EPA’s Proposed Greenhouse Gas Regulation: Why are Conservatives Attacking its Market-Based Options?

This week, the Obama Administration’s Environmental Protection Agency (EPA) released its long-awaited proposed regulation to reduce carbon dioxide (CO2) emissions from existing sources in the electricity-generating sector.  The regulatory (rule) proposal calls for cutting CO2 emissions from the power sector by 30 percent below 2005 levels by 2030.

The Fundamentals in Brief

Through a carefully designed formula, EPA’s proposal lists specific targets for each state, under Section 111(d) of the Clean Air Act. States are given broad flexibility for how to meet their targets, including:  increasing the efficiency of fossil-fuel power plants; switching electricity dispatch from coal-fired generating plants to natural gas-fired generating plants; developing new low-emissions generation, such as new natural gas combined cycle plants, more renewable sources (wind and solar), nuclear, or coal with carbon capture and storage; and more efficient end-use of electricity.

States are also given flexibility to employ (in their implementation plans to be submitted to EPA) any of a wide variety of policy instruments, including but by no means limited to market-based trading systems.  Furthermore, states can work together to submit multi-state plans.

The proposed regulation will be finalized after receipt of comments one year from now (June 30, 2015).  Then states will have until July 2016 to submit their plans, and can request one-year extensions (or two-year extensions for multi-state plans). Compliance commences in 2020.

A Big-Picture Assessment of the Proposed Rule

Let’s start by acknowledging that the proposed policy will be less effective environmentally and less cost-effective economically than the economy-wide approach the Administration previously tried with the Waxman-Markey bill, which passed the U.S. House of Representatives in 2009, but failed to receive a vote in the U.S. Senate.  Electricity generation is responsible for about 38 percent of U.S. CO2 emissions, and about 32 percent of U.S. greenhouse gas (GHG) emissions.

Given ongoing political polarization in Washington and the inability of Congress to approve that more comprehensive and more cost-effective approach, this is probably the best the administration could do.  Together with the motor-vehicle fuel efficiency and appliance energy efficiency standards previously put in place, this is certainly a step in the right direction.

More broadly, the importance of these U.S. moves in the international context should not be underestimated.  Although the United States accounts for only about 17% of global CO2 emissions (second to China’s 26% in 2010), these steps by the U.S. government can help international efforts to bring the large emerging economies (China, India, Brazil, Korea, South Africa, and Mexico) on board for a future (Paris, 2015) agreement under the Durban Platform for Enhanced Action.

Domestically, EPA’s proposed state-by-state approach does not guarantee cost-effectiveness, because under the formula employed, marginal abatement costs will initially vary across states.  However, freedom is given to the states to employ market-based instruments, in particular, cap-and-trade systems (with carbon taxes presumably also an option).  And EPA has emphasized its willingness to consider multi-state implementation plans (think, for example, of the existing Regional Greenhouse Gas Initiative – RGGI – the cap-and-trade system operating in nine northeast states; and the likelihood of a future linked policy bringing together California’s AB-32 cap-and-trade system with policies in Oregon and Washington).

The ability of states to develop under EPA’s rule such linked systems of market-based instruments, as well as the freedom for states and regions to subsequently establish linkages means that although EPA may not be guaranteeing cost-effectiveness, it is certainly allowing for it, indeed it is facilitating it.

Response from Environmental Advocacy Groups and Industry

Much of the response this week has not been surprising.  The major environmental advocacy groups have been supportive of the proposed rule, despite the fact that they would prefer even greater ambition.  Many in industry have also offered praise for the approach, particularly because of the flexibility that EPA has given for the means of achieving emissions reductions.  In fact, some electricity-sector executives have been supportive, precisely for this reason, and appear to be encouraging the adoption of cap-and-trade systems.  At a minimum, leading electric utilities, including some that are fossil-heavy, such as FirstEnergy Corporation and American Electric Power, Inc., have taken a “wait-and-see” attitude, rather than attacking the proposal.

Also not surprising has been strong opposition from the coal industry, as well as some prominent industry trade associations, including the U.S. Chamber of Commerce.  Once the rule has become final (about a year from now), lawsuits will surely be filed by some of these private industry opponents and by a number of resistant states.

I will leave it to the lawyers to comment on the likely grounds of those anticipated lawsuits, as well as their probabilities of success.  But, clearly, for the plan to succeed it will need to survive those legal challenges, which will work their way through the courts over several years.

Also, a significant change in the senate majority and in the party holding power after the next presidential election could result in progress being slowed to a crawl, if not the abandonment of the approach proposed by the current administration.

None of that is particularly surprising, but what should be surprising is the fact that conservative attacks on EPA’s proposed rule have focused, indeed fixated, on one of the options that is given to the states for implementation, namely the use of market-based instruments, that is, cap-and-trade systems.  Given the demonization of cap-and-trade as “cap-and-tax” over the past few years by conservatives, why do I say that this fixation should be surprising?

The Irony of Conservatives Targeting Cap-and-Trade

Not so long ago, cap-and-trade mechanisms for environmental protection were popular in Congress. Now, such mechanisms are denigrated. What happened?  Professor Richard Schmalensee (MIT) and I recently told the sordid tale of how conservatives in Congress who once supported cap and trade had come to lambast climate change legislation as “cap-and-tax.” Ironically, in doing this, conservatives have chosen to demonize their own market-based creation.

In the late 1980s, there was growing concern that acid precipitation – the result of SO2 and, to a lesser extent, nitrogen oxides (NOx) reacting in the atmosphere to form sulphuric and nitric acids – was damaging forests and aquatic ecosystems, particularly in the northeast U.S. and southern Canada. In response, the U.S. Congress passed (and President George H.W. Bush signed into law) the Clean Air Act Amendments of 1990. Title IV of this law established the SO2 allowance-trading system.

By the close of the 20th century, the SO2 allowance-trading system had come to be seen as both innovative and successful.  However, the successful enactment and implementation of the SO2 cap-and-trade system in 1990 combined with the subsequent Congressional defeat of CO2 cap-and-trade legislation 20 years later has produced a striking irony. Market-based, cost-effective policy innovation in environmental regulation – in particular, cap-and-trade – was originally championed and implemented by Republican administrations from that of President Ronald Reagan to that of President George W. Bush.  But in recent years, Republicans have led the way in demonizing cap-and-trade, particularly as an approach to limiting carbon emissions.

For a long time, market-based approaches to environmental protection, such as cap-and-trade, bore a Republican label.  In the 1980s, President Ronald Reagan’s EPA put in place a trading program to phase out leaded gasoline. It produced a more rapid elimination of leaded gasoline from the marketplace than had been anticipated, and at a saving of some $250 million per year, compared with a conventional no-trade, command-and-control approach. Not only did President George H.W. Bush successfully propose the use of cap-and-trade to cut SO2 emissions, his administration advocated in international forums the use of emissions trading to cut global CO2 emissions (a proposal initially resisted but ultimately adopted by the European Union). In 2005, President George W. Bush’s EPA issued the Clean Air Interstate Rule, aimed at reducing SO2 emissions by a further 70% from their 2003 level. Cap-and-trade was again the policy instrument of choice.

From Bi-Partisan Support to Ideological Polarization

When the Clean Air Act Amendments were being considered in the Congress in 1989-1990, political support was not divided on partisan lines. Indeed, environmental and energy debates from the 1970s through much of the 1990s typically broke along geographic lines, rather than partisan lines, with key parameters being degree of urbanization and reliance on specific fuel types. Thus, the Clean Air Act Amendments of 1990 passed the Senate by a vote of 89-11 with 87% of Republican members and 91% of Democrats voting yea, and passed the House of Representatives by a vote of 401-21 with 87% of Republicans and 96% of Democrats voting in support.

But twenty years later, when climate change legislation was receiving serious consideration in Washington, environmental politics had changed dramatically, with Congressional support for environmental legislation coming mainly to reflect partisan divisions. In 2009, the House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454) – the Waxman-Markey bill – that included an economy-wide cap-and-trade system to cut CO2 emissions. The Waxman-Markey bill passed the House by a narrow margin of 219-212, with support from 83% of Democrats, but only 4% of Republicans. In July 2010, the Senate abandoned its attempt to pass companion legislation. In the process of debating this legislation, conservatives (largely Republicans and some coal-state Democrats) attacked the cap-and-trade system as “cap-and-tax,” much as an earlier generation of liberals had denigrated cap-and-trade as “selling licenses to pollute.”

It may be that some conservatives in Congress opposed climate policies because of disagreement about the threat of climate change or the costs of the policies, but instead of debating those risks and costs, they chose to launch an ultimately successful campaign to demonize and thereby tarnish cap-and-trade as an instrument of public policy, rendering it “collateral damage” in the wider climate policy battle.

Today that “scorched-earth” approach may have come back to haunt conservatives.  Have they now boxed themselves into a corner, unable to support the power of the marketplace to reduce their own states’ compliance costs under the new EPA CO2 regulation?  I hope not, but only time will tell.

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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.

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The Real Options for U.S. Climate Policy

The time has not yet come to throw in the towel regarding the possible enactment in 2010 of meaningful economy-wide climate change policy (such as that found in the Waxman-Markey legislation passed by the U.S. House of Representatives in June, 2009, or the more recent Kerry-Lieberman proposal in the Senate).  Meaningful action of some kind is still possible, or at least conceivable.  But with debates regarding national climate change policy becoming more acrimonious in Washington as midterm elections approach, it is important to ask, what are the real options for climate policy in the United States – not only in 2010, but in 2011 and beyond.  That’s the purpose of this essay.

Federal Policy Options

Let’s begin my considering Federal policy options under two distinct categories:  pricing instruments and other approaches.  Carbon-pricing instruments could take the form of caps on the quantity of emissions (cap-and-trade, cap-and-dividend, or baseline-and-credit), or approaches that directly put carbon prices in place (carbon taxes or subsidies).  Beyond pricing instruments, the other approaches include regulation under the Clean Air Act, energy policies not targeted exclusively at climate change, public nuisance litigation, and NIMBY and other public interventions to block permits for new fossil-fuel related investments.  I will discuss each of these in turn.

Quantity-Based Carbon Pricing

I’ve frequently written about cap-and-trade in the past (See, for example:  Here We Go Again: A Closer Look at the Kerry-Lieberman Cap-and-Trade Proposal; Eyes on the Prize:  Federal Climate Policy Should Preempt State and Regional Initiatives; Any Hope for Meaningful U.S. Climate Policy? You be the Judge; Confusion in the Senate Regarding Allowance Allocation?; Cap-and-Trade versus the Alternatives for U.S. Climate Policy; Can Countries Cut Carbon Emissions Without Hurting Economic Growth?; Cap-and-Trade: A Fly in the Ointment? Not Really; National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead; Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal; The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey; The Making of a Conventional Wisdom), and so I will be very brief on this instrument in this essay.

A Quick Reminder about Cap-and-Trade

In brief, there are four principal merits of the cap-and-trade approach to achieving significant reductions of carbon dioxide (CO2) emissions.  First, this approach achieves overall targets at minimum aggregate cost, that is, it is cost-effective, both in the short term by allocating responsibility among sources, and in the long term, by providing price signals that will drive technological innovation and diffusion of carbon-friendly technologies.  Second, the allowance allocation under a cap-and-trade system can be used to build a constituency of political support across sectors and geographic areas without driving up the cost of the program or reducing its environmental performance.  Third, we have significant experience in the United States with the use of this approach, including during the 1980s to phase out leaded gasoline from the marketplace, and since the 1990s to cut acid rain by 50 percent.  Fourth, and of great importance, a domestic cap-and-trade system can be linked directly and cost-effectively with cap-and-trade systems and emission-reduction-credit systems in other parts of the world to keep costs down domestically.

Three principal concerns have been voiced about cap-and-trade systems in U.S. debates.  First, while a cap-and-trade system constrains the quantity of emissions, the costs of control are left uncertain (although such cost uncertainty can be limited — if not eliminated — through the use of safety valves, price collars, or related mechanisms).  Second, in the wake of concerns regarding the roll that financial markets played in the global recession, there have been many fears about the possibilities of market manipulation in a cap-and-trade system.  A third concern – in a political context – is that this cost-effective approach to environmental protection, pioneered by the Republican administration of President George H. W. Bush, has – ironically — been demonized by conservatives in current debates.

That said, a variety of pending design issues will need to be addressed in the development of any cap-and-trade system, including:  ambition, scope (suddenly important because of a renewed focus in Washington on the possibility of a utility-only cap), point of regulation in the economy, allowance allocation, the role of offsets, cost-containment mechanisms, international competition protection, and regulatory oversight.  (I’ve written about all of these design issues in previous essays at this blog and elsewhere.)

A Design-Change for Cap-and-Trade?

Does the current political climate call for a design change — or at least a name change — for cap-and-trade?   Both stepwise and sectoral approaches are being considered.  A stepwise approach of beginning with one or a few sectors of the economy and subsequently expanding gradually to an economy-wide program was embodied in both the Waxman-Markey legislation and in the Kerry-Lieberman proposal.  Under a sectoral approach, cap-and-trade would be used for some sectors, but other approaches would be used for other parts of the economy.  To some degree, the Kerry-Lieberman proposal embodies this approach.  The current focus in Washington is on the possibility of using cap-and-trade for the electricity sector only.

Although the politics may argue for a stepwise or sectoral approach, it should be recognized that neither is likely to be cost-effective, because it is highly unlikely that marginal abatement costs will be equated across all sectors of the economy without the use of a single (implicit) price on carbon.

So the potential approach now receiving much attention in Washington of employing a cap-and-trade system in the electricity sector only would — in all likelihood — achieve less in terms of overall emissions reductions, and would not be cost-effective (due to the exclusion of other sectors).  However, it is at least conceivable that will prove to be the best among politically-feasible paths to a better future policy.  That is, of course, a political — not an economic — question.

A Populist Approach?

Populism has emerged as a major theme in recent electoral politics in the United States, both from the left and from the right.  What might be characterized as a populist approach would be a cap-and-trade system with 100% of the allowances auctioned and the auction revenue returned directly “to the people.”  Although this is a standard variant of cap-and-trade design, contemporary politics — with its demonization of the phrase “cap-and-trade” — might well argue for a name change:  how about “cap-and-dividend?”

This approach is embodied in the CLEAR Act of Senators Maria Cantwell (D-Washington) and Susan Collins (R-Maine).  The merits of this approach include its simplicity, appearance of fairness, and related appeal to the populist mood.  Concerns, however, include the proposal’s relatively modest environmental achievements (according to an analysis by the World Resources Institute), its overall cost due to restrictions on trading, and its apparent political infeasibility, given its lack of visible support in the Congress.

Other Trading Mechanisms

In addition to cap-and-trade, the other major type of tradable permit system is an emission-reduction-credit system, or baseline-and-credit system.  Because such approaches lack caps, they raise some well-known concerns, in particular the necessity of comparing actual emissions with what emissions would have been in the absence of the policy.  In such a system, the latter is fundamentally unobserved and unobservable.  This is the problem of “additionality,” which comes up in spades in the case of the Clean Development Mechanism (CDM), but also in the context of most other offset programs.

A related trading mechanism is found in the Clean Energy Standards approach, embodied in Senator Richard Lugar’s (R-Indiana) legislative proposal.  This mechanism is similar to a Renewable Portfolio Standard (RPS), but allows for a broader set of qualified sources;  not only renewables, but also nuclear power, fossil fuel power with carbon capture and storage (CCS), and – in principle — efficient natural gas.  If the clean energy credits are denominated in units of carbon free megawatt hours and are tradable, then the merits of this approach include the flexibility that is provided through trading.  The concerns include the lack of an emissions cap, and the difficulty of expanding this approach to other sectors or linking it with a cap-and-trade system.  However, if the clean energy credits are denominated in emissions per megawatt hour, then the program can more easily be converted to or linked with a cap-and-trade system.

Direct Carbon Pricing

A carbon tax system would be similar in design to an upstream cap-and-trade approach.  There is some real interest in this approach, mainly from academics, and there is also what I would characterize as “strategic interest,” principally from those who recognize that once the focus is on carbon taxes rather than other instruments, political debates will inevitably result in less ambitious targets or, in fact, no policy at all.

Carbon Taxes in Brief

Having said this, the merits of a carbon tax approach compared with cap-and-trade include the fact that cost uncertainty is eliminated with the tax approach (although, of course, there is quantity uncertainty, that is, no emissions cap).  And, I mentioned earlier, the cost uncertainty inherent in a cap-and-trade system can be reduced, if not eliminated, with cost-containment mechanisms such as a price collar.

Another merit of the carbon tax approach is that it would generate substantial revenues (as would a cap-and-trade system in which the allowances are auctioned).  These revenues can be used – in principle – for a variety of worthwhile public purposes, including reducing distortionary taxes, which would serve to lower the overall social cost of the policy.  Third, the tax approach is (at least perceived to be) much simpler than the allowance market that would be generated by a cap-and-trade scheme.

Major concerns regarding carbon taxes are fourfold.  First, despite their social cost-effectiveness, pollution taxes can be more costly to the regulated sector than even a non-cost-effective command-and-control instrument.  Second, unlike cap-and-trade, the tax approach lacks a benign mechanism for building political constituency, and is likely to lead to requests for tax exemptions, and hence a less ambitious policy and possibly a more costly one.  Third, although it is not impossible to link such as system internationally (for purposes of cost containment), it is more challenging to do so than with the quantity based cap-and-trade alternative.  A fourth and final concern is the apparent political infeasibility of this approach, at least currently in the United States.

In this regard, it is important to note that what has frequently been interpreted as hostility to cap-and-trade in the U.S. Senate is actually – on closer inspection — broader hostility to the very notion of carbon pricing (or any climate change policy).  Surely, the political reception to a carbon tax would be even less enthusiastic than the reception that has greeted recent cap-and-trade proposals.

Subsidies:  The Good, the Bad, and the Ugly

If it’s so politically difficult to tax “bad behavior,” how about subsidizing “good behavior?”  The mirror image of a tax is indeed a subsidy, and two potential price-based approaches to achieving greenhouse gas emission reductions are the use of climate-friendly subsidies and the elimination of problematic subsidies that exacerbate the climate problem.

In thinking about climate-friendly subsidies, we should first keep in mind that the Obama economic stimulus package enacted by the Congress includes significant subsidies (and tax credits) for renewables and efficiency upgrades — to the tune of about $80 billion.  A major problem has been that the administration (in particular, the Department of Energy) has been finding it difficult to spend the money fast enough.  Also, some would consider subsidies for biofuels, such as ethanol, as falling within this category of climate-friendly subsidies, but clearly that is a matter of considerable controversy.

Principal among the problematic subsidies – and hence major candidates for reduction or elimination – are subsidies for the development and use of fossil fuels.  According to the Environmental Law Institute, U.S. fossil-fuel subsidies and tax breaks currently amount to $8-$10 billon per year.  At the global level, the International Energy Agency has estimated that such fossil-fuel subsidies now amount to $550 billion annually!  President Obama proposed at the G20 meeting in Pittsburgh in November, 2009, that such subsidies be phased out around the world, and there seemed at the time to be broad-based support for this proposal.  However, it should not be surprising that less than a year later, it now appears that the commitment may be watered down somewhat at the G20 meeting in Toronto this June.

The merit of trying to use climate-friendly subsidies is based on the fact that subsidies affect relative prices, much like taxes do, but are much more politically attractive, since politicians prefer to give out benefits rather than costs to their constituents.  And eliminating problematic subsidies can be economically efficient.

But a major concern of using climate-friendly subsidies is that the funds go not only to marginal units that otherwise would not be taking specific actions, but also to infra-marginal units that are pleased to accept the funds, but whose behavior is unaffected by them.  This means that this approach is relatively costly to the government (and to society at large) for what is accomplished.  And a concern of removing fossil fuel subsidies – particularly in the current political climate of worries about oil imports – is that this can work against so-called “energy security” (some have therefore suggested the addition of an “oil import fee”).

Climate Change Regulation under the Clean Air Act

Regulations of various kinds may soon be forthcoming – and in some cases, will definitely be forthcoming – as a result of the U.S. Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding” that emissions of carbon dioxide and other greenhouse gases endanger public health and welfare.  This triggered mobile source standards earlier this year, the promulgation of which identified carbon dioxide as a pollutant under the Clean Air Act, thereby initiating a process of using the Clean Air Act for stationary sources as well.

Those new standards are scheduled to begin on January 1, 2011, with or without the so-called “tailoring rule” that would exempt smaller sources.  Among the possible types of regulation that could be forthcoming for stationary sources under the Clean Air Act include:  new source performance standards; performance standards for existing sources (Section 111(d)); and New Source Review with Best Available Control Technology standards under Section 165.

The merits that have been suggested of such regulatory action are that it would be effective in some sectors, and that the threat of such regulation will spur Congress to take action with a more sensible approach, namely, an economy wide cap-and-trade system.

However, regulatory action on carbon dioxide under the Clean Air Act will accomplish relatively little and do so at relatively high cost, compared with carbon pricing.  Also, it is not clear that this threat will force the hand of Congress.  Indeed it is reasonable to ask whether this is a credible threat, or will instead turn out to be counter-productive (when stories about the implementation of inflexible, high-cost regulatory approaches lend ammunition to the staunchest opponents of climate policy).

Furthermore, there is the question of possible preemption.  Although Senator Lisa Murkowski’s (R-Alaska) resolution was defeated in the Senate, Senator Jay Rockefeller’s (D-West Virginia) proposal of a two-year delay of Clean Air Act regulatory action is still pending; and depending upon the outcome of the November elections, there may be a series of further Congressional actions to tie the hands of EPA in this regard.

Regulation of Conventional Pollutants under the Clean Air Act

It’s also possible that air pollution policies for non-greenhouse gas pollutants, the emissions of some of which are highly correlated with CO2 emissions, may play an important role.  For example, the three-pollutant legislation co-sponsored by Senator Thomas Carper (D-Delaware) and Senator Lamar Alexander (R-Tennessee), focused on SOx, NOx, and mercury, could have profound impacts on the construction and operation of coal-fired electricity plants, without any direct CO2 requirements.  Beyond this, there are also possibilities of policies for the non-CO2 greenhouse gases.

Important, Unanswered Questions

An important pending question regarding EPA’s use of the Clean Air Act is whether EPA may legally create CO2 cap-and-trade or offset markets under existing Clean Air Act authority.  The answer appears to be “probably yes.”  There is positive precedent from EPA’s emissions trading program of the 1970s, and it’s a leaded gasoline phase-down of the 1980s, although recent court decisions regarding the Bush administration’s Clean Air Interstate Rule may cause concern in this regard.

The more important question, however, may turn out to be whether EPA can politically create significant CO2 markets in the face of Congressional opposition.  The answer to this is considerably less clear.

Energy Policies Not Targeted Exclusively at Climate Change

The “positive politics” generated by the Gulf oil spill, combined with the “negative politics” of addressing climate change explicitly, may well increase the likelihood of so-called “energy-only” legislation being enacted this year.  Senator Jeff Bingaman’s (D-New Mexico) bill from the Environment and Natural Resources Committee and perhaps Senator Richard Lugar’s bill will feature centrally in any bipartisan initiative.

The possible components of such an approach which would be relevant in the context of climate change include:  a national renewable electricity standard; Federal financing for clean energy projects: energy efficiency measures (building, appliance, and industrial efficiency standards; home retrofit subsidies; and smart grid standards, subsidies, and dynamic pricing policies); and new Federal electricity-transmission siting authority.

Other Legal Mechanisms

Even without action by the Congress or by the Administration, legal action on climate policy is likely to take place within the judicial realmPublic nuisance litigation will no doubt continue, with a diverse set of lawsuits being filed across the country in pursuit of injunctive relief and/or damages.  Due to recent court decisions, the pace, the promise, and the problems of this approach remain uncertain.

Beyond the well-defined area of public nuisance litigation, other interventions which are intended to block permits for new fossil energy investments, including both power plants and transmission lines will continue.  Some of these interventions will be of the conventional NIMBY character, but others will no doubt be more strategic.

Does the Road to National Climate Policy Need to Go through Washington?

With political stalemate in Washington, attention may increasingly turn to regional, state, and even local policies intended to address climate change.  The Regional Greenhouse Gas Initiative (RGGI) in the Northeast has created a cap-and-trade system among electricity generators.  More striking, California’s Global Warming Solutions Act (Assembly Bill 32, or AB 32) will likely lead to the creation of a very ambitious set of climate initiatives, including a statewide cap-and-trade system (unless it’s stopped by ballot initiative or a new Governor, depending on the outcome of the November 2010 elections).  The California system is likely to be linked with systems in other states and Canadian provinces under the Western Climate Initiative.

These sub-national policies will interact in a variety of ways – some good, some bad — with Federal policy when and if Federal policy is enacted.  As Professor Lawrence Goulder (Stanford University) and I have written in a new paper for the National Bureau of Economic Research (NBER), some of these interactions could be problematic, such as the interaction between a Federal cap-and-trade system and a more ambitious cap-and-trade system in California under AB 32, while other interactions would be benign, such as RGGI becoming somewhat irrelevant in the face of a Federal cap-and-trade system that was both more stringent and broader in scope.

An important question is whether there can be sensible sub-national policies even in the presence of an economy-wide Federal carbon-pricing regime?  The answer is surely yes, partly because other market failures will continue to exist that are not addressed by carbon pricing.  A prime example is the principal-agent problem of insufficient energy-efficiency investments in renter-occupied properties, even in the face of high energy prices.  This is a problem that is best addressed at the state or even local level, such as through building codes and zoning.

In the meantime, in the absence of meaningful Federal action, sub-national climate policies could well become the core of national action.  Problems will no doubt arise, including legal obstacles such as possible Federal preemption or litigation associated with the so-called Dormant Commerce Clause.  Also, even a large portfolio of state and regional policies will not be comprehensive of the entire nation, that is, not truly national in scope.  And even if they are nationally comprehensive, with different policies of different stringency in different parts of the country, carbon shadow-prices will by no means be equivalent, and so overall policy objectives will be achieved at excessive social cost.

Is there a solution, if only a partial one?  Yes, state and regional carbon markets can be linked.  Such linkage occurs as a result of bilateral recognition of allowances, which results in reduced costs, price volatility, leakage, and market power.  Such bottom-up linkage of state and regional cap-and-trade systems may be an important part or perhaps the core of future of U.S. climate policy, at least until there is meaningful action at the Federal level.  In the meantime, it is at least conceivable that linkage of state-level cap-and-trade systems across the United States will become the de facto post-2012 national climate policy architecture.

The Path Ahead

Conventional politics clearly disfavors market-based (pricing) environmental policy approaches that render costs obvious or at least somewhat transparent, despite the fact that the costs of these same policies are actually less than those of alternative approaches.  Instead, conventional politics favors approaches to environmental protection that render costs less obvious (or better yet invisible), such as renewable portfolio standards, and — for that matter — all sorts of command-and-control performance and technology standards.

But carbon pricing will be necessary to address the diverse economy-wide sources of CO2 emissions effectively and at sensible cost, whether the carbon pricing comes about through an economy-wide Federal cap-and-trade system or through a Federal carbon tax.  It is inconceivable that truly meaningful reductions in CO2 emissions could be achieved through purely regulatory approaches, and it remains true that whatever would be achieved, would be accomplished at excessively high cost.

So, although it is true – as I have sought to explain in this essay – that there are a diverse set of options for future climate policy in the United States, the best available alternative to an economy-wide cap-and-trade system enacted in 2010 may be an economy-wide cap-and-trade system enacted in 2011.  But ultimately, the question of what is the best alternative this year to an economy-wide cap-and-trade system is a political, not an economic question.

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