Bringing Ambition and Pragmatism to Climate Change Policy

In the world of environmental policy, it is frequently the case that pragmatism and effectiveness are framed as being at odds with passion and ambition.  Even more so, in the realm of climate change, it is the rare individual who can successfully merge ambition and pragmatism in the pursuit of intelligent and effective public policy.  Richard Schmalensee, my guest in the newest episode of our podcast, “Environmental Insights: Discussions on Policy and Practice from the Harvard Environmental Economics Program,” is just such a person.

In my conversation with Dick Schmalensee, the Howard W. Johnson Professor of Management, and Professor of Economics Emeritus at the Massachusetts Institute of Technology, he reflects on his many years working on environmental policy in public service and in academia.  Abundant insights arise, including important lessons for current climate policy deliberations in the United States, Europe, China, and other countries.

Professor Schmalensee was Dean of the MIT Sloan School of Management for 10 years, and Director of the MIT Center for Energy and Environmental Policy Research for 12 years.  Before and during those years, his research and teaching were in multiple areas of application of industrial organization, including antitrust, regulatory, energy, and environmental policies.

He is a Fellow of the Econometric Society and the American Academy of Arts and Sciences, a Director of the National Bureau of Economic Research, and Chairman Emeritus of the Board of Directors of Resources for the Future.  And I’m pleased to say that Dick is also an Associate Scholar of the Harvard Environmental Economics Program, and in recent years, has been my frequent co-author (for example, here, here, and here).

In addition to all of this, during a leave of absence from MIT, he served as a Member of the President’s Council of Economic Advisers in the George H.W. Bush administration.

Professor Schmalensee in his home study in Boston, 2020

In this latest Podcast episode, our conversation begins with Dick’s upbringing in a small town in southern Illinois, his move east to college and graduate school at MIT, his dissertation research, and the professional path that took him after receipt of his Ph.D. degree, first to California, and then back east to MIT’s Sloan School of Management.  We turn to his career in regulatory economics and policy – both his scholarly research and his close involvement in policy development and implementation, where he was “in the words of ‘Hamilton,” in the room where it happened.” 

Speaking at the Harvard Kennedy School, 2020

You won’t be surprised that we take time to focus on:  the pathbreaking cap-and-trade program launched by the Clean Air Act Amendments of 1990; and political changes in the United States that have moved environmental policy from being a truly bipartisan issue to a partisan one in today’s highly polarized politics.  Much of our conversation is about the current state of climate change policy – and policy research – both domestically and globally.

Delivering Keynote Address at the Toulouse School of Economics, 2017

Throughout the interview, Dick is at home in his disarming style of candid conversation, with no punches pulled.  He terms current U.S. climate change policy “a disaster,” saying it was a mistake “walking away from Paris, walking away from any sense that it’s important that we deal with our emissions and indeed walking away from the potential federal role in helping states and localities adapt to change.”

All of this and more is found in the newest episode of “Environmental Insights: Discussions on Policy and Practice from the Harvard Environmental Economics Program.” Listen to this latest discussion here, where you can also find a complete transcript of our conversation.

My conversation with Dick Schmalensee is the eleventh episode in the Environmental Insights series.  Previous episodes have featured conversations with:

 “Environmental Insights” is hosted on SoundCloud, and is also available on iTunes, Pocket Casts, Spotify, and Stitcher.

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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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