rain by 50 percent under the Clean Air Act amendments of 1990 (saving about $1 billion per year in abatement costs).  Most recently, cap-and-trade systems have emerged as the preferred national and regional policy instrument to address carbon dioxide (CO2) emissions linked with global climate change (see my previous posts of February 6th on an “Opportunity for a Defining Moment” and March 7th on “Green Jobs”).

Why has there been a relatively recent rise in the use of market-based approaches?  For academics like me, it would be gratifying to believe that increased understanding of market-based instruments had played a large part in fostering their increased political acceptance, but how important has this really been?  In 1981, my Harvard colleague, political scientist Steven Kelman surveyed Congressional staff members, and found that support and opposition to market-based environmental policy instruments was based largely on ideological grounds: Republicans, who supported the concept of economic-incentive approaches, offered as a reason the assertion that “the free market works,” or “less government intervention” is desirable, without any real awareness or understanding of the economic arguments for market-based programs.  Likewise, Democratic opposition was based largely upon ideological factors, with little or no apparent understanding of the real advantages or disadvantages of the various instruments.  What would happen if we were to replicate Kelman’s survey today?  My refutable hypothesis is that we would find increased support from Republicans, greatly increased support from Democrats, but insufficient improvements in understanding to explain these changes.  So what else has mattered?

First, one factor has surely been increased pollution control costs, which have led to greater demand for cost-effective instruments.  By the late 1980’s, even political liberals and environmentalists were beginning to question whether conventional regulations could produce further gains in environmental quality.  During the previous twenty years, pollution abatement costs had continually increased, as stricter standards moved the private sector up the marginal abatement-cost curve.  By 1990, U.S. pollution control costs had reached $125 billion annually, nearly a 300% increase in real terms from 1972 levels.

Second, a factor that became important in the late 1980’s was strong and vocal support from some segments of the environmental community.  By supporting tradable permits for acid rain control, the Environmental Defense Fund seized a market niche in the environmental movement, and successfully distinguished itself from other groups.  Related to this, a third factor was that the SO2 allowance trading program, the leaded gasoline phasedown, and the CFC phaseout were all designed to reduce emissions, not simply to reallocate them cost-effectively among sources. Market-based instruments are most likely to be politically acceptable when proposed to achieve environmental improvements that would not otherwise be achieved.

Fourth, deliberations regarding the SO2 allowance system, the lead system, and CFC trading differed from previous attempts by economists to influence environmental policy in an important way:  the separation of ends from means, that is, the separation of consideration of goals and targets from the policy instruments used to achieve those targets.  By accepting – implicitly or otherwise – the politically identified (and potentially inefficient) goal, the ten-million ton reduction of SO2 emissions, for example, economists were able to focus successfully on the importance of adopting a cost-effective means of achieving that goal.

Fifth, acid rain was an unregulated problem until the SO2 allowance trading program of 1990; and the same can be said for leaded gasoline and CFC’s.  Hence, there were no existing constituencies – in the private sector, the environmental advocacy community, or government – for the status quo approach, because there was no status quo approach.  We should be more optimistic about introducing market-based instruments for “new” problems, such as global climate change, than for existing, highly regulated problems, such as abandoned hazardous waste sites.

Sixth, by the late 1980’s, there had already been a perceptible shift of the political center toward a more favorable view of using markets to solve social problems.  The George H. W. Bush Administration, which proposed the SO2 allowance trading program and then championed it through an initially resistant Democratic Congress, was (at least in its first two years) “moderate Republican;” and phrases such as “fiscally responsible environmental protection” and “harnessing market forces to protect the environment” do have the sound of quintessential moderate Republican issues.  But, beyond this, support for market-oriented solutions to various social problems had been increasing across the political spectrum for the previous fifteen years, as was evidenced by deliberations on deregulation of the airline, telecommunications, trucking, railroad, and banking industries. Indeed, by the mid-1990s, the concept (or at least the phrase), “market-based environmental policy,” had evolved from being politically problematic to politically attractive.

Seventh and finally, the adoption of the SO2 allowance trading program for acid rain control – like any major innovation in public policy – can partly be attributed to a healthy dose of chance that placed specific persons in key positions, in this case at the White House, EPA, the Congress, and environmental organizations.  The result was what remains the golden era in the United States for market-based environmental strategies.


If you would like to read more about the factors that have brought about the changes that have occurred in the political reception given to market-based environmental policy instruments over the past two decades, here are some references:

Stavins, Robert N.  “What Can We Learn from the Grand Policy Experiment? Positive and Normative Lessons from SO2 Allowance Trading.” Journal of Economic Perspectives, Volume 12, Number 3, pages 69-88, Summer 1998.

Keohane, Nathaniel O., Richard L. Revesz, and Robert N. Stavins.  “The Choice of Regulatory Instruments in Environmental Policy.” Harvard Environmental Law Review, volume 22, number 2, pp. 313-367, 1998.

Hahn, Robert W.  “The Impact of Economics on Environmental Policy.” Journal of Environmental Economics and Management 39(2000):375-399.

Hahn, Robert W., Sheila M. Olmstead, and Robert N. Stavins.  “Environmental Regulation During the 1990s: A Retrospective Analysis.” Harvard Environmental Law Review, volume 27, number 2, 2003, pp. 377-415.

The Myth of Simple Market Solutions

I introduced my previous post by noting that there are several prevalent myths regarding how economists think about the environment, and I addressed the “myth of the universal market” ­– the notion that economists believe that the market solves all problems.  In response, I noted that economists recognize that in the environmental domain, perfectly functioning markets are the exception, not the rule.  Governments can try to correct such market failures, for example by restricting pollutant emissions.  It is to these government interventions that I turn this time.

A second common myth is that economists always recommend simple market solutions for market problems.  Indeed, in a variety of contexts, economists tend to search for instruments of public policy that can fix one market by introducing another.  If pollution imposes large external costs, the government can establish a market for rights to emit a limited amount of that pollutant under a so-called cap-and-trade system.  Such a market for tradable allowances can be expected to work well if there are many buyers and sellers, all are well informed, and the other conditions I discussed in my last posting are met.

The government’s role is then to enforce the rights and responsibilities of permit ownership, so that each unit of emissions is matched by the ownership of one permit.  Equivalently, producers can be required to pay a tax on their emissions.  Either way, the result — in theory — will be cost-effective pollution abatement, that is, overall abatement achieved at minimum aggregate cost.

The cap-and-trade approach has much to recommend it, and can be just the right solution in some cases, but it is still a market.  Therefore the outcome will be efficient only if certain conditions are met.  Sometimes these conditions are met, and sometimes they are not.  Could the sale of permits be monopolized by a small number of buyers or sellers?  Do problems arise from inadequate information or significant transactions costs?  Will the government find it too costly to measure emissions?  If the answer to any of these questions is yes, then the permit market may work less than optimally.  The environmental goal may still be met, but at more than minimum cost.  In other words, cost effectiveness will not be achieved.

To reduce acid rain in the United States, the Clean Air Act Amendments of 1990 require electricity generators to hold a permit for each ton of sulfur dioxide (SO2) they emit.  A robust permit market exists, in which well-defined prices are broadly known to many potential buyers and sellers.  Through continuous emissions monitoring, the government tracks emissions from each plant.  Equally important, penalties are significantly greater than incremental abatement costs, and hence are sufficient to ensure compliance.  Overall, this market works very well; acid rain is being cut by 50 percent, and at a savings of about $1 billion per year in abatement costs, compared with a conventional approach.

A permit market achieves this cost effectiveness through trades because any company with high abatement costs can buy permits from another with low abatement costs, thus reducing the total cost of reducing pollution.  These trades also switch the source of the pollution from one company to another, which is not important when any emissions equally affect the whole trading area.  This “uniform mixing” assumption is certainly valid for global problems such as greenhouse gases or the effect of chlorofluorocarbons on the stratospheric ozone layer.  It may also work reasonably well for a regional problem such as acid rain, because acid deposition in downwind states of New England is about equally affected by sulfur dioxide emissions traded among upwind sources in Ohio, Indiana, and Illinois.  But it does not work perfectly, since acid rain in New England may increase if a plant there sells permits to a plant in the mid-west, for example.

At the other extreme, some environmental problems might not be addressed appropriately by a simple, unconstrained cap-and-trade system.  A hazardous air pollutant such as benzene that does not mix in the airshed can cause localized “hot spots.”  Because a company can buy permits and increase local emissions, permit trading does not ensure that each location will meet a specific standard.  Moreover, the damages caused by local concentrations may increase nonlinearly.  If so, then even a permit system that reduces total emissions might allow trades that move those emissions to a high-impact location and thus increase total damages.  An appropriately constrained permit trading system can address the hot-spot problem, for example by combining emissions trading with a parallel system of non-tradable ambient standards.

The bottom line is that no particular form of government intervention, no individual policy instrument – whether market-based or conventional – is appropriate for all environmental problems.  There is no simple policy panacea.  The simplest market instruments do not always provide the best solutions, and sometimes not even satisfactory ones.  If a cost-effective policy instrument is used to achieve an inefficient environmental target — one that does not make the world better off, that is, one which fails a benefit-cost test – then we have succeeded only in “designing a fast train to the wrong station.”  Nevertheless, market-based instruments are now part of the available environmental policy portfolio, and ultimately that is good news both for environmental protection and economic well-being.