A Golden Opportunity to Please Conservatives and Liberals Alike

The U.S. Environmental Protection Agency (EPA) has a golden opportunity to opt for a smart, low-cost approach to fulfilling its mandate under a Supreme Court decision to reduce carbon dioxide (CO2) and other greenhouse gas (GHG) emissions linked with global climate change.

Such an approach would provide maximum compliance flexibility to private industry while meeting mandated emission reduction targets, would achieve these goals at the lowest possible cost, would work through the market rather than against it, would be consistent with the Obama Administration’s pragmatic approach to environmental regulation, and ought to receive broad political support, including from conservatives, who presumably want to minimize the cost burden of any policy on businesses and consumers.

Background and Context

By now, it is well known that the 2007 U.S. Supreme Court (5-4) decision in Massachusetts v. EPA found that EPA has the authority to regulate GHGs under the existing provisions of the Clean Air Act (CAA). This, combined with EPA’s “endangerment finding” in 2009 that GHGs threaten public health and the environment, led first in January, 2011, to new motor vehicle fuel efficiency standards, and soon will lead to regulations affecting new and modified stationary sources of emissions (under Section 111b of the CAA) via so-called New Source Performance Standards, and regulations for existing stationary sources (under Section 111d).

In quantitative terms, this last set of regulations – for existing stationary sources – will be key, and by far the most important affected sector will be electricity generation, which accounts for fully 40 percent of U.S. CO2 emissions (and a third of national GHG emissions). Within this sector, coal-fired power plants will be the most drastically affected.

EPA could, in principle, promulgate a regulatory approach that incorporates compliance flexibility, such as through various types of credit, offset, or cap-and-trade mechanisms. It could do this, but may it do so under the legal authority of the Clean Air Act?

Call the Lawyers!

Over the past year, there has been a considerable amount of discussion and no small degree of hand-wringing over whether the relevant parts of the Clean Air Act authorize the use of such flexibility mechanisms. In the midst of this, a new report from Resources for the Future by Gregory Wannier (Columbia Law School) and others makes a compelling, but nuanced case in the affirmative. (See “Prevailing Academic View on Compliance Flexibility under §111 of the Clean Air Act”).

Their conclusion, in a nutshell: “EPA has the tools under §111 of the CAA to implement relatively flexible and efficient GHG regulation. The agency could use a range of compliance flexibility options itself, or facilitate state implementation plans that adopt such measures at the state or regional level.” Included are the market-based, economic-incentive instruments mentioned above.

We should take note, by the way, that Section 111d gives states considerable latitude when choosing their actions to follow EPA guidelines, an approach that is consistent with conservatives’ promotion of the primacy of state authorities in tailoring rules for individual state-by-state circumstances.

Now, for Some Economics

Even if the EPA has the legal authority to adopt a progressive, market-based approach to fulfilling this regulatory mandate, would it really make sense to do this? That is, what would be the consequences of adopting a flexible approach, compared with a conventional, inflexible regulatory scheme? Key issues include the implications for environmental performance, aggregate social cost, and consumer impacts via electricity prices.

Another new study, this one by Dallas Burtraw, Anthony Paul, and Matt Woerman (all at RFF), provides the analysis that is needed, using RFF’s well-regarded Haiku model of the U.S. electricity market, to examine the effect of alternative CAA policies on investment and operation of the nation’s electricity system over a 25-year time horizon in 21 interlinked regions. (See: “Retail Electricity Price Savings from Compliance Flexibility in GHG Standards for Stationary Sources”)

Four scenarios which would achieve the same environmental benefits are examined:

(1) a conventional approach in which the operating efficiency of individual coal-fired power plants would be regulated (labeled an “inflexible performance standard”).

(2) a “flexible performance standard,” under which plants that exceeded the standard could transfer a credit (in exchange for payment) to plants that found it more difficult to achieve the standard. The researchers call these “generation efficiency credit offsets.”

(3) cap-and-trade with auctioned CO2 emission allowances, where the revenue generated for government simply displaces the need for other revenue sources on a one-for-one basis (that is, there is no assumption of a double-dividend through increased efficiency of the tax code).

(4) cap-and-trade with free allocation of allowances to Local Distribution Companies (LDCs), which are regulated and hence assumed to pass the benefits of the free allocation on to consumers.

The results are striking. In terms of aggregate social costs, the inflexible standard would bring with it total costs of about $5 billion per year, whereas – at the other extreme – cap-and-trade with free allocation would involve total costs of only $500 million annually, a 90 percent cost savings!

If – despite its legal authority – EPA believes it is politically unable to adopt a cap-and-trade approach (because of last year’s successful tarnishing of that phrase by Congressional conservatives), then it could opt for a second-best approach, the “flexible-performance standard,” above, which would involve total annual costs of about $1.4 billion, still a 70 percent cost savings compared with the conventional, inflexible standard.

Of course, political consideration of such policy alternatives is more frequently driven by estimates of consumer impacts than by overall social costs (which include consumer costs, industry costs, and costs to government). Here, the analysis is also striking. Consumer costs – due to higher electricity prices – under the inflexible standard would increase by 7 percent, while consumer costs under the flexible performance standard would increase by less than 2 percent. With the cap-and-trade regime with free allowances, consumer costs would actually fall by nearly 1 percent, due to lower electricity prices. [For complete numerical results with all of the scenarios, see the RFF discussion paper.]

The Bottom Line

Clearly, much is to be gained – and virtually nothing lost – by adopting a more flexible approach to meeting a court-ordered mandate that, one way or another, will have a regulation promulgated and eventually finalized. It would be foolish to turn away from a potential 90 percent cost savings for the country’s economy, particularly when the same approach yields lower electricity prices for consumers. All this, while meeting national obligations to reduce greenhouse gas emissions.

It’s too soon to forget that a year ago the Senate abandoned its attempt to pass climate legislation that would limit CO2 emissions. In the process, conservative Republicans dubbed cap-and-tradecap-and-tax.’’ But, as I’ve said before, regardless of what they think about climate change, conservatives should resist demonizing market-based approaches to environmental protection and reverting to pre-1980s thinking that saddled business and consumers with needless costs.

Market-based approaches to environmental protection should be lauded, not condemned, by political leaders, no matter what their party affiliation. Otherwise, there will be severe and perverse long-term consequences for the economy, for business, and for consumers.


Eyes on the Prize: Federal Climate Policy Should Preempt State and Regional Initiatives

In just a few days, Senators John Kerry, Lindsey Graham, and Joe Lieberman will release their much-anticipated proposal for comprehensive climate and energy legislation – the best remaining shot at forging a bipartisan consensus on this issue in 2010.  Their proposal has many strengths, but there’s an issue brewing that could undermine its effectiveness and drive up its costs.  I wrote about this in a Boston Globe op-ed on Earth Day, April 22nd (the original version of which can be downloaded here).

Government officials from California, New England, New York, and other northeastern states are vociferously lobbying in Washington to retain their existing state and regional systems for reducing greenhouse gas emissions, even after a new federal system comes into force. That would be a mistake – and a potentially expensive one for residents of those states, who could wind up subsidizing the rest of the country.  The Senate should do as the House did in its climate legislation:  preempt state and regional climate policies.  There’s no risk, because if Federal legislation is not enacted, preemption will not take effect.

The regional systems – including the Regional Greenhouse Gas Initiative (RGGI) in the Northeast and Assembly Bill 32 in California – seek to limit carbon dioxide emissions from power plants and other sources, mainly by making emissions more costly for firms and individuals.  These systems were explicitly developed because the federal government was not moving fast enough.

But times have changed.  Like the House climate legislation passed last June, the new Senate bill will feature at its heart an economy-wide carbon-pricing scheme to reduce carbon dioxide emissions, including a cap-and-trade system (under a different name) for the electricity and industrial sectors.  (In a departure from the House version, it may have a carbon fee for transportation fuels.)

Though the Congress has a history of allowing states to act more aggressively on environmental protection, this tradition makes no sense when it comes to climate change policy.  For other, localized environmental problems, California or Massachusetts may wish to incur the costs of achieving cleaner air or water within their borders than required by a national threshold.  But with climate change, it is impossible for regions, states, or localities to achieve greater protection for their jurisdictions through more ambitious actions.

This is because of the nature of the climate change problem. Greenhouse gases, including carbon dioxide, uniformly mix in the atmosphere – a unit of carbon dioxide emitted in California contributes just as much to the problem as carbon dioxide emitted in Tennessee.  The overall magnitude of damages – and their location – are completely unaffected by the location of emissions.  This means that for any individual jurisdiction, the benefits of action will inevitably be less than the costs. (This is the same reason why U.S. federal action on climate change should occur at the same time as other countries take actions to reduce their emissions).

If federal climate policy comes into force, the more stringent California policy will accomplish no additional reductions in greenhouse gases, but simply increase the state’s costs and subsidize other parts of the country. This is because under a nationwide cap-and-trade system, any additional emission reductions achieved in California will be offset by fewer reductions in other states.

A national cap-and-trade system – which is needed to address emissions meaningfully and cost-effectively – will undo the effects of a more stringent cap within any state or group of states.  RGGI, which covers only electricity generation and which will be less stringent than the Federal policy, will be irrelevant once the federal system comes into force.

In principle, a new federal policy could allow states to opt out if they implement a program at least as stringent.  But why should states want to opt out?  High-cost states will be better off joining the national system to lower their costs. And states that can reduce emissions more cheaply will be net sellers of Federal allowances.

Is there any possible role for state and local policies?  Yes.  Price signals provided by a national cap-and-trade system are necessary to meaningfully address climate change at sensible cost, but such price signals are not sufficient.  Other market failures call for supplementary policies.  Take, for example, the principal-agent problem through which despite higher energy prices, both landlords and tenants lack incentives to make economically-efficient energy-conservation investments, such as installing thermal insulation.  This problem can be handled by state and local authorities through regionally-differentiated building codes and zoning.

But for the core of climate policy – which is carbon pricing – the simplest, cleanest, and best way to avoid unnecessary costs and unnecessary actions is for existing state systems to become part of the federal system.  Political leaders from across the country – including the Northeast and California – would do well to follow the progressive lead of Massachusetts Governor Deval Patrick and Secretary of Energy and Environmental Affairs Ian Bowles, who have played key roles in the design and implementation of RGGI, and yet have also publicly supported its preemption by a meaningful national program.

California’s leaders and those in the Northeast may take great pride in their state and regional climate policies, but if they accomplish their frequently-stated goal – helping to bring about the enactment of a meaningful national climate policy – they will better serve their states and the country by declaring victory and getting out of the way.