Tag Archives: distributional analysis

When Reasonable Policy Discussions Become Unreasonable Personal Attacks

Recently I was reminded of the controversy that erupted late in 2014 about remarks made by the distinguished health economist, Jonathan Gruber, professor at MIT for two decades. Professor Gruber, one of the country’s leading experts on health policy, had played an important role in the construction of the Obama administration’s Patient Protection and Affordable Care Act, subsequently derided by its political opponents as “Obamacare.”

A brief but intense political controversy and media feeding-frenzy erupted when videos surfaced in which Professor Gruber – largely in a series of academic seminars and conferences – explained how the Act was crafted and marketed in ways that would make it easier to develop political support. For example, he noted that insurance companies were taxed instead of patients, fundamentally the same thing economically, but vastly more palatable politically. He went on to note that this was possible because of “the lack of economic understanding of the American voter.” His key point was that the program’s “lack of transparency is a huge political advantage.” Is that a controversial or even unique observation?

A Truism of Political Economy

Any economist who has worked on the development or analysis of public policy – in areas ranging from health care policy to environmental policy to financial regulation – recognizes the truth of the key insight Gruber was communicating to his audiences. It is inevitably in the interests of the advocates of a policy to make the policy’s benefits transparent and to make its costs vague, even unobservable; just as it is in the interests of the opponents of a policy to make that policy’s benefits obscure and its costs as clear as the light of day.

The specific construction of hundreds of public policies are explained by this truism. In the United States, Corporate Average Fuel Economy Standards (or “CAFE standards”) have been a bipartisan Congressional success, despite the fact that the costs they place on the American public per unit of fuel savings are vastly greater than the costs of a commensurate increase in gasoline taxes. Likewise, when conservative opponents of CO2 cap-and-trade wanted to stop the House-passed bill in its tracks, they resorted to demonizing it as “cap-and-tax.”

So, the central lesson Professor Gruber was offering is hardly controversial, and its enunciation ought not lead to the terrible attacks that he suffered. He doesn’t need me to defend him, but he was unfairly demonized, simply because people disagreed with him politically regarding the merits of the public policy he had helped develop and support.

Unfortunately, I was reminded of this recently when I found myself subject to attempted demonization, because someone did not agree with a policy I supported. What happened to me is trivial compared with what Professor Gruber has gone through, but it prompts me to write about it today.

Can We Agree to Disagree?

I have written before at this blog about the reasons why I support my university’s decision not to divest its endowment of its fossil-fuel company holdings. I won’t repeat those arguments here, but will note that I have gone out of my way not to draw conclusions or make recommendations about what other universities or other institutions ought to do in this regard, including when I agreed to write an essay on the subject for Yale Environment 360. My analysis and conclusions were not developed in spite of my decades of research, teaching, and outreach on global climate change policy; rather, they were developed because of my years of work in this area.

There are people, some of whom I greatly respect, who have different perspectives on this issue, and have come to very different conclusions than have I. We have essentially agreed to disagree. They haven’t cast aspersions on me, nor I on them. As my writings on this topic have illustrated, there are many facets to the issue, including economics, politics, ethics, and even religion. No one has cornered the market on wisdom.

And What About the Keystone XL Pipeline?

Likewise, on a quite different topic, on January 8, 2015, Coral Davenport wrote a story in the New York Times about the political debates in Washington regarding the proposed Keystone XL pipeline, and stated that “… most energy and policy experts say the battle over Keystone overshadows the importance of the project as an environmental threat or an engine of the economy. The pipeline will have little effect, they say, on climate change, production of the Canadian oil sands, gasoline prices and the overall job market in the United States.” She went on to quote me (accurately) as having said, “The political fight about Keystone is vastly greater than the economic, environmental or energy impact of the pipeline itself. It doesn’t make a big difference in energy prices, employment or climate change either way.” What I said was consistent with the evidence at the time (note, however, that as oil prices fall, the possibility increases that the Canadian oil sands would be uneconomic to develop without the pipeline). Once again, the analysis is not one-dimensional, and reasonable people can respectfully disagree.

When Policy Debates Become Personal Attacks

But these two topics – the Keystone XL pipeline and fossil-fuel divestment – have increasingly become engulfed in highly-charged campaigns and exceptionally heated political debates. As part of this, my integrity was recently attacked, because of my views.  A young and – I’m sure – well-intentioned climate activist and journalist, writing in the Huffington Post, implied that my assessment in the New York Times of the Washington political debates regarding Keystone XL and my support for Harvard’s divestment policy, are because “Stavins has done consulting work for Chevron, Exelon, Duke Energy and the Western States Petroleum Association.”

The author of the Huffington Post piece selected those three companies and one trade association from a list of 92 “Outside Activities” that I voluntarily provide as a means of public disclosure. The author chose not to note that the vast majority of my outside engagements are with universities, think tanks, environmental advocacy NGOs, foundations, the U.S. Environmental Protection Agency, other federal agencies and departments, international organizations, and environment ministries around the world (not to mention a set of Major League Baseball teams, but that’s another story altogether).

But what about the four he did choose to highlight? First, I am very proud of my work supported by Chevron and the closely-related Western States Petroleum Association, in which I have carried out a series of analyses studying how to strengthen and improve California’s climate policy under AB-32. That’s right – developing and assessing ways to make the AB-32 cap-and-trade system and the related suite of “complementary policies” more environmentally effective, more cost-effective, and more equitable (I’ve written about this work several times at this blog).

Likewise, my work supported by Duke Energy began a decade ago when I helped the former CEO bring home to his senior management the importance of climate change and the importance of well-designed public policies (in particular, carbon cap-and-trade) to address it. All of my subsequent work supported by Duke Energy likewise has focused on the design of better market-based instruments – cap-and-trade – to reduce CO2 emissions.

And, finally, what about Exelon? This was interesting and important work I carried out with my friend and colleague, MIT Professor Richard Schmalensee, Dean Emeritus of the Sloan School of Management (I wrote about this work at this blog and at the Huffington Post). In 2011, with support from Exelon, Professor Schmalensee and I analyzed EPA’s proposals for new rules to regulate the interstate transport of sulfur dioxide and nitrogen oxides emitted from electric power generation facilities. You can read in detail about our multi-faceted assessment, but the bottom-line is that we provided strong support for a stringent rule. Our brief summary at the University of Pennsylvania’s RegBlog concludes: “In sum, while imposing incremental costs to achieve reductions in SO2 and NOX emissions, the Transport Rule would produce significant benefits in terms of improved health outcomes, and better environmental amenities and services, which studies estimate significantly outweigh the costs.”

Sadness and Empathy

It is nothing less than absurd – and, frankly, quite sad – that someone would suggest that my views on divestment and my New York Times quote on the politics of Keystone XL were somehow due to my having received previous support for analytical work for an oil company, a trade association, and two electric utilities. This was an unfortunate move to question my credibility and damage my reputation in a misguided attempt to demonize me, rather than engage in reasonable discussion and debate. Unfortunately, most of those who have read the activist/journalist’s original commentary and have possibly repeated his claims to others will not see the essay you have just read.

This is surely nothing compared with what Professor Gruber has gone through, but it has certainly increased my empathy for him, as well as my admiration.


Personal Attacks: An Even Sadder Epilogue

It’s nearly two months since I wrote the essay above, but a series of recent events prompts me to add this sad epilogue.  My family and I have recently been subject to cyber-bullying, harassment, and threats, because of my public stance in support of Harvard’s decision not to divest from its endowment portfolio its holdings of fossil-fuel company stocks.

In particular, the most recent message sent to me said in part: “You may be assured that I will have a lot to say about your vocal public support of Harvard’s fossil fuel investments, … and that I have a particular interest in making sure that [your] financial connections to the fossil fuel industry are made fully public …” This threat to tarnish my reputation by publicizing a supposed conflict of interest is striking for a number of reasons:

  • In several essays at this blog and elsewhere, I have carefully explained my reasons for supporting Harvard’s decision not to divest;
  • In several essays at this blog and elsewhere, I have been completely up front about receiving support for (publically available) analytical work I’ve carried out for private-sector companies (and have long provided a list of all outside engagements at my website);
  • In the essay above, I documented the fundamentally pro-environment, policy-analytic work I had done for the specific companies mentioned; and
  • The claim that my position regarding Harvard divestment has somehow been influenced by my work with an oil company and an industry trade association defies logic.

The last item on this list – the fundamental illogic of such a claim – merits explanation. People on all sides of the divestment issue (including leaders of the student movement, and including the person who wrote the threat I quoted above) acknowledge that divestment will have no direct financial impacts on the respective companies. Rather, the merit of divestment that is most frequently cited by supporters is its symbolic value. Because divestment has no financial impacts on the fossil-fuel companies, those companies don’t care much about it. They would not care one way or the other what I might have to say on the topic. Hence, even if I did want to curry favor with those companies, that would not lead me (or anyone else) to take a particular position on the divestment issue.

The more important question to ask is whether my research, teaching, and outreach initiatives on climate change economics and policy have been biased by my having carried out consulting assignments for an oil company and trade association (two of a hundred outside engagements over the past several years)? That is, if there really was a conflict of interest, then in an effort to make those companies happy, I would presumably pull my punches regarding recommendations of what does matter to those companies – public policies that will reduce their profits by increasing their costs of doing business and/or by reducing demand for their products. But nothing could be further from the truth!

For a decade or more, my research, teaching, and outreach have focused on more enlightened, stronger, and better climate change policies. I have been outspoken in regard to the pressing need for well-designed carbon-price instruments at the national and sub-national levels, and for the need for better, more effective international climate policies, both under the United Nations Framework Convention on Climate Change and through other venues. This is reflected in my published research, my teaching, and my outreach efforts, including through this blog.

It is ironic, offensive, and sad that anyone would suggest that my support of Harvard’s divestment position is somehow tied to my outside engagements. That suggestion – and the recent threats I have received – defies logic and is contradicted by the record.

The Warsaw Climate Negotiations, and Reason for Cautious Optimism

The Nineteenth Conference of the Parties (COP-19) of the United Nations Framework Convention on Climate Change (UNFCCC) came to a close in Warsaw, Poland, on Saturday, November 23rd, after what has become the norm – several all-night sessions culminating in last-minute negotiations that featured diplomatic haggling over subtle changes to the text on which countries were finally willing to agree.  The key task of this COP was essentially to pave the way for the negotiations next year at COP-20 in Lima, Peru, as a lead-up to the real target, reaching a new international climate agreement at the 2015 negotiations in Paris to be implemented in 2020, when the second commitment period of the Kyoto Protocol comes to an end.  If that was the key objective, then the Warsaw meetings must be judged to be at least a modest success – the baton was not dropped, rather it was passed successfully in this long relay race of negotiations.

Before going further, I would like to acknowledge something else about COP-19 in Warsaw, namely the excellent logistics.  Anyone who suffered through the disastrous logistical arrangements for COP-15 in Copenhagen will not take this for granted.  Perhaps ironically, in the years I’ve been participating in these annual events, the two best organized conferences (in terms of logistical arrangements) were the two Polish COPs – COP-14 in Poznan in 2008 and COP-19 in Warsaw this year.

As I have written in many previous essays at this blog, the challenges standing in the way of an effective international climate change agreement are numerous and severe.  A brief historical account is necessary to explain the significance of what transpired in Warsaw.  However, if you’re familiar with international climate policy, particularly the history of these international negotiations, I suggest you skip the next section and move directly to “Issue #1:  Making Progress toward a Post-Kyoto Agreement.”

Some Historical Background to Place the Warsaw Talks in Context:  the UNFCCC, the Berlin Mandate, the Kyoto Protocol, and the Durban Platform

The U.N. Framework Convention on Climate Change, adopted at the U.N. Conference on Environment and Development (the first “Earth Summit”) in Rio de Janeiro, Brazil, in 1992, contains what was to become a crucial passage:  “The Parties should protect the climate system for the benefit of present and future generations of humankind, on the basis of equity and in accordance with their common but differentiated responsibilities and respective capabilities. Accordingly, the developed country Parties should take the lead in combating climate change and the adverse effects thereof.” [emphasis added]  The countries considered to be “developed country Parties” were listed in an appendix to the 1992 Convention ­– Annex I.

The phrase – common but differentiated responsibilities – was given a specific interpretation three years after the Earth Summit by the first decision adopted by the first Conference of the Parties (COP-1) of the U.N. Framework Convention, in Berlin, Germany, April 7, 1995 ­­– the all important Berlin Mandate, which interpreted the principle as:  (1) launching a process to commit (by 1997) the Annex I countries to quantified greenhouse gas emissions reductions within specified time periods (targets and timetables); and (2) stating unambiguously that the process should “not introduce any new commitments for Parties not included in Annex I.”

Thus, the Berlin Mandate established the dichotomous distinction whereby the Annex I countries were to take on emissions-reductions responsibilities, and the non-Annex I countries were to have no such responsibilities whatsoever.  This had wide-ranging and profound consequences, because it became the anchor that prevented real progress in international climate negotiations.  With 50 non-Annex I countries coming to have greater per capita income than the poorest of the Annex I countries, the distinction was out of whack within a few years.

But, more important than that, this dichotomous distinction meant that:  (a) half of global emissions would be from nations without constraints; (b) the world’s largest emitter – China – would be unconstrained; (c) aggregate compliance costs would be driven up to be four times their cost-effective level, because many opportunities for low-cost emissions abatement in emerging economies were taken off the table; and (d) an institutional structure was perpetuated that made change and progress virtually impossible.

The dichotomous Annex I/non-Annex I distinction remained a central – indeed, the central – feature of international climate negotiations from COP-1 in Berlin in 1995 continuously until COP-15 in 2009, when hints of possible change first appeared.  The Copenhagen Accord (2009) and the Cancun Agreements (2010) began a process of blurring the Annex I/non-Annex I distinction.  But this blurring was only in the context of the interim pledge-and-review system established at COP-15 in Copenhagen and certified at COP-16 in Cancun, not in the context of an eventual successor to the Kyoto Protocol.  Thus, the Berlin Mandate retained its centrality.

Then, in December, 2011, at COP-17 in Durban, South Africa, the Durban Platform for Enhanced Action was adopted.  Under some interpretations, it essentially eliminates the Annex I/non-Annex I (or industrialized/developing country) distinction.  In the Durban Platform, the delegates decided to reach an agreement by 2015 that will be applicable to all countries by 2020.

Rather than adopting the Annex I/non-Annex I (or industrialized/developing country) distinction, the Durban Platform focuses instead on the pledge to create a system of greenhouse gas reductions including all Parties (what matters, really, is all key countries) by 2015 that will come into force by 2020.  Nowhere in the text of the decision were phrases such as “Annex I,” “common but differentiated responsibilities,” “distributional equity,” “historical responsibility,” all of which had long since become code words for targets for the richest countries and blank checks for all others.

By replacing the Berlin Mandate, the Durban Platform opened an important window.  National delegations from around the world took on the challenging task to identify a new international climate policy architecture that is consistent with the process, pathway, and principles laid out in the Durban Platform, namely to find a way to include all (key) countries (such as the 20 largest national and regional economies that together account for upwards of 80% of global carbon dioxide emissions) in a structure that brings about meaningful emissions reductions within an appropriate timetable at acceptable cost, while remaining within the overall framework provided by the UNFCCC, including the celebrated principle of common but differentiated responsibilities.

Issue #1:  Making Progress toward a Post-Kyoto Agreement

In Warsaw, the negotiators were tasked under the Durban Platform track (the so-called “ADP” track) to develop a work plan of substantive topics and a related calendar that will lead to the development of the text of an agreement of a new comprehensive policy architecture that can be discussed at COP-20 in Lima one year from now and then subject to final consideration and adoption a year after that at COP-21 in Paris.  This they did, and in the process they identified six components for the new architecture:  mitigation, adaptation, finance, technology development and transfer, capacity-building, and transparency of action and support.  Some of these are more necessary than others, but it was this package that generated agreement in Warsaw.

The actual agreement in Warsaw could only be achieved through carefully negotiated text.  The delegates’ obligation is to eventually adopt “a protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all Parties…”  In truth, the phrase “under the Convention” is not necessary, because any decision by the UNFCCC is under the Convention, and therefore it is the case that any agreement produced under the Durban Platform is still subject to the UNFCCC principle of “common but differentiated responsibilities.”  But the large emerging economies tend to view the phrase “under the Convention” as supporting the dichotomous distinction of, on the one hand, commitments for Annex I (industrialized) countries to reduce emissions, and, on the other hand, no obligations for non-Annex I (developing) countries, who would take actions only voluntarily and only with financial assistance from the Annex I countries.  The same set of large emerging economies insisted that if they were to be included in the agreement, then the word “commitments” must be replaced by “contributions.”

It is looking increasingly likely that the 2015 agreement will take the form of a hybrid architecture, combining:  (1) a bottom-up system of national commitments (sorry, national contributions) that arise from – or are at least consistent with – national policies and goals; plus (2) top-down, centralized management of oversight, guidance, and coordination, with an eye to increasing ambition over time.  At the Harvard Project on Climate Agreements, we outlined such a hybrid international climate policy architecture four years ago (“A Portfolio of Domestic Commitments: Implementing Common but Differentiated Responsibilities”), and we explored it further just last month in a new report (“Identifying Options for a New International Climate Regime Arising from the Durban Platform for Enhanced Action”).  In Warsaw, we co-hosted and participated in two sessions that explored these ideas in considerable detail (you can learn more about that here; we will soon place all of the slide decks from those sessions at the Harvard Project web site).

Issue #2:  Loss and Damage

As I predicted at the conclusion of last year’s climate negotiations (COP-18) in Doha, Qatar, the issue that held the greatest potential for blowing up this year’s talks in Warsaw was the topic of “loss and damage,” which the delegates agreed to put on the agenda for discussion this year at COP-19.  The phrase “loss and damage” is typically understood to refer to the range of damages and loss associated with climate change impacts in developing countries that are particularly vulnerable to the adverse effects of climate change.  Discussions about potential international policy in this realm frequently bring up thoughts about who should pay for such loss and damages, presumably those most responsible for climate change.

Since climate change is a function not of current emissions, but of concentrations, responsibility for damages is presumably correlated with cumulative emissions.  Hence, the industrialized countries, in particular, the United States, worry that negotiations on “loss and damage” would soon raise the specter of unlimited legal liability.

The link is less direct than one might think, however.  First, there is the global commons nature of the problem, meaning that climate change cannot be linked to emissions from a specific country.  Second, there is the highly stochastic link from climate change to changes in weather patterns, so that no specific weather incident – whether Superstorm Sandy in New York, Hurricane Katrina in New Orleans, or Typhoon Haiyan in the Philippines – can be deterministically linked with global climate change.  These two scientific realities mean that moving from “loss and damage” to legal liability would be a long and perilous road.

But this is a very important issue in the climate negotiations for many developing countries, in particular, for the small island states that are most at risk.  Hence, it should not be surprising that this area of discussion – in some ways only a sideshow of the primary talks on reducing emissions and the risk of climate change – almost caused the talks to collapse.

In the end, the delegates agreed to finesse the topic by creating the Warsaw International Mechanism for Loss and Damage, which does not mention liability or promise compensation, but rather states that this is a topic to be discussed further at future meetings, and under the general topic of adaptation to climate change.

Issue #3:  Finance

Those are two – the Durban Platform, and Loss and Damage – of three major issues that were considered in Warsaw.  The third was “finance,” that is, the question of when and how the industrialized countries will meet the commitment they made at COP-15 in Copenhagen in 2009 to begin delivering $100 billion per year of financial assistance to developing countries in 2020 to help with mitigation and adaptation.  Not surprisingly, there was little or no progress on that front.  More about this in a future essay.  For now ….

The Path Ahead – Any Reason for Optimism?

Given my description above of the debates and “resolution” regarding the major issues, is there any cause for optimism regarding the path ahead.  Regular readers of this blog will know that I tend to see the half-full glass (or one-tenth full glass) of water, and in this case I think there really is cause for cautious optimism regarding the path ahead.

This is based upon a singular reality – the growing convergence of interests between the two most important countries in the world when it comes to climate change and international policy to address it, namely, China and the United States.

First of all, the annual carbon dioxide (CO2) and greenhouse gas (GHG) emissions of these two countries have already converged. Whereas U.S. CO2 emissions in 1990 were almost twice the level of Chinese emissions, by 2006 China had overtaken the United States.  We are the world’s two largest emitters.

Second, as I explained above, cumulative emissions are particularly important, because they are what cause climate change.  Any discussion of distributional equity in the climate realm inevitably turns to considerations of historic responsibility.  Looking at the period 1850-2010, the United States led the pack, accounting for nearly 19% of cumulative global emissions of GHGs, with the European Union in second place with 17%, and China third, accounting for about 12% of global cumulative emissions.  But that is changing rapidly, because of the fact that emissions are flat to declining throughout the industrialized world, but increasingly rapidly in the large emerging economies, in particular, China.  Depending upon the relative rates of economic growth of China and the United States, as well as many other factors, China may top all countries in cumulative emissions within 10 to 20 years from now.

Third, China and the United States both have historically high reliance on coal for generating electricity.  At a time at which U.S. dependence on coal is decreasing (due to increased supplies of unconventional natural gas and hence lower gas prices ), China continues to rely on coal, but is very concerned about this, partly because of localized health impacts of particulates and other pollutants.  Importantly, both countries have very large shale gas reserves.  U.S. output (and use for electricity generation) has been increasing rapidly, bringing down CO2 emissions, whereas Chinese exploitation and output has been constrained by available infrastructure (i.e., lack of pipelines, but that will change).

Fourth, in both countries, sub-national climate policies – cap-and-trade systems – are moving forward.  In the case of the China, seven pilot CO2 cap-and-trade regimes at the local level are under development, while in the United States, California’s ambitious AB-32 cap-and-trade system continues to make progress.

Fifth and finally, there is the reality of global geopolitics.  If the twentieth century was the American Century, then many observers, including leaders in China, anticipate (or hope) that the twenty-first century will be the Chinese Century.  And, as I was quoted by David Jolly in the New York Times as saying, “If it’s your century, you don’t obstruct, you lead.”


There was no fundamental setback in Warsaw to the stream of work that needs to be accomplished in Lima in 2014 in preparation for an agreement to be reached in Paris in 2015 under the Durban Platform for Enhanced Action.  This, combined with the reality of increasing convergence of Chinese and U.S. perspectives and interests, leaves me cautiously optimistic (or perhaps, just hopeful) about the path ahead.


You can view and listen to an assessment of the Warsaw negotiations in a discussion in which I participated on the PBS NewsHour on November 27th, moderated by Judy Woodruff.

For other summaries and analyses of Warsaw’s COP-19 climate conference, I recommend:

Carraro, Carlo.  “COP19:  Between Weak Commitments and Tiny Successes.”  International Center for Climate Governance.  November 27, 2013.

Center for Climate and Energy Solutions.  “Outcomes of the U.N. Climate Change Conference in Warsaw.”  November, 2013.

Stowe, Robert.  “COP-19:  Different Strokes?”The Energy Collective, November 27, 2013.

Economics and Politics in California: Cap-and-Trade Allowance Allocation and Trade Exposure

In my previous essay at this blog – The Importance of Getting it Right in California – I wrote about the precedents and lessons that  California’s Global Warming Solutions Act (AB 32) and its greenhouse gas (GHG) cap-and-trade system will have for other jurisdictions around the world, including other states, provinces, countries, and regions.  This is particularly important, given the failure of the U.S. Senate in 2009 to pass companion legislation to the Waxman-Markey bill, passed by the U.S. House of Representatives, highlighting the absence of a national, economy-wide carbon pricing policy.

In my previous essay, I focused on three pending design issues in the emerging rules for the AB-32 cap-and-trade system:  (1) the GHG allowance reserve; (2) the role of offsets; and (3) proposals for allowance holding limits.  I drew upon a presentation I made on “Offsets, Holding Limits, and Market Liquidity (and Other Factors Affecting Market Performance)” at the 2013 Summer Issues Seminar of the California Council for Environmental and Economic Balance.

At the same conference, I made another presentation, which was on “Allowance Value Distribution and Trade Exposure,” a topic that is of great importance both economically and politically, not only in the context of the design of California’s AB-32 cap-and-trade system, but for the design of any cap-and-trade instrument in any jurisdiction.  It is to that topic that I turn today.  (For a much more detailed discussion, please see a white paper I wrote with Dr. Todd Schatzki of Analysis Group, “Using the Value of Allowances from California’s GHG Cap-and-Trade System,” August, 2012).

Why Does Anyone Care About the Allowance Value Distribution?

A cap-and-trade policy creates a valuable new commodity – emissions allowances.  In a well-functioning emissions trading market, the financial value of these allowances (per ton of emissions, for example) is approximately equivalent to their opportunity cost, which is the marginal cost of emissions reductions.  This is because of the existence of the overall cap, which – if binding – fosters scarcity of available allowances, and hence generates their economic value.

It should not be surprising, then, that the initial allocation of these allowances can have important consequences both for environmental and for economic outcomes.

Environmental Consequences of the Initial Allowance Allocation

No matter how many times I meet with policy makers around the world to talk about alternative policy instruments (for climate change and other environmental problems), I never cease to be struck by the confusion that abounds regarding the environmental (and the economic) consequences of the initial allocation of allowances in a cap-and-trade system.  As I have written many times in the past at this blog, the initial allocation does not directly affect environmental outcomes.  Regardless of the allocation method used, aggregate emissions are limited by the emissions cap.  This is true whether the allowances are sold (auctioned) or distributed without charge.  Furthermore, which firms or sources receive the initial allocation of allowances has no effect on either aggregate emissions or the ultimate distribution of emissions reductions among sources.

This independence of a cap-and-trade system’s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery in a path-breaking article in the Journal of Economic Theory (based upon his 1971 Harvard economics Ph.D. dissertation). It has been validated with empirical evidence repeatedly over the years.  (More below about the initial allocation’s potential effects on economic performance.)

However, it is also true that the initial allocation method can indirectly affect emissions.  In particular, emissions leakage can arise if economic activity shifts to unregulated sources – this risk is greatest with auctions or free fixed allocations.  In contrast, an updating, output-based allocation (used in AB 32 for “industry assistance”) can reduce leakage risk by making the free allocation of allowances marginal, rather than infra-marginal (as is the case with a simple free allocation).

Economic Consequences of the Initial Allowance Allocation

A favorite topic of academic economists is that the allowance allocation method in a cap-and-trade system can affect the overall social cost of the policy if the allowances are auctioned (sold by government to compliance entities), and if the revenues are then used to reduce distortionary taxes (such as taxes on labor and investment), thereby eliminating some deadweight loss and cutting overall social cost.  I discuss this a bit more below, but for now let’s recognize that the combination of two California propositions and subsequent court rulings means that the State is not permitted to use the auction proceeds to cut taxes (rather, any auction proceeds must be used to achieve the purposes of AB 32, that is, reducing GHG emissions).

So, within the set of feasible options, the initial allowance allocation will not directly affect the cost-effectiveness of actions taken by emission sources to reduce emissions.  In other words, aggregate abatement costs will not be directly affected by the nature of the initial allocation.

I was careful to use the word, “directly,” because the initial allowance allocation can indirectly affect economic outcomes.  In particular, the use of updating, output-based allocations can:  (1) lower the costs seen by consumers, which can reduce incentives to conserve; (2) avoid reductions in economic activity within California, with associated distributional impacts; and (3) avoid potential shifts of production to less efficient, more distant producers.

Auction Revenue Use

Decisions about how auction revenues are used can have profound consequences for the potential benefits of auctioning.  There are three basic options.

First, as I emphasized above, in theory, reducing distortionary taxes provides the greatest net economic benefit (by reducing the social cost of the policy).  But California’s unique legal context takes this option off the table.

Second, funding programs to address other market failures that are not addressed by the price signals provided by the cap-and-trade system can be meritorious.   For example, information spillovers can be addressed through financing of research and development activities, and the principal-agent problems that infect energy-efficiency adoption decisions in rental properties can be addressed — to some degree — through zoning and other local policies.

The third and final option, however, is highly problematic, if not completely without merit, and yet, ironically, there are strong incentives in place for policy makers to go this third route.  This third option is to use auction revenues to fund programs to subsidize emission reductions.  There is a strong incentive to do this, because of California’s legal constraint to employ any auction revenues in pursuit of the objectives of the statute, that is, reducing GHG emissions.

What’s the problem?  The AB-32 cap-and-trade system will cover approximately 85% of the economy.  In other words, the vast majority of sources are under the cap.  As I have explained in detail in several previous essays at this blog, under the umbrella of a cap-and-trade mechanism, (successful) efforts to further reduce emissions of capped sources will have three consequences:  (1) allowance prices will be supressed (take a look at the hand-wringing in Europe over allowance prices in its CO2 Emissions Trading System); (2) aggregate compliance costs will be increased (cost-effectiveness is reduced because marginal abatement costs are no longer equated among all sources); and (3) nothing is accomplished for the environment, in the sense that there are no additional CO2 emissions reductions (rather, the CO2 emissions reductions are simply relocated among sources under the cap).

Economics, Policy, and Politics

As I concluded in my previous essay, the California Air Resources Board has done an impressive job in its initial design of the rules for its GHG cap-and-trade system.  Of course, there are flaws, and therefore there are areas for improvement. A major issue continues to be the mechanisms used for the initial allocation of allowances.  Because of the economics and politics of this issue, it will not go away.  But, going forward, it would be helpful if those debating this issue could demonstrate better understanding of the allowance allocation’s real – as opposed to fictitious – environmental and economic consequences.

On the Origins of Research

In response to my last essay at this web site, “On Becoming an Environmental Economist,” several readers suggested that someday I should write about the origins of my various research initiatives over the past 25 years.  Today, I’m doing that sooner than anyone might have expected!

This is feasible because — also quite recently — I was asked by my colleague, Hannah Riley Bowles, the instructor in the Harvard Kennedy School’s Doctoral Research Seminar, to make a presentation to the first-year students in the Ph.D. program in public policy on how research programs develop.  To prepare for this, I reflected on my research projects over the past 25 years since receiving my PhD in economics at Harvard and joining the Kennedy School faculty, and as I began to write some notes for my presentation, a flow chart of research origins, subjects, and products started to emerge.  You can view my PowerPoint presentation (you need to use Slide Show mode to see the animation) here.

In this essay, I describe the elements of that flow chart of research sources, topics, and selected publications (and provide some screen shots of the PowerPoint deck).

As will probably be apparent, I found the process of preparing for Professor Bowles’s seminar valuable, because it forced me – for the first time in 25 years – to step back and reflect systematically on the origins of my research projects and the connections among them.  So, I recommend this process to other researchers, as I think you may find it rewarding.  And, for would-be researchers, that is, PhD students, I hope the results below will be informative.

An Ex Post Exploration of How Research Programs Develop

In carrying out this ex post exploration of how research programs may develop, I identified eleven types of sources of research ideas and projects.  In approximate chronological order (but not necessarily in order of importance), these are:

      • Dissertation
      • Involvement with the Policy World
      • Picking Up on Someone Else’s Work
      • Conferences
      • Funders
      • Student Interest
      • Responding to Others’ Work
      • Teaching
      • Consulting
      • Class Assignment
      • Invitation

I begin with how my dissertation research subsequently led to several avenues of further research and writing.

Dissertation — Analyzing Land Use

My 1988 Ph.D. thesis examined econometrically the factors that had led to the dramatic depletion of forested wetlands in the southern United States over the previous five decades.  Before commenting on how my dissertation stimulated my subsequent research, I should acknowledge that my dissertation topic itself grew of out of some consulting work I was doing at the time for the Environmental Defense Fund, in particular an analysis for James T. B. Tripp of how U.S. Army Corps of Engineers flood control projects were providing economic incentives for landowners to convert their forested wetlands to agricultural croplands.

My dissertation led directly to a pair of journal articles published in 1990 in the American Economic Review (with Adam Jaffe) and the Journal of Environmental Economics and Management.  But more striking – given the theme of this essay – is that several years later I realized that the general econometric approach and simulation model could be applied to a very different question, namely, analyzing the anticipated costs of biological carbon sequestration as a means of reducing net concentrations of carbon dioxide (CO2) in the atmosphere, linked with global climate change.  That recognition led to another article in the American Economic Review (1999), and then to a series of other, related projects on carbon sequestration (with Richard Newell 2000, and with Ruben Lubowski and Andrew Plantinga 2006, both in the Journal of Environmental Economics and Management), as well as a broader research initiative on factors affecting land-use decisions (with Plantinga and Lubowski in the Journal of Urban Economics in 2002 and Land Economics in 2008).  More recent work with Andrew Plantinga and Robin Cross (that does not appear in the schematic below) has involved an econometric analysis of the concept and reality of “terroir” associated with the production of premium wines (American Economic Review 2011, Journal of Wine Economics 2011).

A Less Direct Legacy of Dissertation:  Economics of Technological Change

A fundamental aspect of the econometric modeling involved in some of the land-use models above, including my dissertation research, was the estimation of the parameters of an empirical distribution of some heterogeneous attribute of land parcels, such as potential crop revenue (due to varying land quality, for example).  As costs of production fall, for example, that distribution would be swept, with various parcels going into production at various points in time.  Adam Jaffe and I hoped that this same sort of model could be applied to the process of technological diffusion, that is, the process of gradual adoption of some new technology over time.

As it turned out, however, the model was less useful than we first thought it would be for analyzing the factors affecting technology diffusion, and so we abandoned it for that purpose.  But this led us to explore other conceptual and empirical approaches to assessing the factors that lead to the diffusion of environmental technologies.  We developed a new framework for comparing empirically the effects of alternative environmental policy instruments on the diffusion of new technology, including Pigouvian taxes, technology adoption subsidies, and technology standards, with an empirical application to the diffusion of thermal insulation in new home construction, comparing the effects of energy prices, insulation cost, and building codes (Journal of Environmental Economics and Management 1995).  Related work with Nolan Miller and Lori (Snyder) Bennear followed in 2003 (American Economic Review).

Given our interest in the diffusion (adoption) of energy-efficiency technologies, it was natural to think about exploring the factors that affect the innovation (commercialization) of such technologies.  A very different model was developed — with Richard Newell taking the lead as part of his Harvard dissertation research — and an empirical application was made to analyzing the innovation of specific household energy-consuming durable goods (such as water heaters and air conditioners).  This work appeared in the Quarterly Journal of Economics in 1999.

More broadly, our interest in the innovation and diffusion energy efficiency technologies led us to explore in a series of articles the so-called “energy paradox” of apparently slow diffusion of technologies that appear to pay for themselves, as well as other issues related to energy-efficiency technological change (Energy Journal 1994, Resource and Energy Economics 1994, Energy Policy 1994, Elsevier Handbook of Economics 2003, Ecological Economics 2005, Energy Economics 2006, and many others).  And, recently, with a resurgence of interest in the energy paradox in the context of global climate change, Richard Newell and I have launched a new research initiative, with support from the Alfred P. Sloan Foundation.

Because I’ve sought to describe the origins of my research somewhat chronologically, I began with my dissertation research.  The fact that several strands of research — some directly related and some indirectly related to my dissertation — subsequently emerged will surely not surprise academic readers of this essay.  However, a considerably greater influence (indeed, the most important influence) on my research portfolio has come from my involvement — not with fellow scholars — but with practitioners in the world of public policy.  That may come as a surprise to some readers, and it is to this illustration of the two-way street between research and practice to which I now turn.

Involvement with the Policy World

A phone call I received in the late spring of 1988 — a week before my Harvard graduation — from Senator Timothy Wirth (D-Colorado), and a meeting shortly thereafter in Washington with Senator Wirth and his long-time friend and colleague, Senator John Heinz (R-Pennsylvania) led to an agreement that I would direct for them a study intended to inform the Presidential debates on environmental policy in that election year — Project 88:  Harnessing Market Forces to Protect the Environment (and a follow-up study in 1991, Project 88 — Round II, Incentives for Action: Designing Market-Based Environmental Strategies).

Many pages could be written — and, indeed, many have been written — about the influence that Project 88, sponsored by Senators Wirth and Heinz, subsequently had on policy developments at the federal level in Washington (including the path-breaking SO2 allowance trading program in the 1990 Clean Air Act amendments), within many states, and internationally in locations ranging from the European Union to China.  But my purpose in this essay is to examine the origins of my research portfolio, and so I will turn instead to reflect on the ways my experience with Project 88 (and related policy engagements with the White House, the Congress, and others) stimulated new paths of my scholarly research.

One path of research activity soon focused on normative analysis of alternative policy instruments, including work on:  transaction costs in cap-and-trade markets (Journal of Environmental Economics and Management 1995), the effects of correlated uncertainty on the choice between price and quantity instruments (Journal of Environmental Economics and Management 1996), vintage-differentiated regulations (Stanford Environmental Law Journal 2006), and policy instruments in second-best settings (with Lori Bennear, Environmental and Resource Economics 2007).  [The work on correlated uncertainty also illustrates an example of another source of research ideas, namely picking up on research by someone else, because this work was directly inspired by a footnote in Professor Martin Weitzman‘s classic work on “Prices vs. Quantities” (Review of Economic Studies 1974).]

Another area of work on normative analysis of policy instruments focused broadly on market-based instruments (with Robert Hahn, American Economic Review 1992; with Richard Newell, Journal of Regulatory Economics 2003; and the Elsevier Handbook of Environmental Economics 2003).  Other work focused more specifically on cap-and-trade systems (Journal of Economic Perspectives 1998; with Robert Hahn, Journal of Law and Economics 2011; and with Richard Schmalensee, Journal of Economic Perspectives 2013).

A conceptually distinct path of research that also found its origins in my work on Project 88 has involved examinations of the positive political economy of environmental policy (with Robert Hahn, Ecology Law Quarterly 1991; with Nathaniel Keohane and Richard Revesz, Harvard Environmental Law Review 1998; with Robert Hahn and Sheila Olmstead, Harvard Environmental Law Review 2003).

Even this extensive set of research projects and publications that derive from my work on Project 88 — depicted in the figure above — understates the influence that my work on Project 88 with Senators Wirth and Heinz has had on my scholarly research over the years.  This is because much of my work on global climate change policy, for example, has in fact focused on the potential use of market-based instruments in that realm, but for purposes of this essay, I associate that later work on climate policy with two other origins, namely, conferences and funders.

Conferences and Funders

Gradually over the 25 years since receipt of my PhD, my research has evolved from diverse work across environmental and natural resources economics, to more and more focus each year on various aspects of global climate change and related public policies.

“Climate skeptics” and other opponents of action to address climate change have sometimes accused the research community of focusing on climate change because “that is where the money is.”  Although there are sound reasons for focusing on climate change other than the availability of funds (such as the importance of the problem, and the methodological challenges it poses), there is some partial truth to the accusation.  Indeed, numerous national governments and major philanthropic foundations have made it their goal to stimulate research (and action) on climate change.

One part of my work in this realm has been research on national and sub-national climate policy instruments, often focused on the design of market-based instruments, including but not limited to cap-and-trade mechanisms (Brookings Institution 2007; Harvard Environmental Law Review 2008; Oxford Review of Economic Policy 2008; and my work on the Intergovernmental Panel on Climate Change, Second, 1995, and Third, 2001, and Fifth Assessment Reports.

An invitation from the Doris Duke Charitable Foundation to propose and eventually direct an international research and outreach project on international climate policy architecture led to much (but not all) of my work on international climate policy cooperation (with Joseph Aldy and Scott Barrett, Climate Policy 2003; with Scott Barrett, International Environmental Agreements 2003: with Sheila Olmstead, American Economic Review 2006; three books with Joseph Aldy published by Cambridge University Press 2007, 2009, 2010; an article with Judson Jaffe and Matthew Ranson, Ecology Law Quarterly 2010; and ongoing work on the IPCC Fifth Assessment Report 2010-2014; and much more).

Student Interest

Many professors who are reading this essay will not be the least bit surprised to learn that another origin of research ideas has been interest expressed by graduate students.  Three important examples stand out in my case.

One I have already written about above.  When Richard Newell (my very first PhD student) came to Harvard for graduate school in 1993, he brought with him an abiding interest in the relationship between science, technology, and policy.  At the time, Adam Jaffe and I were continuing our work on the diffusion of energy-efficiency technologies, and then the U.S. Department of Energy (DOE) solicited proposals for research that could improve the modeling of technological change in integrated assessment models of climate change (so this covers two other origins — involvement with the policy world, and potential funding).  All of this came together in a joint research initiative, funded by DOE, which supported Newell’s dissertation research on factors affecting the pace and direction of energy-efficiency technology innovation.  This led to a subsequent publication with Jaffe and Newell (Quarterly Journal of Economics 1999), as well as series of other collaborations with Newell, which are on-going to this day.

In 1999, Sheila (Cavanagh) Olmstead came to the Harvard PhD program in public policy with a strong background and keen interests in water resources and water policy.  I brought on board Michael Hanemann, then a professor at the University of California at Berkeley, as a collaborator, and together we applied (successfully) to the National Science Foundation for a grant that supported Sheila’s dissertation research on econometrically estimating demand for municipal water in the presence of block-rate pricing schedules.  Not only did that lead directly to some published work (with Olmstead and Hanemann, Journal of Environmental Economics and Management 2007), but led indirectly to other research on water pricing(with Olmstead, Water Resources Research 2009).

The work on carbon sequestration and land use described above with Ruben Lubowski and Andrew Plantinga (Journal of Environmental Economics and Management 2006; Journal of Urban Economics 2002; Land Economics 2008) also deserves mention in this part of the essay, because it all grew out of Ruben Lubowski‘s PhD dissertation research at Harvard.

Responding to Others’ Work

I mentioned above an example of picking up on someone else’s work (in a positive sense), namely a footnote in Marty Weitzman’s classic 1974 article on “Prices vs Quantities” in which he noted that he was assuming statistical independence between marginal benefits and marginal costs, which stimulated me to relax that assumption and pursue the analysis (which led to my article on the effects of correlated uncertainty in 1996 in the Journal of Environmental Economics and Management).

By contrast, sometimes researchers can be stimulated to do work in order to question others’ previous work (and related conventional wisdom).  This was the case with my collaborative work examining the topic of “corporate social responsibility,” an area of scholarship that some colleagues and I believed was populated by research and writing that generated more heat than light.  A conference we organized at Harvard led to a subsequent book that examined Environmental Protection and the Social Responsibility of Firms:  Perspectives from Law, Economics, and Business (with Harvard Law School professor, Bruce Hay, and Harvard Business School professor, Richard Vietor, 2005).  Later, I took the next step with a follow-up article with Vietor and his Harvard Business School colleague, Forest Reinhardt (Review of Environmental Economics and Policy 2008), and another with Reinhardt (Oxford Review of Economic Policy 2010).


Classroom teaching can itself provide inspiration for research.  In 2002, I was teaching a small “reading and research course” for PhD students interested in environmental economics, and lamented one day that the increasingly popular concept of “sustainability” seemed to lack a clear definition or interpretation that made sense in economic terms.  I offered a possible economic interpretation in class, and within a week, two students — Gernot Wagner and Alexander Wagner (unrelated) — had written out a mathematically formalized version of my interpretation.  We collaborated on writing a brief article that provided background as well as further exploration (Economic Letters 2003).


It may (or may not) come as a surprise that consulting (work I do outside of my Harvard responsibilities, sometimes for compensation, sometimes not) can also lead to interesting research ideas.  In my case, this has led to my thinking more carefully — with collaborators — about the analytical methods that surround net present value analysis (also called, benefit-cost analysis).

This has led to a series of papers on various dimensions of net present value analysis in the environmental realm, including such topics as:  the meaning, limits, and value of the Kaldor-Hicks criterion (with Kenneth Arrow and others, Science 1996); the role of discounting (with Lawrence Goulder, Nature 2002); new benefit-estimation methods (with Paul Portney, Journal of Risk and Uncertainty 1994; and with Lori Bennear and Alexander Wagner, Journal of Regulatory Economics 2005); and the use of Monte Carlo analysis to incorporate uncertainty in regulatory impact analysis (with Judson Jaffe, Regulation and Governance 2007).

Also, as I mentioned at the outset, my 1988 dissertation topic had grown out of some consulting work I was doing at the time for the Environmental Defense Fund.

Class Assignments

Many of my PhD students over the years have written term papers for courses that led to manuscript that were eventually published in academic journals.  But in my own case, because my PhD training in economics at Harvard did not include any courses in environmental economics (none existed at the time, as you may have noted in my previous essay, “On Becoming an Environmental Economist”), the only example I can provide of this origin of research is in a different area, namely economic history.  This is an area in which I took two wonderful courses from Professor Jeffrey Williamson (about which I wrote in my previous post).  An econometric analysis I carried out for one of those courses — “A Model of English Demographic Change: 1573-1873” was subsequently published (Explorations in Economic History 1988).

Invitations (and other origins)

There’s a clear positive correlation between the onset of grey hair and the frequency of invitations to write articles (or books) for publication.  These have included:  an article with Don Fullerton on how economists view the environment in Nature (1998); an article on common property resources in the American Economic Review (2011); my ongoing column, “An Economic Perspective” in The Environmental Forum (2006-present); my blog, “An Economic View of the Environment,” which was launched in 2009; two books of my collected works, 1988-1999 and 2000-2011 (Edward Elgar 2001, 2013); and three editions of a book of selected readings in environmental economics (W. W. Norton 2000, 2005, 2012).

Results of an Ex Post Exploration of Research Origins

Putting all of that together in a single flow chart results in the figure below, which is much clearer in a PDF version.  You can also view the entire PowerPoint presentation (you need to use Slide Show mode to see the animation) here.

As I said at the outset, I found the process of preparing this slide deck for Professor Bowles’s seminar valuable, because it enabled me to step back and reflect systematically on the origins of my research initiatives over the years and the relationships among them.  I recommend this process to other academics, because I believe it can be rewarding.  And, for academics in-the-making, that is, PhD students, I hope this essay may be informative.

On Becoming an Environmental Economist

My essay this month represents a departure from my standard blog posts about a contemporary environmental policy issue.  Rather, it is of a more personal nature, and stems from the fact that the second volume of my collected papers has just been published by Edward Elgar, Economics of Climate Change and Environmental Policy:  Selected Papers of Robert N. Stavins, 2000-2011 (2013), a successor to the first volume, published in 2000, Environmental Economics and Public Policy:  Selected Papers of Robert N. Stavins, 1988-1999.

When the publisher invited me to collect my papers in these edited volumes, it was suggested that I write a personal introduction in which I might reflect on the professional path that led to my research and writing.  I did this, and the introductory chapter of the second volume contains my latest reflections on that path.  This essay essentially consists of an abbreviated version.  My hope is that some readers will find it of interest, particularly students and others who aspire to work in this exciting and growing field.

A Professional Path

Over the past two decades, environmental and resource economics has evolved from what was once a relatively obscure application of welfare economics to a prominent field of economics in its own right.  The number of articles on the natural environment appearing in mainstream economics periodicals has continued to increase, as has the number of economics journals dedicated exclusively to environmental and resource topics.  Likewise, the influence of environmental economics on public policy has increased significantly, particularly as greater use has been made of market-based instruments for environmental protection.

In retrospect, my own professional path may now appear somewhat direct, if not altogether linear, but it hardly seemed so as I traveled along it.  The path I describe below took me back and forth across the United States and to several continents, and it took me from physics to philosophy, to agricultural extension, to international development studies, to agricultural economics, and eventually to environmental economics.  It culminated in my receipt in 1988 of a Ph.D. degree in economics at Harvard University, where I have since been a faculty member at the John F. Kennedy School of Government.  During this time, much has changed in the profession.

Early Days at Harvard

The early ascendency of the field of environmental economics, during the period from 1970 to 1990, was centered within departments of agricultural and resource economics, mainly at U.S. universities, and at Resources for the Future (RFF), the Washington research institution.  Within most economics departments, however, environmental studies remained a relatively minor area of applied welfare economics.  So, when I enrolled in the Ph.D. program in Harvard’s Department of Economics in 1983, and when I received my degree five years later, no field of study was offered in the field of environmental or resource economics.

Fortunately, Harvard permitted its graduate students to develop an optional, self-designed field as one of two “special fields” on which they were to be examined orally before proceeding to dissertation research.  Without an active environmental economist in the Department of Economics (Robert Dorfman had retired, and Martin Weitzman had yet to move to Harvard from the Massachusetts Institute of Technology), I developed an outline and reading list of the field through correspondence with leading scholars from other institutions, most prominently Kerry Smith, then at North Carolina State University.  My proposal to prepare for and be examined in the special field of environmental and resource economics (along with econometrics) was approved by the Department’s director of graduate study, Dale Jorgenson.  So began my entry into the scholarly literature.

A Nurturing Environment at Cornell

But my interest in environmental economics pre-dated by a considerable number of years my matriculation at Harvard.  Like many others before and since, I came to the field because of a personal interest in the natural environment (the origin of which I describe below).  This personal interest evolved into a professional one while I was studying for an M.S. degree in agricultural economics at Cornell University in the late 1970’s, where my thesis advisor and mentor was Kenneth Robinson.  I had originally gone to Cornell to study for a professional degree in international development, but found agricultural economics more appealing, largely because of the opportunity to examine social questions with quantitative methods within a disciplinary framework.

The faculty at Cornell and the care given to graduate students (including masters students like me) were both outstanding.  Ken Robinson, my first mentor within the economics profession, became my ongoing role model for intellectual integrity.  It was a very sad day in 2010 when Professor Robinson passed away.

A course in linear algebra, brilliantly taught by S. R. Searle, inspired me to pursue quantitative methods of analysis, and I was fortunate to then have the opportunity to study econometrics with Tim Mount.  One summer I had the great privilege of learning comparative economic systems in a small workshop setting from George Staller of the Cornell Department of Economics.   Working with Bud Stanton, I had my first experience teaching at the university level, and with Olan Forker, I had my first try at serious writing.  All of this led to research and writing of an M.S. thesis, “Forecasting the Size Distribution of Farms:  A Methodological Analysis of the Dairy Industry in New York State.”  The methodology in question was a variable Markov transition probability matrix, the cells of which were estimated econometrically in a multinomial logit framework.  Much to my surprise, this work subsequently received the Outstanding Master’s Thesis Award in the national competition of the American Agricultural Economics Association.

A Defining Move from Ithaca to Berkeley

Armed with my M.S. degree, I moved from Cornell to Berkeley, California, where I eventually met up with Phillip LeVeen, who had until shortly before that time been a faculty member in the Department of Agricultural and Resource Economics at the University of California, Berkeley.  Phil was another superb mentor, and from him I learned the power of using simple models — by which I mean a set of supply and demand curves hastily drawn on a piece of scrap paper — to develop insights into real-world policy problems.  He introduced me to a topic that was to occupy me for the next few years — California’s perpetual concerns with water allocation.  I remember many afternoons spent working with Phil at his dining room table on questions of water supply and demand.

This work with Phil LeVeen led to a consultancy and then a staff position with the Environmental Defense Fund (EDF), the national advocacy group consisting of lawyers, natural scientists, and — then almost unique among environmental advocacy organizations — economists.  At EDF, I was able to experience for the first time the use of economic analysis in pursuit of better environmental policy.  With W. R. Zach Willey, EDF’s senior economist in California, as a role model, and Thomas Graff, EDF’s senior attorney, as my mentor, I thrived in EDF’s collegial atmosphere, while thoroughly enjoying life in Berkeley’s “gourmet ghetto,” as my neighborhood was called.  Sadly, Tom Graff — without whose mentorship I would not be where I am today — passed away in 2009 after a heroic battle with cancer.

Although I found the work at EDF exceptionally rewarding, I worried that I would eventually be constrained — either within the organization or outside it — by my limited education.  So, like many others in similar situations, I considered a law degree as the next logical step.  In fact, I came very close to enrolling at Stanford Law School, but instead, in 1983, I accepted an offer of admission to the Department of Economics at Harvard, moved back east to Cambridge, Massachusetts, and began what has turned out to be a long-term relationship with the University.

Origins of Interest in Environmental Economics

But where did my interest in the natural environment begin?  Not at Cornell; it was present long before those days.  But it had not yet arisen when I was studying earlier at Northwestern University, from which I received a B.A. degree in philosophy, having departed from my first scholarly interest, astronomy and astrophysics.

Rather, the origins of my affinity for the natural environment and my interest in resource issues are to be found in the four years I spent in a small, remote village in Sierra Leone, West Africa, as a Peace Corps Volunteer, working in agricultural extension (in particular, paddy rice development).  It was there that I was first exposed both to the qualities of a pristine natural environment and the trade-offs associated with economic development.

So, I had begun in astrophysics, moved to philosophy (both at Northwestern), then to agricultural extension in a developing country (Sierra Leone), then to international development studies and subsequently to agricultural economics (both at Cornell), then to environmental economics and policy (EDF), and eventually to graduate study in economics at Harvard.

From Berkeley to Cambridge

My dissertation research at Harvard was directed by a committee of three faculty members:  Joseph Kalt, Zvi Griliches, and Adam Jaffe.  Joseph Kalt was the first faculty member at the Department of Economics to validate my interest in environmental and resource issues, and he was unfailingly generous to me and many other graduate students in making his office (and computer, then a rather scarce resource) available at all hours.  Now a colleague at the Kennedy School, Joe provided examples never to be forgotten — that economics could be a meaningful and enjoyable pursuit, and that excellence in teaching was a laudable goal.

Zvi Griliches was not only my advisor and mentor, but my spiritual father as well.  Generations of Harvard graduate students would offer similar testimony.  My own father had died only a year before I entered Harvard, and Zvi soon filled for me many paternal needs.  It is now more than a decade since Zvi himself passed away.  I felt as if I had lost my father a second time.

If Zvi Griliches provided caring and inspiration, Adam Jaffe provided invaluable day-to-day guidance.  It was Adam who convinced me not to go on the job market in my fourth year with what would have been a mediocre dissertation, but to put in another year and do it right.  That turned out to be some of the best professional advice I have ever received.  Our intensive faculty-student relationship from dissertation days subsequently evolved into a very productive professional (and personal) one that continues to this day.  The name of Adam Jaffe appears frequently in my curriculum vitae as a co-author; he has been and continues to be much more than that.

Although they were not members of my thesis committee, I should acknowledge two other faculty members at the Harvard Department of Economics who played important roles in my education.  I was fortunate to take two courses in economic history (a department requirement) from Jeffrey Williamson, who had recently arrived from the University of Wisconsin.  Williamson’s class sessions were as close as anything I have witnessed to being an economic research laboratory.  In class after class, we would carefully dissect one or more articles — examining hypothesis, theoretical model, data, estimation method, results, and conclusions.  If there was any place where I actually learned how to carry out economic research, it was in those classes.

The other name that is important to highlight is that of Lawrence Goulder, then a faculty member at Harvard, and now a professor at Stanford.  I say this not simply because he was willing to be my examiner in my chosen field of environmental and resource economics, nor because he subsequently became such a close friend.  Rather, what is striking about my professional relationship with Larry is the degree to which he has been an unnamed collaborator on so many projects of mine.  Although he and I have co-authored no more than a few articles, his name probably appears more frequently than anyone else’s in the acknowledgments of papers I have written.  There is no one whose overall judgement in matters of economics I trust more, and no one who has been more helpful.

First Steps for a Newly-Minted Ph.D. Recipient

When I began graduate school at Harvard in 1983, it was my intention to return to EDF as soon as I received my degree.  But by my third year in the program, I had decided to pursue an academic career, although one that was heavily flavored with involvement in the real world of public policy.  Within the context of this professional objective, it was not a difficult decision to accept the offer I received in February, 1988, to become an Assistant Professor at the Kennedy School.  Although some of the other offers I received at that time were also very attractive, the choice for me was obvious, and I have never regretted it — not for a moment.

I remain at the Kennedy School today, where I was promoted to Associate Professor in 1992 (an untenured rank at Harvard), and to a tenured position as Professor of Public Policy in 1997.   In 1998, I accepted an appointment as the Albert Pratt Professor of Business and Government.

Twenty-Five Years on the Harvard Faculty

Two years later, I launched the Harvard Environmental Economics Program, which today brings together — from across the University — thirty Faculty Fellows and twenty-five Pre-Doctoral Fellows, who are graduate students studying for the Ph.D. degree in economics, political economy and government, public policy, or health policy.  The Program, which I continue to direct, forms links among faculty and graduate students engaged in research, teaching, and outreach in environmental, natural resource, and energy economics and related public policy, by sponsoring research projects, convening workshops, and supporting graduate (and undergraduate) education.

A key reason why the Program — and its various projects, including the Harvard Project on Climate Agreements — have been so successful is the superb administrative leadership and staff support  it enjoys.  Everyone who has been involved in virtually any way has come away impressed by our Executive Director, Robert Stowe, and Program Manager, Jason Chapman.

At the Kennedy School, I have had an excellent mentor, William Hogan, and a superb advisor and friend, Richard Zeckhauser.  Over the years, five successive deans have provided leadership, guidance, and support (including abundant time for my research and writing) — Graham Allison, Robert Putnam, Albert Carnesale, Joseph Nye, and David Ellwood.  At Harvard more broadly, I have benefitted from regular interactions with Daniel Schrag, director of the Harvard University Center for the Environment, and Martin Weitzman of the Department of Economics.  For two decades, Marty and I have co-directed a bi-weekly Seminar in Environmental Economics and Policy, which has provided me with frequent opportunities to learn both from seminar speakers and from Marty’s questions and comments.  I will refrain from naming the many others at Harvard and elsewhere from whom I continue to learn — including my many co-authors — only because the list of such valued colleagues and friends is so long.  Included have been a most remarkable set of Ph.D. students, many of whom have gone on to productive — indeed illustrious — careers.

Along the way, I have had my share of administrative responsibilities at Harvard, including serving as Director of Graduate Studies for the Doctoral Program in Public Policy and the Doctoral Program in Political Economy and Government, and Co-Chair of the Harvard Business School-Harvard Kennedy School Joint Degree Programs.  Outside of Harvard, I have had the privilege of being a University Fellow of Resources for the Future, a Research Associate of the National Bureau of Economic Research, and the founding Editor and now Co-Editor of the Review of Environmental Economics and Policy, as well as a member of the Board of Directors of Resources for the Future, the Scientific Advisory Board of the Fondazione Eni Enrico Mattei, and numerous editorial boards. I must also note that I serve as an editor of the Journal of Wine Economics.  In 2009, I was elected a Fellow of the Association of Environmental and Resource Economists.

Working with the “Real World”

What originally attracted me to the Kennedy School was the possibility of combining an academic career with extensive involvement in the development of public policy.  I have not been disappointed.  Indeed, a theme that emerges from my collected papers is the interplay between scholarly economic research and implementation in real-world political contexts.  This is a two-way street.   In some cases, my policy involvement has come from expertise I developed through research, following a path well worn by academics.  But, in many other cases, my participation in policy matters has stimulated for me entirely new lines of inquiry.

What I have characterized as involvement in policy matters is described at the Kennedy School as faculty outreach, recognized to be of great institutional and social value, along with the two other components of our three-legged professional stool — research and teaching.  Because they relate to a number of the papers collected in this volume, I should note that my outreach efforts fall into five broad categories:  advisory work with members of Congress and the White House (for example, Project 88, a bipartisan effort co-chaired by former Senator Timothy Wirth and the late Senator John Heinz, to develop innovative approaches to environmental and resource problems); service on federal government panels (for example, my role as Chairman of the Environmental Economics Advisory Committee of the U.S. Environmental Protection Agency Science Advisory Board); on-going consulting — often on an informal basis — with environmental NGOs (most frequently, the Environmental Defense Fund) and private firms; advisory work with state governments; and professional interventions in the international sphere, such as service as a Lead Author for the Second and the Third Assessment Reports and a Coordinating Lead Author for the Fifth Assessment Report of the Intergovernmental Panel on Climate Change, professional roles with the World Bank and other international organizations, and advisory work with foreign governments.

Finally, because my two books of collected papers focus on my articles, not my books, I should note that over the years I have been privileged to be co-editor with Joseph Aldy of Post-Kyoto International Climate Policy:  Implementing Architectures for Agreement (Cambridge University Press, 2010), Post-Kyoto International Climate Policy:  Summary for Policymakers (Cambridge University Press, 2009), and Architectures for Agreement: Addressing Global Climate Change in the Post-Kyoto World (Cambridge University Press, 2007); editor of three editions of Economics of the Environment (W. W. Norton, 2000, 2005, 2012); co-editor with Bruce Hay and Richard Vietor of Environmental Protection and the Social Responsibility of Firms:  Perspectives from Law, Economics, and Business (Resources for the Future, 2005); editor of The Political Economy of Environmental Regulation (Edward Elgar, 2004), co-editor with Paul Portney of Public Policies for Environmental Protection (Resources for the Future, 2000); and author of Environmental Economics and Public Policy: Selected Papers of Robert N. Stavins, 1988-1999 (Edward Elgar, 2000).

The New Volume

That last book is the predecessor of the new volume.  Whereas the first volume (Stavins 2000) included selected papers from the period 1988 through 1999, the second volume covers the period from 2000 through 2011.  To prepare this new book, I selected 26 articles from the (many more) published papers I wrote  — frequently with co-authors — over the past decade.  Making this selection was not an easy task, but it was a rewarding one, because choosing the papers and organizing them has forced me to step back and reflect on the set of research endeavors in which I have been engaged over this decade, and thus to think more clearly about current and possible future directions.

The book is divided into seven parts.  The papers in Part I provide an overview of environmental and resource economics, treating broadly several key topics, including economic views of:  the problem of the commons (Stavins, American Economic Review, 2011); the history of U.S. environmental regulation (Hahn, Olmstead, and Stavins, Harvard Environmental Law Review, 2003); and corporate social responsibility (Reinhardt, Stavins, and Vietor, Review of Environmental Economics and Policy, 2008).

The articles in Part II deal with methods of environmental policy analysis, focusing, respectively, on:  interpreting sustainability in economic terms (Stavins, Wagner, and Wagner, Economic Letters, 2003); the use of discounting in net present value analysis (Goulder and Stavins, Nature, 2002); the development of a new revealed-preference method for inferring environmental benefits (Bennear, Stavins, and Wagner, Journal of Regulatory Economics, 2005); and the value of formal assessment of uncertainty (that is, Monte Carlo analysis) in regulatory impact analysis (Jaffe and Stavins, Regulation and Governance, 2007).

Part III turns to economic analysis of alternative environmental policy instruments, with examinations of: vintage-differentiated environmental regulation (Stavins, Stanford Environmental Law Journal, 2006); cost heterogeneity and the potential savings from employing market-based environmental policies (Newell and Stavins, Journal of Regulatory Economics, 2003); the effects of allowance allocations on the performance of cap-and-trade systems (Hahn and Stavins, Journal of Law and Economics, 2011); and second-best theory and the use of multiple policy instruments (Bennear and Stavins, Environmental and Resource Economics, 2007).

Part IV focuses on a topic that also received considerable treatment in the predecessor to this volume, namely the economics of technological change.  Here the articles include: a survey of the literature on environmental policy and technological change (Jaffe, Newell, and Stavins, Environmental and Resource Economics, 2002); an analysis of the interaction of environmental and technological market failures (Jaffe, Newell, and Stavins, Ecological Economics, 2005); an empirical assessment of the effect of environmental regulation on technology diffusion in the case of chlorine manufacturing (Miller, Snyder, and Stavins, American Economic Review Papers and Proceedings, 2003); and the effects of economic and policy incentives on carbon mitigation technologies (Jaffe, Newell, and Stavins, Energy Economics, 2006).

Part V consists of three articles in the area of natural resource economics dealing with land and water resources:  an analysis of the factors driving land-use change in the United States (Lubowski, Plantinga, and Stavins, Land Economics, 2008); an econometric examination of the significance of terroir, the notion that wine quality is primarily determined by location (Cross, Plantinga, and Stavins, American Economic Review Papers and Proceedings, 2011); and an assessment of urban water demand under alternative pricing structures (Olmstead, Hanemann, and Stavins, Journal of Environmental Economics and Management, 2007).

Part VI consists of four articles on domestic (national and sub-national) climate change policy, beginning with a description and assessment of a comprehensive U.S. cap-and-trade system for carbon dioxide and other greenhouse gas emissions (Stavins, Oxford Review of Economic Policy, 2008), and followed by:  an examination of the interactions of national and sub-national climate policies (Goulder and Stavins, American Economic Review Papers and Proceedings, 2011); an econometric study of the carbon-sequestration supply function (Lubowski, Plantinga, and Stavins, Journal of Environmental Economics and Management, 2006); and an assessment of the factors that affect the costs of biological carbon sequestration (Newell and Stavins, Journal of Environmental Economics and Management, 2000).

Finally, Part VII focuses on the international dimensions of climate change policy, and consists of four articles:  a comparison of alternative global climate change policy architectures (Aldy, Barrett, and Stavins, Climate Policy, 2003); an assessment of the Kyoto Protocol (Stavins, Milken Institute Review, 2005); an examination of a promising post-Kyoto international climate regime (Olmstead and Stavins, American Economic Review Papers and Proceedings, 2006); and a detailed examination of a key element of emerging international climate policy architecture, namely the linkage of regional, national, and sub-national tradable permit systems (Ranson, Jaffe, and Stavins, Ecology Law Quarterly, 2010).

Reflections on Common Themes

Selecting the essays for this second volume of my papers permitted me to take note of some common themes that emerge from this decade of research and writing.  First, there is the value — or at least, the potential value — of economic analysis of environmental policy.  The cause of virtually all environmental problems in a market economy is economic behavior (that is, imperfect markets affected by externalities), and so economics offers a powerful lens through which to view environmental problems, and therefore a potentially effective set of analytical tools for designing and evaluating environmental policies.

A second message, connected with the first, is the specific value of benefit-cost analysis for helping to promote efficient policies.  Economic efficiency ought to be one of the key criteria for evaluating proposed and existing environmental policies.  Despite its limitations, benefit-cost analysis can be useful for consistently assimilating the disparate information that is pertinent to sound decision making.  If properly done, it can be of considerable help to public officials when they seek to establish or assess environmental goals.

Third, the means governments use to achieve environmental objectives matter greatly, because different policy instruments have very different implications along a number of dimensions, including abatement costs in both the short and the long term.  Market-based instruments are particularly attractive in this regard.

Fourth, an economic perspective is also of considerable value when reflecting on the use of natural resources, whether land, water, fisheries, or forests.  Excessive rates of depletion of these resources are frequently due to the nature of the respective property-rights regimes, in particular, common property and open-access.  Economic instruments — such as ITQ systems in the case of fisheries — can and have been employed to bring harvesting rates down to socially efficient levels.

Fifth and finally, policies for addressing global climate change — linked with emissions of carbon dioxide and other greenhouse gases — can benefit greatly from the application of economic thinking.  On the one hand, the long time-horizon of climate change, the profound uncertainty in links between emissions and actual damages, and the possibility of catastrophic climate change present significant challenges to conventional economic analysis.  But, at the same time, the ubiquity of energy generation and use in modern economies means that only market-based policies — essentially carbon pricing regimes — are feasible instruments for achieving truly meaningful emissions reductions.  Hence, despite the challenges, an economic perspective on this grandest of environmental threats is essential.

Final Words

On a personal level, the professional path I have taken offers some confirmation that research can influence public policy, and it also illustrates that involvement in public policy can stimulate new research.  The quest — both professional and personal — that took me from Evanston, Illinois, to Sierra Leone, West Africa, to Ithaca, New York, to Berkeley, California, and finally to Cambridge, Massachusetts suggests some consistency of purpose and even function.  I continue to find myself doing similar things, but in different contexts.  It is fair to say that my professional life has taken me along a path that has brought me home.  The words of T. S. Eliot (1943) ring true:

                                        We shall not cease from exploration
                                        And the end of all our exploring
                                        Will be to arrive where we started
                                        And know the place for the first time.

Selecting the papers for this volume forces me to reflect on the past and think more clearly about the future.  The twenty-six articles that comprise this book and the twenty-two essays that comprised the predecessor volume are the product of twenty-three wonderful years on the faculty of the Harvard Kennedy School.  During this time, I have continued to learn about environmental economics and related public policy from colleagues, collaborators, students, friends, and inhabitants of the ”real world” of public policy, individuals from government, private industry, advocacy groups, and the press.  I hope that my learning will continue.

Cap-and-Trade, Carbon Taxes, and My Neighbor’s Lovely Lawn

The recent demise of serious political consideration of an economy-wide U.S. CO2 cap-and-trade system and the even more recent resurgence in interest among policy wonks in a U.S. carbon tax should prompt reflection on where we’ve been, where we are, and where we may be going.


Almost fifteen years ago, in an article that appeared in 1998 in the Journal of Economic Perspectives, “What Can We Learn from the Grand Policy Experiment?  Lessons from SO2 Allowance Trading,” I examined the implications of what was then the very new emissions trading program set up by the Clean Air Act Amendments of 1990 to cut acid rain by half over the succeeding decade.  In that article, I attempted to offer some guidance regarding the conditions under which cap-and-trade (then known as “tradable permits”) was likely to work well, or not so well.  Here’s a brief summary of what I wrote at the time:

(1)  SO2 trading was a case where the cost of abating pollution differed widely among sources, and where a market-based system was therefore likely to have greater gains, relative to conventional, command-and-control regulations (Newell and Stavins 2003). It was clear early on that SO2 abatement cost heterogeneity was great, because of differences in ages of plants and their proximity to sources of low-sulfur coal. But where abatement costs are more uniform across sources, the political costs of enacting an allowance trading approach are less likely to be justifiable.

(2)  The greater the degree to which pollutants mix in the receiving airshed or watershed, the more attractive a cap-and-trade (or emission tax) system will be, relative to a conventional uniform standard. This is because taxes or cap-and-trade can – in principle – lead to localized “hot spots” with relatively high levels of ambient pollution. Some states (in particular, New York) tried unsuccessfully to erect barriers to trades they thought might increase deposition within their borders.  This is a significant distributional issue.  It can also be an efficiency issue if damages are nonlinearly related to pollutant concentrations.

(3)  The efficiency of a cap-and-trade system will depend on the pattern of costs and benefits. If uncertainty about marginal abatement costs is significant, and if marginal abatement costs are quite flat and marginal benefits of abatement fall relatively quickly, then a quantity instrument, such as cap-and-trade, will be more efficient than a price instrument, such as an emission tax (Weitzman 1974).  With a stock pollutant (such as CO2), this argument favors a price instrument (Newell and Pizer 2003).  However, when there is also uncertainty about marginal benefits, and marginal benefits are positively correlated with marginal costs (which, it turns out, is a relatively common occurrence for a variety of pollution problems), then there is an additional argument in favor of the relative efficiency of quantity instruments (Stavins 1996).

(4)  Cap-and-trade will work best when transaction costs are low (Stavins 1995), and the S02 experiment showed that if properly designed, private markets will tend to render transaction costs minimal.

5)  Considerations of political feasibility point to the wisdom of proposing trading instruments when they can be used to facilitate emissions reductions, as was done with SO2 allowances and lead rights trading, less so for the purpose of reallocating existing emissions abatement responsibility (Revesz and Stavins 2007).

(6)  National policy instruments that appear impeccable from the vantage point of Cambridge, Massachusetts, Berkeley, California, or Madison, Wisconsin, but consistently prove infeasible in Washington, D.C., can hardly be considered “optimal.”

Implications for CO2 Policy

In the same article, I noted that many of these issues could be illuminated by considering a concrete example:  the “current interest” in applying cap-and-trade to the task of cutting CO2 emissions to reduce the risk of global climate change.  Some of the points I made in this regard in my 1998 article were:

(a)  The number of sources of CO2 emissions are vastly greater than in the case of SO2 emissions as a precursor of acid rain, where the focus could be placed on a few hundred electric utility plants.  Feasibility considerations alone argue for market-based instruments (cap-and-trade or taxes) to achieve meaningful reductions of CO2 emissions.

(b)  The diversity of sources of CO2 in a modern economy and the consequent heterogeneity of emission reduction costs bolster the case for using cost-effective market-based instruments.

(c)  As the ultimate global-commons problem, CO2 is a truly uniformly-mixed pollutant.  With no concern for hot spots, market-based instruments present none of the problems that can arise in the case of localized environmental threats.

(d)  Any pollution-control program must face the possibility of emissions leakage from regulated to unregulated sources. This would be a severe problem for an international CO2 program, where emissions would tend to increase in nonparticipant countries. Furthermore, it raises concerns for the emission-reduction-credit (not cap-and-trade) system in the Kyoto Protocol known as the Clean Development Mechanism (CDM).  Such an offset system can lower aggregate costs by substituting low-cost for high-cost control, but may also have the unintended effect of increasing aggregate emissions beyond what they would otherwise have been, because there is an incentive for adverse selection: sources in developing countries that would reduce their emissions, opt in, and receive credit for actions they would have taken anyway.

(e)  Although any trading program could potentially serve as a model for the case of global climate change, I argued that the trading system that accomplished the U.S. phaseout of leaded gasoline in the 1980s merited particular attention. The currency of that system was not lead oxide emissions from motor vehicles, but the lead content of gasoline. So too, in the case of global climate, great savings in monitoring and enforcement costs could be had by adopting input trading linked with the carbon content of fossil fuels. This is reasonable in the climate case, since – unlike in the SO2 case – CO2 emissions are roughly proportional to the carbon content of fossil fuels and scrubbing alternatives are largely unavailable, at least at present.

(f)   Natural sequestration of CO2 from the atmosphere by expanding forested areas is available (even in the United States) at reasonable cost (Stavins 1999).  Hence, it could be valuable to combine any carbon trading (or carbon tax) program with a carbon sequestration program, although this will raise significant challenges in regard to monitoring and enforcement.

(g)  In regard to carbon permit allocation mechanisms, auctions would have the advantage that revenues could be used to finance reductions in distortionary taxes.  Free allocation could increase regulatory costs enough that the sign of the efficiency impact could conceivably be reversed from positive to negative net benefits (Parry, Williams, and Goulder 1999).  On the other hand, free allocation of carbon permits would meet with much less political resistance.

The Necessity of Market-Based Instruments:  Cap-and-Trade or Carbon Taxes

I concluded that developing a cap-and-trade system for climate change would bring forth an entirely new set of economic, political, and institutional challenges.  At the same time, I recognized that the diversity of sources of CO2 emissions and the magnitude of likely abatement costs made it equally clear that only a market-based instrument – some form of carbon rights trading or (probably revenue-neutral) carbon taxes – would be capable of achieving the domestic targets that might eventually be forthcoming.

In other words, my conclusion in 1998 strongly favored a market-based carbon policy, but was somewhat neutral between carbon taxes and cap-and-trade.  Indeed, at that time and for the subsequent eight years or so, I remained agnostic regarding what I viewed as the trade-offs between cap-and-trade and carbon taxes.  What happened to change that?  Three words:  The Hamilton Project.

The Making of an Advocate

For those of you who don’t know, the Hamilton Project is an initiative based at the Brookings Institution that – according to its web site – “offers a strategic vision and produces innovative policy proposals on how to create a growing economy that benefits more Americans.”

In 2007, the Project’s leadership asked me to write a paper proposing a U.S. CO2 cap-and-trade system.  I responded that I would prefer to write a paper proposing the use of a market-based CO2 policy, describing the two alternatives of cap-and-trade and carbon taxes.  I explained that I was by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years.  Indeed, I noted, both cap-and-trade and carbon taxes would be good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences.

The Hamilton Project leaders said no, they wanted me to make the best case I could for cap-and-trade, not a balanced investigation of the two policy instruments.  Someone else would be commissioned to write a proposal for a carbon tax.  (That turned out to be Professor Gilbert Metcalf of Tufts University – now on leave at the U.S. Department of the Treasury – who did a splendid job!)  Thus, I was made into an advocate for cap-and-trade.  It’s as simple as that.

Giving It My Best Shot

I argued in my Hamilton Project paper (which you can read here) that despite the tradeoffs between the two principal market-based instruments that could target CO2 emissions, the best (and most likely) approach for the short to medium term in the United States was a cap-and-trade system, based on three criteria:  environmental effectiveness, cost effectiveness, and distributional equity.  Although my position was not simple capitulation to politics, I argued that sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should be made in a real-world political context.

I said that the key merits of the cap-and-trade approach were, first, the program could provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels.  Second, it offered an easy means of compensating for the inevitably unequal burdens imposed by a climate policy.  Third, it provided a straightforward means to link with other countries’ climate policies.  Fourth, it avoided the political aversion in the United States to taxes.  Fifth, it was unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach had a history of successful adoption and implementation in this country over the past two decades.

I recognized that there were some real differences between taxes and cap-and-trade that needed to be recognized.  First, environmental effectiveness:  a tax does not guarantee achievement of an emissions target, but it does provide greater certainty regarding costs.  This is a fundamental tradeoff.  Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly cost-containment mechanisms.  On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and is why virtually no environmental NGOs have favored the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same.  But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table.  But political pressures on a cap-and-trade system lead to different allocations of the free allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.

I concluded that proponents of carbon taxes worried about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax would be sensitive to the same political pressures, and should be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

Of course, such positive political economy arguments look much less compelling in the wake of the defeat of cap-and-trade legislation in the U.S. Congress and its successful demonization by conservatives as “cap-and-tax.”

A Political Opening for Carbon Taxes?

Does the defeat of cap-and-trade in the U.S. Congress, the obvious unwillingness of the Obama White House to utter the phrase in public, and the outspoken opposition to cap-and-trade by Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO2 emissions reductions?

First of all, there surely is such an opening in the policy wonk world.  Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax.  And a much-publicized meeting in July at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy.  Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world.  But what about in the real political world?  The good news is that a carbon tax is not “cap-and-trade.”  That presumably helps with the political messaging!  But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax!   Also, note that Romney’s stated opposition and Obama’s silence extend beyond disdain for cap-and-trade per se.  Rather, they cover all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington, no matter what the outcome of the election.  Note that the only election outcome that could lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would be:  the Democrats take back control of the House of Representatives, and the Democrats achieve a 60+ vote margin in the Senate, and the President is reelected.  A quick check at Five Thirty Eight (Nate Silver’s superb election forecast website at the New York Times) and other polling web sites makes it abundantly clear that the probability of such Democratic control of the White House and Congress is so small that it’s hardly worth discussing.

What About Fiscal Policy Reform?

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with either a Romney or Obama White House to work together constructively to address not only the short-term fiscal cliff at the end of this calendar year, but also the longer-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “if’s”) it turns out to be easier politically to eschew increases in taxes on labor and investment and therefore turn to taxes on consumption, then there could be a political opening for new energy taxes, in particular, (drum roll ….) a carbon tax.

Such a carbon tax – if intended to help alleviate budget deficits – could not be the economist’s favorite, a revenue-neutral tax swap of cutting distortionary taxes in exchange for implementing a carbon tax.  Rather, as a revenue-raising mechanism – like the Obama administration’s February 2009 budget for a 100%-auction of allowances in a cap-and-trade scheme – it would be a new tax, pure and simple.  Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – are not optimistic.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax.  The key question is whether the phrases “climate policy” or “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure.  The key group to bring on board will presumably be conservative Tea Party Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.


Even if the much-ballyhooed political opening for carbon taxes is largely illusory, the opening for policy wonks is real.  And here is where action is happening, and should continue to happen.  At some point the politics will change, and it’s important to be ready.  This is why economic research on carbon taxes is very much needed, particularly in the context of broader fiscal challenges, and it is why I’m pleased to see it happening at Resources for the Future, Harvard University, and elsewhere.

Bottom Line

I would personally be delighted if a carbon tax were politically feasible in the United States, or were to become politically feasible in the future.  But I’m forced to conclude that much of the current enthusiasm about carbon taxes in the academic and broader policy-wonk community in the wake of the defeat of cap-and-trade is – for the time being, at least – largely a manifestation of the grass looking greener across the street.

Two Notable Events Prompt Examination of an Important Property of Cap-and-Trade

In December of 2010, a group of economists and legal scholars gathered at the University of Chicago to celebrate two notable events. One was the fiftieth anniversary of the publication of Ronald Coase’s “The Problem of Social Cost” (Coase 1960).  The other was Professor Coase’s 100th birthday.  The conference resulted in a special issue of The Journal of Law and Economics, which has just been published (although it is dated November 2011).

My frequent co-author, Robert Hahn (of the University of Oxford), and I were privileged to participate in the conference (a video of our presentation is available here).  We recognized that the fiftieth anniversary of the publication of Coase’s landmark study provided an opportunity for us to examine one of that study’s key implications, which is of great importance not only for economics but for public policy as well, in particular, for environmental policy.

The Coase Theorem and the Independence Property

In our just-published article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” Hahn and I took as our starting point a well-known result from Coase’s work, namely, that bilateral negotiation between the generator and the recipient of an externality will lead to the same efficient outcome regardless of the initial assignment of property rights, in the absence of transaction costs, income effects, and third party impacts. This result, or a variation of it, has come to be known as the Coase Theorem.

We focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We call this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.

The Practical Political Importance of the Independence Property

We were interested in the independence property because of its great political importance.  The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs.  Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.

In Theory, Does the Property Always Hold?

Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice.  In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

In Reality, Has the Property Held?

Of course, the fact that these factors can lead to the violation of the independence property does not mean that in practice they do so in quantitatively significant ways.  Therefore, Hahn and I also carried out an empirical assessment of the independence property in past and current cap-and-trade systems: lead trading; chlorofluorocarbons (CFCs) under the Montreal Protocol; the sulfur dioxide (SO2) allowance trading program; the Regional Clean Air Incentives Market (RECLAIM) in Southern California; eastern nitrogen oxides (NOX) markets; the European Union Emission Trading Scheme (EU ETS); and Article 17 of the Kyoto Protocol.

I encourage you to read our article, but, a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).

Politicians Have Had it Right

That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.

This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost.  So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted.  It is of real political importance and remarkable social value.

If the Durban Platform Opened a Window, Will India and China Close It?

In my December 12th essay – following the 17th Conference of the Parties (COP-17) of the United Nations Framework Convention on Climate Change (UNFCCC), which adjourned on December 11, 2011 – I offered my assessment of the Durban climate negotiations by taking note of three major outcomes of the negotiations:  (1) elaboration on several components of the Cancun Agreements; (2) a second five-year commitment period for the Kyoto Protocol; and (3) a “non-binding agreement to reach an agreement” by 2015 that will bring all countries under the same legal regime by 2020.   Subsequently, in my January 1st essay – The Platform Opens a Window: An Unambiguous Consequence of the Durban Climate Talks – I focused on the third outcome of the talks, the “Durban Platform for Enhanced Action.”

Some Necessary History

The U.N. Framework Convention on Climate Change, adopted at the U.N. Conference on Environment and Development (the first “Earth Summit”) in Rio de Janeiro, Brazil, in 1992, contains what was to become a crucial passage:  “The Parties should protect the climate system for the benefit of present and future generations of humankind, on the basis of equity and in accordance with their common but differentiated responsibilities and respective capabilities. Accordingly, the developed country Parties should take the lead in combating climate change and the adverse effects thereof.” [emphasis added]  The countries considered to be “developed country Parties” were listed in an appendix to the 1992 Convention ­– Annex I.

The phrase – common but differentiated responsibilities – was given a specific interpretation three years after the Earth Summit by the first decision adopted by the first Conference of the Parties (COP-1) of the U.N. Framework Convention, in Berlin, Germany, April 7, 1995 ­­– the all important Berlin Mandate, which interpreted the principle as:  (1) launching a process to commit (by 1997) the Annex I countries to quantified greenhouse gas emissions reductions within specified time periods (targets and timetables); and (2) stating unambiguously that the process should “not introduce any new commitments for Parties not included in Annex I.”

Thus, the Berlin Mandate established the dichotomous distinction whereby the Annex I countries are to take on emissions-reductions responsibilities, and the non-Annex I countries are to have no such responsibilities whatsoever.  This had wide-ranging and profound consequences, because it became the anchor that prevented real progress in international climate negotiations.  With 50 non-Annex I countries having greater per capita income than the poorest of the Annex I countries, the distinction is clearly out of whack.

But, more important than that, this dichotomous distinction means that:  (a) half of global emissions soon will be from nations without constraints; (b) the world’s largest emitter – China – is unconstrained; (c) aggregate compliance costs are driven up to be four times their cost-effective level, because many opportunities for low-cost emissions abatement in emerging economies are taken off the table; and (d) an institutional structure is perpetuated that makes change and progress virtually impossible.

The dichotomous Annex I/non-Annex I distinction remained a central – indeed, the central – feature of international climate negotiations ever since COP-1 in Berlin in 1995.  Then, at COP-15 in 2009, there were hints of possible change.

The Copenhagen Accord (2009) and the Cancun Agreements (2010) began a process of blurring the Annex I/non-Annex I distinction.  But this blurring was only in the context of the interim pledge-and-review system established at COP-15 in Copenhagen and certified at COP-16 in Cancun, not in the context of an eventual successor to the Kyoto Protocol.  Thus, the Berlin Mandate retained its centrality.

The Durban Platform for Enhanced Action

The third of the three outcomes of the December 2011 talks in Durban, South Africa – the Durban Platform for Enhanced Action – eliminates the Annex I/non-Annex I (or industrialized/developing country) distinction.  In the Durban Platform, the delegates reached a non-binding agreement to reach an agreement by 2015 that will bring all countries under the same legal regime by 2020.  That’s a strange sentence, but it’s important.

Rather than adopting the Annex I/non-Annex I (or industrialized/developing country) distinction, the Durban Platform focuses instead on the pledge to create a system of greenhouse gas reductions including all Parties (that is, all key countries) by 2015 that will come into force by 2020.  Nowhere in the text of the decision are phrases such as “Annex I,” “common but differentiated responsibilities,” “distributional equity,” “historical responsibility,” all of which had long since become code words for targets for the richest countries and blank checks for all others.

Thus, in a dramatic departure from some seventeen years of U.N. international negotiations on climate change, the 17th Conference of the Parties in Durban turned away from the Annex I/non-Annex I distinction, which had been the centerpiece of international climate policy and negotiations since it was adopted at the 1st Conference of the Parties in Berlin in 1995.  In truth, only time will tell whether the Durban Platform delivers on its promise, or turns out to be another “Bali Roadmap,” leading nowhere, but there is a key unambiguous consequence of this development.

Durban Opens a Window

By replacing the Berlin Mandate, the Durban Platform has opened an important window.  National delegations from around the world now have a challenging task before them:  to identify a new international climate policy architecture that is consistent with the process, pathway, and principles laid out in the Durban Platform, namely to find a way to include all key countries (such as the 20 largest national and regional economies that together account for upwards of 80% of global carbon dioxide emissions) in a structure that brings about meaningful emissions reductions on an appropriate timetable at acceptable cost, while remaining within the overall framework provided by the UNFCCC.

Is India Seeking to Close the Window?

As part of the agreement to launch the Durban Platform for Enhanced Action, the nations of the world agreed to initiate a work plan on enhancing mitigation ambition.  As a first step, each country was to submit its initial ideas.

On February 28, 2012, the Indian government made its official submission to the UNFCCC, “Increasing Ambition Level under Durban Platform for Enhanced Action.”  In seventeen paragraphs across three pages of text, India’s submission makes absolutely clear its view that the Durban Platform is under the overall legal umbrella of the UNFCCC, and therefore that the principles of “equity” and “common but differentiated responsibilities” remain intact and must inform all commitments for enhanced action.  In fact, the lion’s share of India’s submission talks about the responsibilities of industrialized countries, not about India’s ideas for its own contributions.

India’s submission actually quantifies what it sees as the necessary future commitments of Annex I (“developed”) countries – by referring to the 2007 Fourth Assessment Report (AR4) of the Intergovernmental Panel on Climate Change:  “AR4 has recommended that Annex I Parties should reduce their emissions at least by 25-40% in the short term by 2020” [emphasis added].  But, in truth, AR4 made no such recommendation.  Indeed, the IPCC – in general – does not make any policy recommendations whatsoever.  This is one of the key organizing principles under which the IPCC operates.  I know this from decades of direct work with the IPCC, having served as a Lead Author in two rounds of the IPCC, and currently serving as a Coordinating Lead Author in AR5.

China Weighs In

A week after India made its submission, the Chinese government followed suit on March 8th with “China’s Submission on Options and Ways for Further Increasing the Level of Ambition.”  The submission is consistent with India’s, maintaining that industrialized countries alone bear responsibility for reducing emissions before 2020:  “Developed country Parties should take the lead in reducing their emissions by undertaking ambitious mitigation commitments and fulfill their obligations by providing financial resources and transferring technology to developing country Parties.”

They Have a Point

India and China have a point.  The Durban Platform did not supplant the Convention, so the general notions of “equity” and “common but differentiated responsibilities” do remain.  But – and here is the key reality – the Durban Platform did replace the Berlin Mandate.  And so a window has been opened to explore new, more sophisticated, and more subtle ways of involving all key countries in an environmentally effective and cost-effective global agreement, with a new interpretation of common but differentiated responsibilities.

For example, replacing the dichotomous Annex I/non-Annex I distinction with a formula that generates a continuous spectrum of degrees of responsibility would be fully consistent both with the Durban Platform for Enhanced Action and the U.N. Framework Convention on Climate Change.  Such a formulaic approach – as developed by Professors Jeffrey Frankel and Valentina Bosetti for the Harvard Project on Climate Agreements – merits serious consideration, along with other innovative international policy architectures.

Although some in the press and blogosphere have characterized the Chinese and Indian submissions as hitting “the brakes on Durban pledges” and “hitting the reset button on international climate change commitments,” in reality the Chinese and Indian submissions refer only to emission reductions prior to 2020, whereas the Durban Platform for Enhanced Action focuses on (agreeing by 2015 on) a new international agreement that would be implemented only in 2020.  Thus, there’s no inconsistency.

Stay Tuned

Whether or not the submissions by China and India are part of a diplomatic dance or represent a real step backward from their positions in Durban, the fact remains that the Durban Platform – by replacing the Berlin Mandate – has opened an important window.  Governments around the world need fresh, outside-of-the-box ideas over the next few years of a possible future international climate policy architecture that can meet the call of the Durban Platform while remaining true to the Framework Convention on Climate Change.  That’s the challenge, as well as the opportunity.

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.

Economics of the Environment

The Sixth Edition of Economics of the Environment: Selected Readings has just been published by W. W. Norton & Company of New York and London.  Through five previous editions, Economics of the Environment has served as a valuable supplement to environmental economics texts and as a stand-alone book of original readings in the field of environmental economics.  Nearly seven years have passed since the previous edition of this volume was published, and it is now more than three decades since the first edition appeared, edited by Robert and Nancy Dorfman.  The Sixth Edition continues this tradition.

Motivation and Audience

Environmental economics continues to evolve from its origins as an obscure application of welfare economics to a prominent field in its own right, which combines elements from public finance, industrial organization, microeconomic theory, and many other areas of economics.  The number of articles on the environment appearing in mainstream economics periodicals continues to increase, and more and more economics journals are dedicated exclusively to environmental and resource topics.

There has also been a proliferation of environmental economics textbooks for college courses.  Many are excellent, but none can be expected to provide direct access to timely and original contributions by the field’s leading scholars.  As most teachers of economics recognize, it is valuable to supplement the structure and rigor of a text with original readings from the literature.

Scope and Style

With that in mind, this new edition of Economics of the Environment consists of thirty-four chapters that instructors will find to be of great value as a complement to their chosen text and their lectures.  The scope is comprehensive, and the list of authors is a veritable “who’s who” of environmental economics, including:  Joseph Aldy, Kenneth Arrow, Trudy Cameron, Ronald Coase, Maureen Cropper, Peter Diamond, George Eads, Jeffrey Frankel, Rick Freeman, Don Fullerton, Lawrence Goulder, John Graham, Robert Hahn, Michael Hanemann, Jerry Hausman, Steven Kelman, Nathaniel Keohane, Alan Krupnick, Lester Lave, John Livernois, Eric Maskin, Leonardo Maugeri, Gilbert Metcalf, Richard Newell, Roger Noll, William Nordhaus, Wallace Oates, Sheila Olmstead, Elinor Ostrom, Karen Palmer, Ian Parry, Carl Pasurka, Robert Pindyck, William Pizer, Michael Porter, Paul Portney, Forest Reinhardt, Richard Revesz, Milton Russell, Michael Sandel, Richard Schmalensee, Steven Shavell, Jason Shogren, Kerry Smith, Robert Solow, Nicholas Stern, Laura Taylor, Richard Vietor, and myself.

The articles are timely, with more than 90 percent published since 1990, and half since 2005.  There are two completely new sections of the book, “Economics of Natural Resources” and “Corporate Social Responsibility,” and all of the chapters in the section on global climate change are new to the sixth edition.

In order to make the readings in Economics of the Environment accessible to students at all levels, one criterion I use in the selection process is that articles should not only be original and well written — and meet the highest standards of economic scholarship — but also be non-technical in their presentations.  Hence, readers will find virtually no formal mathematics in any of the book’s 34 chapters throughout its 733 pages.

The Path Ahead

Environmental economics is a rapidly evolving field.  Not only do new theoretical models and improved empirical methods appear on a regular basis, but entirely new areas of investigation open up when the natural sciences indicate new concerns or the policy world turns to new issues.  Therefore, this book remains a work in progress.  I owe a great debt to the teachers and students of previous editions who have sent their comments and suggestions for revisions.  Looking to future editions, I invite all readers — whether teachers, students, or practitioners — to send me any thoughts or suggestions for improvement.

In the meantime, if you’re interested finding out more about the book, immediately below is a chapter-by-chapter summary of the book.  Alternatively, you can check out the W. W. Norton or Amazon web sites.


Appendix:  A Summary of Economics of the Environment, Sixth Edition

Part I of the volume provides an overview of the field and a review of its foundations.  Don Fullerton and I start things off with a brief essay about how economists think about the environment (Nature 1998).  This is followed by the classic treatment of social costs and bargaining by Ronald Coase (Journal of Law and Economics 1960), and a new article by Jason Shogren and Laura Taylor on the important, emerging field of behavioral environmental economics (Review of Environmental Economics and Policy 2008).

The Costs of Environmental Protection

Part II examines the costs of environmental protection, which might seem to be without controversy or current analytical interest.  This is not, however, the case.  This section begins with a survey article by Carl Pasurka that reviews the theory and empirical evidence on the relationship between environmental regulation and so-called “competitiveness” (Review of Environmental Economics and Policy 2008).

A somewhat revisionist view is provided by Michael Porter and Class van der Linde, who suggest that the conventional approach to thinking about the costs of environmental protection is fundamentally flawed (Journal of Economic Perspectives 1995).  Karen Palmer, Wallace Oates, and Paul Portney provide a careful response (Journal of Economic Perspectives 1995).

The Benefits of Environmental Protection

In Part III, the focus turns to the other side of the analytic ledger — the benefits of environmental protection.  This is an area that has been even more contentious — both in the policy world and among scholars.  Here the core question is whether and how environmental amenities can be valued in economic terms for analytical purposes.

The book features a provocative debate on the stated-preference method known as “contingent valuation.”  Paul Portney outlines the structure and importance of the debate, Michael Hanemann makes the affirmative case, and Peter Diamond and Jerry Hausman provide the critique (all three articles are from the Journal of Economic Perspectives 1994).

In the final article in Part III, the book turns to a concept that is both very important in assessments of the benefits of environmental regulations and is also very widely misunderstood — the value of a statistical life.  In an insightful essay, Trudy Cameron seeks to set the record straight (Review of Environmental Economics and Policy 2010).

There are two principal policy questions that need to be addressed in the environmental realm:  how much environmental protection is desirable; and how should that degree of environmental protection be achieved.  The first of these questions is addressed in Part IV and the second in Part V.

The Goals of Environmental Policy:  Economic Efficiency and Benefit-Cost Analysis

In an introductory essay, Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and I ask whether there is a role for benefit-cost analysis to play in environmental, health, and safety regulation (Science 1996).

Then, Lawrence Goulder and I focus on an ingredient of benefit-cost analysis that non-economists seem to find particularly confusing, or even troubling — intertemporal discounting (Nature 2002).  Next, Robert Pindyck examines a subject of fundamental importance — the role of uncertainty in environmental economics (Review of Environmental Economics and Policy 2007).  Steven Kelman provides an ethically-based critique of benefit-cost analysis, which is followed by a set of responses (Regulation 1981).

Part IV concludes with an up-to-date essay by John Graham on the critical role of the U.S. Office of Management and Budget in federal regulatory impact analysis (Review of Environmental Economics and Policy 2008).

The Means of Environmental Policy:  Cost Effectiveness and Market-Based Instruments

Part V examines the policy instruments — the means — that can be employed to achieve environmental targets or goals.  This is an area where economists have made their greatest inroads of influence in the policy world, with tremendous changes having taken place over the past twenty  years in the reception given by politicians and policy makers to so-called market-based or economic-incentive instruments for environmental protection.

Lawrence Goulder and Ian Parry start things off with a broad-ranging essay on instrument choice in environmental policy (Review of Environmental Economics and Policy 2008).  Following this, I examine lessons that can be learned from the innovative sulfur dioxide allowance trading program, set up by the Clean Air Act Amendments of 1990 (Journal of Economic Perspectives 1998).  Finally, Michael Sandel provides a critique of market-based instruments, with responses offered by Eric Maskin, Steven Shavell, and others (New York Times 1997).

Economics of Natural Resources

Part VI consists of three essays on a new topic for this book — the economics of natural resources.  First, John Livernois examines the empirical significance of a central tenet in natural resource economics, namely the Hotelling Rule — the proposition that under conditions of efficiency, the scarcity rent (price minus marginal extraction cost) of natural resources will rise over time at the rate of interest (Review of Environmental Economics and Policy 2009).

Essays by Leonardo Maugeri (Review of Environmental Economics and Policy 2009) and Sheila Olmstead (Review of Environmental Economics and Policy 2010), respectively, examine two particularly important resources:  petroleum and water.

The next four sections of the book treat some timely and important topics and problems.

Corporate Social Responsibility and the Environment

Part VII examines corporate social responsibility and the environment, discussion of which has too often been characterized by more heat than light.  Forest Reinhardt, Richard Vietor, and I provide an overview of this realm from the perspective of economics, examining the notion of firms voluntarily sacrificing profits in the social interest.  In a second essay, Paul Portney provides a valuable empirical perspective (both are from the Review of Environmental Economics and Policy 2008).

Global Climate Change

Part VIII is dedicated to investigations of economic dimensions of global climate change, which may in the long term prove to be the most significant environmental problem that has arisen, both in terms of its potential damages and in terms of the costs of addressing it.  First, a broad overview of the topic is provided in a survey article by Joseph Aldy, Alan Krupnick, Richard Newell, Ian Parry, and William Pizer (Journal of Economic Literature 2010).

Next, William Nordhaus critiques the well-known Stern Review on the Economics of Climate Change, and Nicholas Stern and Chris Taylor respond (both are from Science 2007).  In the final essay in this section, Gilbert Metcalf examines market-based policy instruments that can be used to address greenhouse gas emissions (Journal of Economic Perspectives 2009).

Sustainability, the Commons, and Globalization

Part IX begins with Robert Solow’s economic perspective on the concept of sustainability.  This is followed by Elinor Ostrom’s development of a general framework for analyzing sustainability (Science 2009), and my own historical view of economic analysis of problems associated with open-access resources (American Economic Review 2011).  Then, Jeffrey Frankel draws on diverse sources of empirical evidence to examine whether globalization is good or bad for the environment (Council on Foreign Relations 2004).

Economics and Environmental Policy Making

The final section of the book, Part X, departs from the normative concerns of much of the volume to examine some interesting and important questions of political economy.  It turns out that an economic perspective can provide useful insights into questions that might at first seem to be fundamentally political.

Nathaniel Keohane, Richard Revesz, and I utilize an economic framework to ask why our political system has produced the particular set of environmental policy instruments it has (Harvard Environmental Law Review 1998).  Myrick Freeman reflects on the benefits that U.S. environmental policies have brought about since the first Earth Day in 1970 (Journal of Economic Perspectives 2002).  Lastly, Robert Hahn addresses the question that many of the articles in this volume raise:  what impact has economics actually had on environmental policy (Journal of Environmental Economics and Management 2000)?

Good News from the Regulatory Front

As each day passes, the upcoming November 2012 general elections produce new stories about potential Republican candidates for President, as well as stories about President Obama’s anticipated re-election campaign.  At the same time, the 2012 elections are already affecting Congressional debates, where each side seems increasingly interested in taking symbolic actions and scoring political points that can play to its constituencies among the electorate, rather than working earnestly on the country’s business.

The new Tea Party Republicans in the House of Representatives decry the “fact” that the U.S. Environmental Protection Agency (EPA) continues to promulgate “job-killing regulations” for made-up non-problems.  And Democrats in the Congress – not to mention the Administration – are eager to talk about “win-win” policies that will produce “clean energy jobs” and protect Americans from the evils of imported oil and gas.

Neither side seems willing to admit that environmental regulations bring both good news – a cleaner environment – and bad news – costs of compliance that affect not only businesses but consumers as well.  Sometimes the cost-side of proposed regulations dominates.  Those regulatory moves are – from an economic perspective – fundamentally unwise, since they make society worse off.  In other cases, the benefits of a proposed regulation more than justify the costs that will be incurred.  Such regulations are – to use a word now favored by President Obama –  a wise investment.  They make society better off.  Failure to take action on such opportunities is imprudent, if not irresponsible.  Just such an opportunity now presents itself with EPA’s Clean Air Transport Rule.

In an op-ed that appeared on April 25, 2011, in The Huffington Post (click here for link to the original op-ed), Richard Schmalensee and I assess this opportunity.  Rather than summarize (or expand on) our op-ed, I simply re-produce it below as it was published by The Huffington Post, with some hyperlinks added for interested readers.

For anyone who is not familiar with my co-author, Richard Schmalensee, please note that he is the Howard W. Johnson Professor of Economics and Management at MIT, where he served as the Dean of the Sloan School of Management from 1998 to 2007.  Also, he served as a Member of the President’s Council of Economic Advisers in the George H. W. Bush administration from 1989 to 1991.  By the way, in previous blog posts, I’ve featured other op-eds that Dick and I have written in The Huffington Post (“Renewable Irony”) and The Boston Globe (“Beware of Scorched-Earth Strategies in Climate Debates”).


An Opportunity for Timely Action:  EPA’s Transport Rule Passes the Test

by Richard Schmalensee and Robert Stavins

The Huffington Post, April 25, 2011

At a time when EPA regulations are under harsh attack, one new environmental regulation – at least – stands out as an impressive winner for the country.  Studies of the soon-to-be-finalized Clean Air Transport Rule have consistently found that the benefits created by the rule would far outweigh its costs.  By reducing sulfur dioxide and nitrogen oxide emissions from power plants in 31 states in the East and Midwest, the Transport Rule will create substantial benefits through lower incidence of respiratory and heart disease, improved visibility, enhanced agricultural and forestry yields, improved ecosystem services, and other environmental amenities.  According to EPA, these benefits will be 25 to 130 times greater than the associated costs.  We document this in our new report, “A Guide to Economic and Policy Analysis of EPA’s Transport Rule,” which was commissioned by the Exelon Corporation.

Despite the benefits offered by the Transport Rule, some argue that it – and other EPA regulations – will stifle economic growth and threaten the reliability of our electric power system.  However, a careful look at the evidence reveals that the Transport Rule is unlikely to create such risks.  Analyses of the Transport Rule have found that it need not lead to significant plant retirements.   Robust regulatory and market mechanisms ensure that the nation can meet emission targets while reliably meeting customer demand.

While compliance with the Transport Rule would – in some cases – require installation of new pollution control equipment, the capital expenditures required would comprise a small fraction of aggregate capital spending by the power industry.  In fact, because of the Transport Rule’s unique legal circumstances, in which the Courts have mandated that EPA replace a stringent predecessor, utilities have already begun to make pollution control investments needed to comply with the Transport Rule.

The Rule’s timing can also contribute to lowering its cost and supporting other policy goals.  Installation of the pollution control technologies needed to comply with the Rule could increase short-term employment.  Although the longer term job impacts are less clear, these short-term employment effects would complement other policy initiatives aimed at supporting the nation’s economic recovery.

EPA analysis estimates modest impacts on regional electricity rates, but reductions in health care expenditures could partially or fully offset these effects.  Expanded supplies of low-cost natural gas can also help lower the Transport Rule’s cost by providing a less costly substitute for power generated from coal.

Most importantly, actions taken to reduce emissions would create substantial health benefits.  Tens of thousands of premature deaths would be eliminated annually, as would millions of non-fatal respiratory and cardiovascular illnesses.  A diverse set of studies find that these health improvements will create $20 to over $300 billion in benefits annually.  And, while the Transport Rule is designed to reduce the impact of upwind emissions on downwind states, upwind states would also receive substantial health benefits from the cleaner air brought about by the Rule.  These upwind states have much to gain, because states with the highest emissions from coal-fired power plants are also among those with the greatest premature mortality rates from these emissions.

Along with these health benefits, the largest shares of short-term improvements in employment and regional economies are likely to accrue to the regions that are most dependent on coal-fired power, as they invest in new pollution control equipment.  Thus, while designed to help regions downwind of coal-fired power plants, the Transport Rule also offers substantial benefits to upwind states.

As the U.S. economy emerges from its worst recession since the Great Depression of the 1930s and faces an increasingly competitive global marketplace, regulation such as the Transport Rule that creates positive net benefits and allows industry flexibility in creating public goods can complement strategies intended to foster economic growth.  Such regulations are best identified by careful analyses to ensure that benefits truly exceed costs and avoid unfair impacts on particular groups or sectors.  The Transport Rule has undergone a series of such thorough assessments, and the results consistently indicate that it would create benefits that far exceed its costs.  Failure to take timely action on this opportunity would seem to be imprudent, if not irresponsible.


*Richard Schmalensee is the Howard W. Johnson Professor of Economics and Management at the Massachusetts Institute of Technology, a research associate of the National Bureau of Economic Research, and a fellow of the Econometric Society and the American Academy of Arts and Sciences.  He served as a member of the Council of Economic Advisers with primary responsibility for environmental and energy policy from 1989 through 1991.  Robert N. Stavins is the Albert Pratt Professor of Business and Government at the Harvard Kennedy School, a university fellow of Resources for the Future, a research associate of the National Bureau of Economic Research, and a fellow of the Association of Environmental and Resource Economists.  He served as chairman of the EPA’s Environmental Economics Advisory Committee from 1997 through 2002.  Their report, “A Guide to Economic and Policy Analysis of EPA’s Transport Rule,” which was commissioned by the Exelon Corporation, can be downloaded at: http://www.analysisgroup.com/uploadedFiles/Publishing/Articles/2011_StavinsSchmalansee_TransportRuleReport.pdf

Reflecting on a Century of Progress and Problems

As the first decade of the twenty-first century comes to a close, the problem of the commons is more important to our lives – and more central to economics – than a century ago when the first issue of the American Economic Review appeared, with an examination by Professor Katharine Coman of Wellesley College of “Some Unsettled Problems of Irrigation” (1911).  Since that time, 100 years of remarkable economic progress have accompanied 100 years of increasingly challenging problems.

As the U.S. and other economies have grown, the carrying-capacity of the planet – in regard to natural resources and environmental quality – has become a greater concern, particularly for common-property and open-access resources.  In an article that appears in the 100th anniversary issue of the American Economic Review (AER) “The Problem of the Commons:  Still Unsettled After 100 Years” – I focus on some important, unsettled problems of the commons.

100 Years of Economic Progress and More Challenging Environmental Problems

Within the realm of natural resources, there are special challenges associated with renewable resources, which are frequently characterized by open-access.  An important example is the degradation of open-access fisheries.  Critical commons problems are also associated with environmental quality, including the ultimate commons problem of the twenty-first century – global climate change.

Small communities frequently provide modes of oversight and methods for policing their citizens, a topic about which Professor Elinor Ostrom of Indiana University has written extensively.  But as the scale of society has grown, commons problems have spread across communities and even  across nations.  In some of these cases, no over-arching authority can offer complete control, rendering commons problems more severe.

Although the type of water allocation problems of concern to Coman have frequently been addressed by common-property regimes of collective management, less easily governed problems of open-access are associated with growing concerns about air and water quality, hazardous waste, species extinction, maintenance of stratospheric ozone, and – most recently – the stability of the global climate in the face of the steady accumulation of greenhouse gases.

Whereas common property resources are held as private property by some group, open-access resources are non-excludable.  My article in the AER focuses exclusively on the latter, and thereby reflects on some important, unsettled problems of the commons.  It identifies both the contributions made by economic analysis and the challenges facing public policy.

The article begins with natural resources, highlighting the difference between most non-renewable natural resources, pure private goods that are both excludable and rival in consumption, and renewable natural resources, many of which are non-excludable.

Some of these are rival in consumption but characterized by open-access.  An example is the degradation of ocean fisheries. An economic perspective on these resources helps identify the problems they present for management, and provides guidance for sensible solutions.

The article then turns to a major set of commons problems that were not addressed until the last three decades of the twentieth century – environmental quality.  Although frequently characterized as textbook examples of externalities, these problems can also be viewed as a particular category of commons problems:  pure public goods, that are both non-excludable and non-rival in consumption.

A key contribution of economics has been the development of market-based approaches to environmental protection, including emission taxes and tradable rights.  These have potential to address the ultimate commons problem of the twenty-first century, global climate change.

Themes That Emerge

First, economic theory – by focusing on market failures linked with incomplete systems of property rights – has made major contributions to our understanding of commons problems and the development of prudent public policies.

Second, as our understanding of the commons has become more complex, the design of economic policy instruments has become more sophisticated, enabling policy makers to address problems that are characterized by uncertainty, spatial and temporal heterogeneity, and long duration.

Third, government policies that have not accounted for economic responses have been excessively costly, often ineffective, and sometimes counter-productive.

Fourth, commons problems have not diminished.  While some have been addressed successfully, others have emerged that are more important and more difficult.

Fifth, environmental economics is well positioned to offer better understanding and better policies to address these ongoing challenges.


Although I hope you will read the full article – which is very accessible — I will summarize its conclusions here.

Problems of the commons are both more widespread and more important today than when Coman wrote about unsettled problems in the first issue of the American Economic Review 100 years ago.  A century of economic growth and globalization have brought unparalleled improvements in societal well-being, but also unprecedented challenges to the carrying-capacity of the planet.  What would have been in 1911 inconceivable increases in income and population have come about and have greatly heightened pressures on the commons, particularly where there has been open access to it.

The stocks of a variety of renewable natural resources – including water, forests, fisheries, and numerous other species of plant and animal – have been depleted below socially efficient levels, principally because of poorly-defined property-right regimes.  Likewise, the same market failures of open-access – whether characterized as externalities, following A. C. Pigou (1920), or public goods, following Ronald Coase (1960) – have led to the degradation of air and water quality, inappropriate disposal of hazardous waste, depletion of stratospheric ozone, and the atmospheric accumulation of greenhouse gases linked with global climate change.

Over this same century, economics – as a discipline – has gradually come to focus more and more attention on these commons problems, first with regard to natural resources, and more recently with regard to environmental quality.  Economic research within academia and think tanks has improved our understanding of the causes and consequences of excessive resource depletion and inefficient environmental degradation, and thereby has helped identify sensible policy solutions.

Conventional regulatory policies, which have not accounted for economic responses, have been excessively costly, ineffective, or even counter-productive.  The problems behind what Garrett Hardin (1968) characterized as the “tragedy of the commons” might better be described as the “failure of commons regulation.”  As our understanding of the commons has become more complex, the design of economic policy instruments has become more sophisticated.

Problems of the commons have not diminished, and the lag between understanding and action can be long.  While some commons problems have been addressed successfully, others continue to emerge.  Some – such as the threat of global climate change – are both more important and more difficult than problems of the past.

Fortunately, economics is well positioned to offer better understanding and better policies to address these ongoing challenges.  As the first decade of the twenty-first century comes to a close, natural resource and environmental economics has emerged as a productive field of our discipline and one that shows even greater promise for the future.

Pursuing Real Environmental Justice in California

California Governor Jerry Brown plans to move forward with the implementation of Assembly Bill 32, the Global Warming Solutions Act, under which California seeks to take dramatic steps to reduce its greenhouse gas emissions.  Questions have been raised about the wisdom of a single state trying to address a global commons problem, but with national climate policy developments having slowed dramatically in Washington, California is now the focal point of meaningful U.S. climate policy action.

California’s Plan

A key element of the mechanisms to be used for achieving California’s ambitious emissions reductions will be cap-and-trade, a promising approach with a successful track record, despite its recent demonization as “cap-and-tax” by conservatives and other opponents in the U.S. Congress.

Under this approach, regulators restrict emissions by issuing a limited number of emission allowances, with the number of allowances ratcheted down over time, thus assuring ever-larger reductions in overall emissions.  Pollution sources such as electric power plants and factories are allowed to trade allowances, and as a result, sources able to reduce emissions least expensively take on more of the pollution-reduction effort.  Experience has shown that cap-and-trade programs achieve emissions reductions at dramatically lower cost than conventional regulation.


Yet some groups in California have been very uneasy about the prospect of cap-and-trade.  In particular, the Environmental Justice movement has opposed this approach, citing concerns that it would hurt low-income communities.  Professor Lawrence Goulder of Stanford University and I addressed such concerns in an article in The Sacramento Bee.

One expressed concern has been that a cap-and-trade policy might increase pollution in low-income or minority communities.  The apprehension is not about greenhouse gases (the focus of AB 32), since these gases spread evenly around the globe and thus would have no discernible impact in the immediate area.  Rather, it’s about “co-pollutants,” such as nitrogen oxides, carbon monoxide, and particulates, which can be emitted alongside greenhouse gases.

Because a cap-and-trade system would reduce California’s overall greenhouse gas emissions, it would also lower the state’s emissions of co-pollutants. Still, it’s possible, though unlikely, that co-pollutant emissions would increase in a particular locality.  But here it’s crucial to recognize that existing air pollution laws address such pollutants, and so any greenhouse gas allowance trades that would violate local air pollution limits would be prohibited.

If current limits for co-pollutants are thought to be insufficient, the best response is not to scuttle a statewide system that can achieve AB 32’s ambitious targets at minimum cost.  Rather, the most environmentally and economically effective way to address such pollution is to revisit existing local pollution laws and perhaps make them more stringent.

While much attention has rightly been given to the effects of potential climate policies on environmental conditions in low-income communities, it’s also important to consider their economic impacts on these communities.  Reducing greenhouse gas emissions will require greater reliance on more costly energy sources and more costly appliances, vehicles and other equipment.  Because low-income households devote greater shares of their income to energy and transportation costs than do higher-income households, virtually any climate policy will place relatively greater burdens on low-income households.  But because cap-and-trade will minimize  energy-related and other costs, it holds an important advantage in this regard over conventional regulations.

Moreover, a cap-and-trade system gives the public a tool for compensating low-income communities for the potential economic burdens:  If some emission allowances are auctioned, revenues can be used to mitigate economic burdens on these communities.

The Way Forward

All in all, cap-and-trade serves the goal of environmental justice better than the alternatives.  This progressive policy instrument merits a central place in the arsenal of weapons California employs.  Beyond helping the state meet its emissions-reduction targets at the lowest cost, it offers a promising way to reduce economic burdens on low-income and minority communities.

Any Hope for Meaningful U.S. Climate Policy? You be the Judge.

The current conventional wisdom ­– broadly echoed by the news media and the blogosphere – is that comprehensive, economy-wide CO2 cap-and-trade legislation is dead in the current U.S. Congress, and perhaps for the next several years.

Watch out for conventional wisdoms!  They inevitably appear to be the collective judgment of numerous well-informed observers and sources, but frequently they are little more than the massive repetition of a few sample points of opinion across the echo-chamber of the professional news media and the blogosphere.

Keep in mind that the conventional wisdom as recently as June of 2009 had it that – with the Waxman-Markey bill having been passed triumphantly by the House of RepresentativesSenate action would follow; the only question raised by many commentators was whether the final legislation could be sent to the President for his signature by the time of the Copenhagen climate talks in December.  My, how the conventional wisdom has changed!

But over the past nine months, the politics have not fundamentally changed.  In June of 2009, passage of meaningful climate legislation in the Senate was already unlikely, because of the terrible economic recession in which the country found itself, and – of even greater political salience ­– lingering high rates of unemployment.  And with the lack of Republican support for the stimulus bill, the relatively small (partisan) margin by which the House passed Waxman-Markey, the then-upcoming challenges of health care and financial regulatory reform dominating the legislative calendar, and concerns voiced about climate legislation by moderate Senate Democrats, success in the Senate was always a long-shot.

What is the Likely Legislative Outcome?

In addition to ongoing consideration of an economy-wide cap-and-trade system, another possibility now receiving attention is a utility-only cap-and-trade system, which some members of the Congress inexplicably find more attractive than an economy-wide approach.  The result of such a system would be much less accomplished (forget about the President’s “conditional commitment” under the Copenhagen Accord), and at much greater cost.  This would be equivalent to taking the Northeast’s Regional Greenhouse Gas Initiative (RGGI) as a model for national action.  Not a good idea.

Even more likely is that the Congress would develop a so-called energy-only bill, which would – to a large degree – consist of killing the one part of Waxman-Markey worth saving (the comprehensive CO2 cap-and-trade system), and moving forward with the worst parts of that legislation – the smorgasbord of regulatory initiatives.  As I’ve written previously, those additional elements of the legislation are highly problematic.  When implemented under the cap-and-trade umbrella, many of those conventional standards and subsidies would have no net greenhouse-gas-reducing benefits, would limit flexibility, and would thereby have the unintended consequence of driving up compliance costs. That’s the soft under‑belly of the House legislation.

Without the cap-and-trade umbrella, that same set of standards and subsidies will accomplish very little, and do so at exceedingly high cost.  Take just one example that seems to be popular among politicians – “renewable portfolio standards” (RPS), requirements that all states or all electricity utilities derive some fixed share of their power, say 20%, from renewable sources.  Note, for example, that such an approach does not distinguish between coal and natural gas, despite the dramatically different impacts these fuels have on CO2 emissions (and a host of other environmental outcomes).  Furthermore, although an RPS may displace some new coal-fired generation with other types of generation, there is little, if any, effect on the operation of existing coal-fired power plants.

If those other, regulatory parts of the climate legislation are so ineffective and so costly, why are they so popular with politicians?  The reason is simple.  The costs are hidden.  The government simply mandates that electric utilities or manufacturers take particular actions, employing the best technology available.  Where’s the cost?  Unlike a cap-and-trade system, there’s no analysis and debate about the cost of allowances (and the marginal abatement costs they represent); and unlike a carbon tax, there’s no analysis and no focus on the dollar amount of the tax and the aggregate cost.  That is the unfortunate but fundamental political economy behind much of U.S. environmental policy since the first Earth Day in 1970.

What about Court-Ordered Regulation?

Whether “best-available-control technology standards” are crafted by the Congress or put in place by the Environmental Protection Agency (EPA) under the court-ordered mandate stemming from the Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding,” such an approach will be relatively ineffective and terribly costly for what is accomplished.  The EPA route would essentially apply the mechanisms of the Clean Air Act, intended for localized, “criteria air pollutants,” to CO2, resulting in ineffective and costly regulations.

The White House (and most member of Congress) recognize that this is an inappropriate way to address climate change, but they seem determined to go forward, claiming that this threat will force the hand of Congress to do something more sensible instead.  Unfortunately, this is akin to my telling you that if you don’t do what I want, I will shoot myself in the foot – not a very credible or intelligent threat.  What I am referring to is that costly Clean Air Act regulation of CO2 will play into the hands of right-wing opponents of climate action, creating a poster-child of excessive regulatory intervention that will bring about a backlash against sensible climate policies.  EPA claims that there will be no such excessive regulatory actions, because it will exempt small sources through a so-called “tailoring rule.”  But legal scholars have noted that the tailoring rule stands on questionable legal grounds and could be invalidated by the courts.  In this regard, note that the first lawsuits to stop EPA from exempting small sources are coming from groups on the right, not the left.

Perhaps Senator Murkowski’s proposed joint resolution (H.J. Res. 66), introduced on January 21, 2010, disapproving (stopping) EPA’s regulatory action under the endangerment finding could save the Administration.  The conventional wisdom is that Senator Murkowski’s resolution has no political future, but with a bi-partisan list of 40 co-sponsors, that’s a total of 41 votes (more than the current total of 40 “Yes” and “Probably Yes” votes in the Senate for serious climate legislation, according to Environment and Energy Daily).  And remember that the disapproval resolution requires only 51, not 60 votes in the Senate, under the rules of the enabling statute, the Congressional Review Act of 1996 (signed by President Clinton, and part of the Republican “Contract with America”).  Of course, House action, not to mention signature by President Obama, would also be required for the resolution to take effect.  But a positive vote in the Senate will send a strong political message.

So Is There No Hope for Good Climate Policy?

Here is where it gets interesting, because as much as the current political environment in Washington may seem increasingly unreceptive to an economy-wide cap-and-trade system or some other meaningful and sensible climate policy, there is one promising approach that could actually benefit from the national political climate.

In these pages, I have expressed support for cap-and-trade mechanisms to address climate change, including the system embodied in the Waxman-Markey legislation that emerged from the House in June of last year.  Although that approach is scientifically sound, economically sensible, and may still turn out to be politically acceptable, there’s a modified version of cap-and-trade that could be much more attractive in this era of rampant expressions of populism, coming both from the right (“no new taxes”) and the left (“bash the corporations”).  Neither of those views, of course, is consistent with sound economic thinking on the environment, but it’s nevertheless possible to recognize their national appeal and build upon them.

This could be done with a simple upstream cap-and-trade system in which all of the needed allowances are sold (auctioned) – not given freely – to fossil-fuel producers and importers, and a very large share – say 75% – of the revenue is rebated directly to American households through monthly checks in a progressive scheme through which all individuals receive identical payments.

Such an approach could appeal to the populist sentiments that are increasingly dominating political discourse and judgments in this mid-term election year.  Such a system – which would have direct and visible positive financial consequences (i.e., rebate checks larger than energy price increases) for 80% of American households – might not only not be difficult for politicians to support, but it might actually be difficult for politicians to oppose!

Importantly, even though this is a specific type of cap-and-trade design (which has been known, studied, and proposed for decades), for better political optics, it should be called something else.  How about “cap-and-dividend?”

A CLEAR Answer?

What I’ve described bears a close resemblance to the “Carbon Limits and Energy for America’s Renewal (CLEAR) Act,” sponsored by Senators Maria Cantwell (D-Washington) and Susan Collins (R-Maine).  So, the politics of their proposal looks appealing, and the substance of it looks promising – a simple upstream cap-and-trade system (called something else), with 100% of the allowances auctioned (with a “price collar” on allowance prices to reduce cost uncertainty), 75% of the revenue refunded to all legal U.S. residents, each month, on an equal per capita basis as non-taxable income, the other 25% of the revenue dedicated to specified purposes, including “transition assistance,” and some built-in measures of protection for particularly energy-intensive, trade-sensitive sectors (not unlike Waxman-Markey).

That’s the good news.  The bad news, however, is that the proposal needs to be changed before it can promise to be not only politically attractive, but economically and environmentally sensible.  In particular, as it is currently structured, only producers and importers of fossil fuels can buy the carbon allowances.  In an up-stream system – an approach I have endorsed for years – it is producers and importers that are subject to compliance, that is, must eventually hold the allowances.  That’s fine.  But there is no sound reason to exclude other entities from participating in the auction markets; and doing so will greatly reduce market liquidity.

Furthermore, the Senators’ proposal says that holders of carbon allowances are actually prohibited from creating, selling, purchasing, or trading carbon derivatives, thereby tremendously reducing the efficiency of the market and needlessly driving up costs.  While no doubt borne out of a well-intentioned desire to protect consumers (remembering the recent impacts of mortgage-backed securities on financial markets), the Senators’ approach is akin to responding to a tragic airplane crash by concluding that the best way to protect consumers from air disasters in the future is simply to ban flying.

Less important structurally, but most important environmentally, an analysis by the World Resources Institute (which I have not validated) indicates that the caps – as currently set – would not bring about emissions reductions by 2020 that would even come close to the President’s announced goal of 17% reductions (equivalent to the Waxman-Markey targets), as submitted by the United States under the Copenhagen Accord.

But these and other problems with the CLEAR proposal can – in principle – be addressed while maintaining its basic structure and political attraction.

An Economic Perspective

It is interesting to note that many – perhaps most – economists have long favored the variant of cap-and-trade whereby allowances are auctioned and the auction revenue is used to cut distortionary taxes (on capital and/or labor), thereby reducing the net social cost of the policy.  Cap-and-Dividend moves in another direction.  This system (which was introduced several years ago in the “Sky Trust” proposal) has some merits compared with the economist’s favorite approach of tax cuts, namely that the Cap-and-Dividend scheme addresses some of the distributional issues that would be raised by using the auction revenue to fund tax cuts (which could favor higher income households).  On the other hand, it eliminates the efficiency (cost-effectiveness) gains associated with the tax-cut approach.  In fact, Stanford’s Larry Goulder has estimated that the tax-and-dividend approach would cost 40% more than an approach of combining an auction of allowances with ideal income tax rate cuts.  (By “ideal,” I mean focusing on tax cuts that would lead to the lowest net cost.)

In general, there are sound reasons to seek to compensate consumers for the energy price increases that will be brought about by a cap-and-trade system, or any meaningful climate change policy. But it is important not to insulate consumers from those price increases, as diluting the price signal reduces the effectiveness and drives up the cost of the overall policy.  Thus, “compensation” as in Cap-and-Dividend is fine, but “insulation” is not.

The most politically salient question with the Waxman-Markey approach of freely allocating a significant portion of the allowances to the private sector is how to distribute (that is, who gets) those allowances which are freely allocated.  In this regard, contrary to much of the hand-wringing in the press, the deal-making that took place in the House and may still take place in the Senate for shares of free allowances is an example of the useful and important mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled without reducing the policy’s effectiveness or driving up its cost.

The ultimate political question seems to be whether there is greater (geographic and sectoral) political support for the Waxman-Markey (H.R. 2454) approach of substantial free allocations and targeted use of auction revenue, or if there is greater (populist) political support for the full auction combined with lump-sum rebate which characterizes the “cap-and-dividend” approach.  Alas, the textbook economics preference — full auction combined with cuts of distortionary taxes — appears to be a political, if not academic, orphan.

Confusion in the Senate Regarding Allowance Allocation?

According to an October 22nd  story in Environment & Energy Daily (“Climate:  GOP Fence Sitters Voice Concerns Over Allocations” by Darren Samuelson), several key swing-vote Senate Republicans — including Senator Lisa Murkowski, ranking member of the Energy and Natural Resources Committee — are voicing skepticism about the Senate’s Boxer-Kerry climate bill’s cap-and-trade system because of the free allocation of some of the allowances to various recipients in the private (and public) sector.  Although the testimony by a group of very knowledgeable economists (see below) made some important points about the implications of alternative allocation mechanisms in a cap-and-trade system, the questions and comments from some members of the Senate Committee suggest that there is lingering confusion on some points that are absolutely central to the debate.  This is important because debate is now advancing on “The Clean Energy Jobs and American Power Act” (Boxer-Kerry), S. 1733, an important (but not sole) element of which is the carbon cap-and-trade system.

First, I want to acknowledge that there are sound reasons for considering allocation mechanisms other than free allocation — for example, auctioning allowances (more about this below) — but the distribution of those allowances that are freely allocated need not be a great source of concern.  In some respects, the new debate is repeating the confusion which was prevalent in the press and the blogosphere about the allowance allocation in the Waxman-Markey legislation in the House of Representatives (H.R. 2454).

It is important to distinguish the above question of whether to employ free allocation or auction, from the question how to allocate the total number of freely allocated allowances among various potential recipients.  As Denny Ellerman of MIT pointed out at the Senate Energy and Natural Resources Committee hearings, “it is not enough to simply say that allowances should be auctioned or allocated freely.  The real issue is the use to which the newly created value will be directed and the households that will thereby ultimately receive the benefit of the allowance value.”   This is a point which I carefully explained and quantified in a post on May 27th (“The Wonderful Politics of Cap-and-Trade:  A Closer Look at Waxman-Markey.”)

Rather than being a “massive corporate give-away” of 80% of the allowances to private industry — as it was frequently characterized — the H.R. 2454 allowance allocation would result in precisely the opposite, namely, about 80% of the value of allowances accruing to consumers, small business, and public purposes, and some 20% accruing to covered, private industry, a split which is roughly consistent with the recommendations from independent economic research.  (I want to acknowledge that estimates by Lawrence Goulder (Stanford) and his colleagues suggest that H.R. 2454 would convey more than 20% of the allowance value to industry.  Perhaps in some future blog post, I can look at these alternative estimates, particularly in the context of analysis of the emerging Senate legislation, S. 1733.)

Directly to Senator Murkowski’s and others’ concern — how the total number of freely allocated allowances is divided up among various potential recipients — does not with some relatively minor exceptions (see list below) — affect either the environmental performance or the overall social cost of the system.

The division of the free allowances among recipients largely affects the distribution of costs, rather than aggregate social cost or the degree of environmental performance.  To this point, the independence of the equilibrium allowance allocation from the initial allocation in a cap-and-trade system was demonstrated by David Montgomery in a path-breaking article in 1972 in the Journal of Economic Theory, and is a more or less direct consequence of principles established by Nobel laureate Ronald Coase in 1960 in “The Problem of Social Cost.”  This independence does not, however, hold in all situations, a topic which Robert Hahn and I are currently analyzing for a conference to be held at the University of Chicago in December.   Examples of such specific conditions include particular types of transaction costs, market power, conditional allowance allocations, non-cost minimizing behavior by firms, and differential regulatory treatment of firms.   We are investigating this topic both theoretically, and empirically, assessing the impacts of initial allowance allocations on the performance of actual and planned cap-and-trade systems in the United States, Europe, Australia, and elsewhere.

Let me emphasize again that I am not talking about the decision regarding whether to freely allocate or auction the allowances.  That decision certainly can affect aggregate social costs, because if some of the allowances are auctioned and if the revenue thereby generated is used to cut distortionary taxes, then the social cost of the overall policy (cap-and-trade plus tax cut) can be less than it would be if the allowances were freely allocated.  This is a well-known distinction both from theory and empirical analysis, with much of the relevant academic work having been done by Stanford University Professor Lawrence Goulder.

So, many economists have long favored a system whereby allowances are auctioned and the auction revenue is used to cut distortionary taxes (on capital and/or labor), thereby reducing the net social cost of the policy.  But recent interest by Senate Energy and Natural Resources Committee Chairman Jeff Bingaman (D-NM) and others seems to be moving in the direction of a so-called “cap-and-dividend” approach.   In such a system (which was originally raised several years ago in the “Sky Trust” proposal), all allowances would be auctioned to complying firms, and the auction revenue distributed to U.S. households on a per capita basis.  This can address some of the distributional issues that would be raised by using the auction revenue to fund tax cuts (which could favor higher income households), but it would eliminate the efficiency (cost-effectiveness) gains associated with the tax cut approach.  In fact, Stanford’s Goulder has estimated that the tax-and-dividend approach would cost 40% more than an approach of combining an auction of allowances with ideal income tax rate cuts.  By “ideal,” I mean cutting those distortionary taxes which would lead to the lowest net cost.

In general, there are sound reasons to seek to compensate consumers for the energy price increases that will be brought about by a cap-and-trade system for climate change, but it is important not to insulate consumers from those price increases (which — as Professor Gilbert Metcalf of Tufts University pointed out at the Senate hearings — dilutes the price signal and thereby reduces the effectiveness and drives up the cost of the overall policy).  So, in my language, “compensation” is fine, but “insulation” is not.

Distinct from that issue, however, is the politically salient question of how to distribute (that is, who gets) those allowances which are freely allocated.  This is the issue on which I have focused.  In this regard, the deal-making that took place in the House and will take place in the Senate for shares of the free allowances is an example of the useful, important, and fundamentally benign mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled (without reducing the policy’s effectiveness or driving up its cost).

Beyond this, the ultimate political question associated with the allocation mechanism may be whether there is greater (geographically and sectoraly based) political support for the partially free allocation and targeted use of auction revenue, which characterizes the Waxman-Markey (H.R. 2454) approach, or greater (“populist”) political support for the full auction combined with lump-sum rebate which characterizes the “cap-and-dividend” approach.  Alas, the textbook economics preference — full auction combined with cuts of distortionary taxes — may be a political, if not, academic orphan.

Cap-and-Trade versus the Alternatives for U.S. Climate Policy

Let’s credit Senator Lisa Murkowski (R-Alaska) for raising questions in the National Journal about the viability of cap-and-trade versus other approaches for the United States to employ in addressing CO2 and other greenhouse gas emissions linked with global climate change.

Senator Murkowski says that only one approach – cap-and-trade – has received significant attention in the Congress.  Let’s put aside for the moment the fact that most of the 1,428 pages of H.R. 2454 – the American Clean Energy and Security Act of 2009 (otherwise known as the Waxman-Markey bill) – are not about cap-and-trade at all, but about a host of other regulatory approaches (several of which are highly problematic, as I’ve discussed in a previous post).  We can also put aside the fact that both conventional regulatory approaches and carbon taxes have been discussed repeatedly in numerous House and Senate committees over the past decade, and received detailed attention from a succession of U.S. administrations.

So, let’s not quibble about the Senator’s claim that cap-and-trade is the only approach that has received serious attention.  Instead, let’s address the key substantive questions which Senator Murkowski raises, because they are important questions:  Is cap-and-trade the most effective way of addressing climate change?  And are there other approaches capable of achieving the same results at lower cost?  From my perspective, as a card-carrying environmental economist, these are indeed the key questions.

While political leaders in the European Union, Canada, Australia, New Zealand, Japan, and the United States (Congress) move toward cap-and-trade systems as their preferred approach for achieving meaningful reductions in emissions of CO2 and other greenhouse gases, many people – including some of my fellow economists — have been critical of the cap-and-trade approach in the climate context and have endorsed the use of carbon taxes.  The Senator is correct that we should reflect on the merits of that alternative approach.

But, first, what about conventional regulatory approaches, that is, performance standards and technology standards?

Conventional Regulatory Standards

In short, experience has shown that such standards cannot ensure achievement of emissions targets, create problematic unintended consequences, and are very costly for what they achieve.

Why can conventional standard not ensure achievement of reasonable emissions targets?  First, standards typically focus on new emissions sources, and do not address emissions from existing sources.  Think about greenhouse gas standards for new cars and new power plants, for example.  Second, standards cannot possibly address all types of new sources, given the ubiquity of energy generation and use (and hence CO2 emissions) in a modern economy.  Third, emissions depend upon many factors that cannot be addressed by standards, such as:  emissions from existing sources and unregulated new sources; how quickly the existing capital stock is replaced; the growth in the number of new emissions sources; and how intensively emissions-generating plants and equipment are utilized.

Next, what about those unintended consequences?  First, by reducing operating costs, energy-efficiency standards – for example — can cause more intensive use of regulated equipment (for example, air conditioners are run more often), leading to offsetting increases in emissions — the “rebound effect.”  Second, firms and households may delay replacing existing equipment if standards make new equipment more costly.  This is the well-known problem with vintage-differentiated regulations or “New Source Review.”  Third, standards may encourage counterproductive, unintended shifts among regulated activities (for example, from purchasing cars to purchasing SUVs under the CAFE program).  All of these unintended consequences result from the problematic incentives that standards can create, compared with the efficient incentives created by a cap-and-trade system (or a carbon-tax, for that matter).

If you favor a regulatory approach, then you may welcome what’s coming from EPA as a result of the Supreme Court ruling of a few years ago combined with the Administration’s endangerment finding.  For my part, I don’t welcome it; I worry about it, because the set of regulatory approaches that could be forthcoming will accomplish relatively little, do so at an unnecessarily high cost, and hence play into the hands of opponents of progressive climate policy.  (More about that in some other, future post.)

Putting a Price on Carbon

To virtually all participants in the policy world, it has become increasingly clear that the only approach that can do the job and do it cost-effectively is one which involves at its core putting a price on carbon.  That leaves cap-and-trade and carbon taxes.  Let me take these in turn.


Let’s step back from the debate regarding the details of the Waxman-Markey House bill or the new Senate proposal by Senators Boxer and Kerry, and think about the essence of the cap-and-trade approach.  (For some of those details, however, please see my previous posts, where I have commented on various aspects of Waxman-Markey and described a proposal I developed for The Hamilton Project of an up-stream, economy-wide CO2 cap-and-trade system to cost-effectively achieve meaningful greenhouse gas emissions reductions.)

Here are the basics.  First, aggregate emissions from regulated sources are capped, and the cap is enforced through a requirement for affected firms to hold emissions allowances.  Importantly, allowance trading minimizes costs of meeting the cap.  It does this because allowances migrate to the highest-valued uses, covering emissions that are the most costly to reduce.  So, the emission reductions undertaken are those that are least costly to achieve.  In essence, the uniform market price of allowances creates incentives for all covered sources to reduce all emissions, and do so cost-effectively.

A cap-and-trade system can be more environmentally-effective and more cost-effective than standards.  First, in terms of environmental-effectiveness, a cap-and-trade system can ensure achievement of emissions targets.  Cap-and-trade allows policymakers to set specific overall emissions targets.  And a well-enforced system guarantees achievement of those targets, because emissions will not exceed available allowances.  An economy-wide, upstream cap-and-trade system on the carbon content of fossil fuels can cover all fossil-fuel-related CO2 emissions without needing to regulate each emissions source individually.

In terms of cost-effectiveness, a well-designed cap-and-trade system minimizes emission reduction costs.  Unlike NOx, SO2, and other pollutants, GHG emission reductions have the same effect no matter how, where, or when they are achieved.  This makes the climate change problem unique in the degree to which compliance flexibility can be used to lower costs without compromising environmental integrity.  Hence, a cap-and-trade system can minimize costs while still meeting environmental objectives by offering three forms of flexibility: what flexibility; where flexibility; and when flexibility.

In regard to “what flexibility,” many types of actions offer low-cost emission reductions, and a cap-and-trade system allows emission reductions through whatever measures are least costly.  By contrast, standards can target only certain identified emission reduction measures, leaving other cost-effective opportunities untapped.  Furthermore, predictions of what measures are cost-effective may be wrong.

In regard to “where flexibility,” the costs of emission reductions vary widely across industries, across facilities, and even across users of the same equipment.  A cap-and-trade system exploits this variation in costs by achieving reductions wherever they are least costly.  By contrast, standards would only be cost-effective if they accounted for all of the variation in costs across sectors, technologies, and regulated entities — but it is completely infeasible for standards to do this.  Emission reduction costs across sectors and technologies change over time, making the flexibility offered by a cap-and-trade system even more valuable.  Also, lower-cost opportunities to reduce emissions may exist in other countries.  Importantly, a cap-and-trade system creates a common currency (emissions allowances) that makes it possible to link with other systems.

A cap-and-trade system also minimizes costs through “when flexibility.”  Costs can be reduced through flexibility in the timing of emission reductions by avoiding:  premature retirement of capital stock or lock-in of existing technologies; and unnecessarily costly reductions in one year due to unusual circumstances when less-costly offsetting reductions can be achieved in other years.  A cap-and-trade can incorporate “when flexibility”
without compromising cumulative emissions targets through: allowance banking and borrowing; and multi-year compliance periods.

Beyond such “static cost-effectiveness,” cap-and-trade creates incentives for technology innovation, and thereby lowers long-run costs.  By rewarding any means of reducing emissions, a cap-and-trade system provides broad incentives for any innovations that lower the cost of achieving emissions targets.  Although standards may encourage development of lower cost means of meeting the standards’ specific requirements, they do not encourage efforts to exceed those standards.

Several cap-and-trade systems have been successful at achieving environmental goals and cost savings:  the phase-out of leaded gasoline in the 1980s; the phase-out of ozone depleting substances; and the Clean Air Act amendments of 1990 SO2 allowance trading program to cut acid rain by 50%.  Perceived shortcomings in other cap-and-trade systems reflect design choices, not problems with the policy instrument itself.  This applies both to California’s RECLAIM program, and the pilot phase of the EU Emissions Trading Scheme (which is operating successfully in its real, Kyoto phase).

In summary, compared with conventional standards, a cap-and-trade system can be more environmentally-effective and more cost-effective.  As with any policy instrument, however, careful design is important.

Taxing Carbon

As I mentioned, it is clear that the only approach that can do the job and do it cost-effectively is one that involves putting a price on carbon.  So, what about the other carbon-pricing approach — a carbon tax?

I am by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years.  Indeed, both cap-and-trade and carbon taxes are good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences.   I am opposed, however, to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.

While there are tradeoffs between these two principal market-based instruments targeting CO2 emissions — a cap-and-trade system and a carbon tax – the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system.  I say this based on three criteria:  environmental effectiveness, cost effectiveness, and distributional equity.  So, my position is not capitulation to politics.  On the other hand, sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should surely be made in the real-world political context.

The key merits of the cap-and-trade approach I have described above are, first, the program can provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels.  Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by a climate policy.  Third, it provides a straightforward means to harmonize with other countries’ climate policies.  Fourth, it avoids the current political aversion in the United States to taxes.  Fifth, it is unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach has a history of successful adoption and implementation in this country over the past two decades.

Having said this, there are some real differences between taxes and cap-and-trade that need to be recognized.  First, environmental effectiveness:  a tax does not guarantee achievement of an emissions target, but it does provides greater certainty regarding costs.  This is a fundamental tradeoff.  Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly a cost-containment mechanism.  On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and this is why environmental NGOs are opposed to the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same.  But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table.  But political pressures on a cap-and-trade system lead to different allocations of allowances, which affect distribution, but not environmental effectives, and not cost-effectiveness.

Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

The Bottom Line

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects.  Hence, they said, the two primary questions to use in deciding between them should be:  which is more politically feasible; and which is more likely to be well-designed?

The answer to the first question is obvious; and I have argued here that given real-world political forces, the answer to the second question also favors cap-and-trade.  In other words, it is important to identify and design policy that will be “optimal in Washington,” not just from the perspective of Cambridge, New Haven, or Berkeley.

In “policy heaven,” the optimal instrument to address climate-change emissions may well be a carbon tax (largely because of its simplicity), but in the real world in which policy is developed and implemented, cap-and-trade is the best approach if one is serious about addressing the threat of climate change with meaningful, effective, and cost-effective policies.

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.

Is Benefit-Cost Analysis Helpful for Environmental Regulation?

With the locus of action on Federal climate policy moving this week from the House of Representatives to the Senate, this is a convenient moment to step back from the political fray and reflect on some fundamental questions about U.S. environmental policy.

One such question is whether economic analysis – in particular, the comparison of the benefits and costs of proposed policies – plays a truly useful role in Washington, or is it little more than a distraction of attention from more important perspectives on public policy, or – worst of all – is it counter-productive, even antithetical, to the development, assessment, and implementation of sound policy in the environmental, resource, and energy realms.   With an exceptionally talented group of thinkers – including scientists, lawyers, and economists – now in key environmental and energy policy positions at the White House, the Environmental Protection Agency, the Department of Energy, and the Department of the Treasury, this question about the usefulness of benefit-cost analysis is of particular importance.

For many years, there have been calls from some quarters for greater reliance on the use of economic analysis in the development and evaluation of environmental regulations.  As I have noted in previous posts on this blog, most economists would argue that economic efficiency — measured as the difference between benefits and costs — ought to be one of the key criteria for evaluating proposed regulations.  (See:  “The Myths of Market Prices and Efficiency,” March 3, 2009; “What Baseball Can Teach Policymakers,” April 20, 2009; “Does Economic Analysis Shortchange the Future?” April 27, 2009)  Because society has limited resources to spend on regulation, such analysis can help illuminate the trade-offs involved in making different kinds of social investments.  In this sense, it would seem irresponsible not to conduct such analyses, since they can inform decisions about how scarce resources can be put to the greatest social good.

In principle, benefit-cost analysis can also help answer questions of how much regulation is enough.  From an efficiency standpoint, the answer to this question is simple — regulate until the incremental benefits from regulation are just offset by the incremental costs.  In practice, however, the problem is much more difficult, in large part because of inherent problems in measuring marginal benefits and costs.  In addition, concerns about fairness and process may be very important economic and non-economic factors.  Regulatory policies inevitably involve winners and losers, even when aggregate benefits exceed aggregate costs.

Over the years, policy makers have sent mixed signals regarding the use of benefit-cost analysis in policy evaluation.  Congress has passed several statutes to protect health, safety, and the environment that effectively preclude the consideration of benefits and costs in the development of certain regulations, even though other statutes actually require the use of benefit-cost analysis.  At the same time, Presidents Carter, Reagan, Bush, Clinton, and Bush all put in place formal processes for reviewing economic implications of major environmental, health, and safety regulations. Apparently the Executive Branch, charged with designing and implementing regulations, has seen a greater need than the Congress to develop a yardstick against which regulatory proposals can be assessed.  Benefit-cost analysis has been the yardstick of choice

It was in this context that ten years ago a group of economists from across the political spectrum jointly authored an article in Science magazine, asking whether there is role for benefit-cost analysis in environmental, health, and safety regulation.  That diverse group consisted of Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and myself.  That article and its findings are particularly timely, with President Obama considering putting in place a new Executive Order on Regulatory Review.

In the article, we suggested that benefit-cost analysis has a potentially important role to play in helping inform regulatory decision making, though it should not be the sole basis for such decision making.  We offered eight principles.

First, benefit-cost analysis can be useful for comparing the favorable and unfavorable effects of policies, because it can help decision makers better understand the implications of decisions by identifying and, where appropriate, quantifying the favorable and unfavorable consequences of a proposed policy change.  But, in some cases, there is too much uncertainty to use benefit-cost analysis to conclude that the benefits of a decision will exceed or fall short of its costs.

Second, decision makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations.  Removing statutory prohibitions on the balancing of benefits and costs can help promote more efficient and effective regulation.

Third, benefit-cost analysis should be required for all major regulatory decisions. The scale of a benefit-cost analysis should depend on both the stakes involved and the likelihood that the resulting information will affect the ultimate decision.

Fourth, although agencies should be required to conduct benefit-cost analyses for major decisions, and to explain why they have selected actions for which reliable evidence indicates that expected benefits are significantly less than expected costs, those agencies should not be bound by strict benefit-cost tests.  Factors other than aggregate economic benefits and costs may be important.

Fifth, benefits and costs of proposed policies should be quantified wherever possible.  But not all impacts can be quantified, let alone monetized.  Therefore, care should be taken to assure that quantitative factors do not dominate important qualitative factors in decision making.  If an agency wishes to introduce a “margin of safety” into a decision, it should do so explicitly.

Sixth, the more external review that regulatory analyses receive, the better they are likely to be.  Retrospective assessments should be carried out periodically.

Seventh, a consistent set of economic assumptions should be used in calculating benefits and costs.  Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

Eighth, while benefit-cost analysis focuses primarily on the overall relationship between benefits and costs, a good analysis will also identify important distributional consequences for important subgroups of the population.

From these eight principles, we concluded that benefit-cost analysis can play an important role in legislative and regulatory policy debates on protecting and improving the natural environment, health, and safety.  Although formal benefit-cost analysis should not be viewed as either necessary or sufficient for designing sensible public policy, it can provide an exceptionally useful framework for consistently organizing disparate information, and in this way, it can greatly improve the process and hence the outcome of policy analysis.

If properly done, benefit-cost analysis can be of great help to agencies participating in the development of environmental regulations, and it can likewise be useful in evaluating agency decision making and in shaping new laws (which brings us full-circle to the climate legislation that will be developed in the U.S. Senate over the weeks and months ahead, and which I hope to discuss in future posts).

The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey

The headline of this post is not meant to be ironic.   Despite all the hand-wringing in the press and the blogosphere about a political “give-away” of allowances for the cap-and-trade system in the Waxman-Markey bill voted out of committee last week, the politics of cap-and-trade systems are truly quite wonderful, which is why these systems have been used, and used successfully.

The Waxman-Markey allocation of allowances has its problems, which I will get to, but before noting those problems it is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems:  the allocation of allowances – whether the allowances are auctioned or given out freely, and how they are freely allocated – has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs.  (Well, there are some relatively minor, but significant caveats – those “problems” I mentioned — about which more below.)  By the way, this independence of a cap-and-trade system’s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery in a path-breaking article in the Journal of Economic Theory (based upon his 1971 Harvard economics Ph.D. dissertation). It has been validated with empirical evidence repeatedly over the years.

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms’ production and emission reduction decisions.  Firms face the same emissions cost regardless of the allocation method.  When using an allowance, whether it was received for free or purchased, a firm loses the opportunity to sell that allowance, and thereby recognizes this “opportunity cost” in deciding whether to use the allowance.  Consequently, the allocation choice will not influence a cap’s overall costs.

Manifest political pressures lead to different initial allocations of allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.  This means that ordinary political pressures need not get in the way of developing and implementing a scientifically sound, economically rational, and politically pragmatic policy.  Contrast this with what would happen when political pressures are brought to bear on a carbon tax proposal, for example.  Here the result will most likely be exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs (as some low-cost emission reduction opportunities are left off the table).  Furthermore, the hypothetical carbon tax example is the norm, not the exception.  Across the board, political pressures often reduce the effectiveness and increase the cost of well-intentioned public policies.  Cap-and-trade provides natural protection from this.  Distributional battles over the allowance allocation in a cap-and-trade system do not raise the overall cost of the program nor affect its environmental impacts.

In fact, the political process of states, districts, sectors, firms, and interest groups fighting for their share of the pie (free allowance allocations) serves as the mechanism whereby a political constituency in support of the system is developed, but without detrimental effects to the system’s environmental or economic performance.  That’s the good news, and it should never be forgotten.

But, depending upon the specific allocation mechanisms employed, there are several ways that the choice to freely distribute allowances can affect a system’s cost.  Here’s where the “caveats” and “problems” come in.

First, auction revenue may be used in ways that reduce the costs of the existing tax system or fund other socially beneficial policies.  Free allocations to the private sector forego such opportunities.  Below I will estimate the actual share of allowance value that accrues to the private sector.

Second, some proposals to freely allocate allowances to electric utilities may affect electricity prices, and thereby affect the extent to which reduced electricity demand contributes to limiting emissions cost-effectively.  Waxman-Markey allocates allowances to local distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets.  So, electricity prices would likely be affected by these allocations under existing state regulatory regimes.  The Waxman-Markey legislation seeks to address this problem by specifying that the economic value of the allowances given to electricity and natural gas local distribution companies should be passed on to consumers through lump-sum rebates, not through a reduction in electricity rates, thereby compensating consumers for increases in electricity prices, but without reducing incentives for energy conservation.

Third, and of most concern in the context of the Waxman-Markey legislation, “output-based updating allocations” provide perverse incentives and drive up costs of achieving a cap.  This merits some explanation.  If allowances are freely allocated, the allocation should be on the basis of some historical measures, such as output or emissions in a (previous) base year, not on the basis of measures which firms can affect, such as output or emissions in the current year.  Updating allocations, which involve periodically adjusting allocations over time to reflect changes in firms’ operations, contrast with this.

An output-based updating allocation ties the quantity of allowances that a firm receives to its output (production).  Such an allocation is essentially a production subsidy.  This distorts firms’ pricing and production decisions in ways that can introduce unintended consequences and may significantly increase the cost of meeting an emissions target.  Updating therefore has the potential to create perverse, undesirable incentives.

In Waxman-Markey, updating allocations are used for specific sectors with high CO2 emissions intensity and unusual sensitivity to international competition, in an effort to preserve international competitiveness and reduce emissions leakage.  It’s an open question whether this approach is superior to an import allowance requirement, whereby imports of a small set of specific commodities must carry with them CO2 allowances.  The problem with import allowance requirements is that they can damage international trade relations.  The only real solution to the competitiveness issue is to bring non-participating countries within an international climate regime in meaningful ways.  (On this, please see the work of the Harvard Project on International Climate Agreements.)

Also, output-based allocations are used in Waxman-Markey for merchant coal generators, thereby discouraging reductions in coal-fired electricity generation, another significant and costly distortion.

Now, let’s go back to the hand-wringing in the press and blogosphere about the so-called massive political “give-away” of allowances.  Perhaps unintentionally, there has been some misleading press coverage, suggesting that up to 75% or 80% of the allowances are given away to private industry as a windfall over the life of the program, 2012-2050 (in contrast with the 100% auction originally favored by President Obama).

Given the nature of the allowance allocation in the Waxman-Markey legislation, the best way to assess its implications is not as “free allocation” versus “auction,” but rather in terms of who is the ultimate beneficiary of each element of the allocation and auction, that is, how the value of the allowances is allocated.  On closer inspection, it turns out that many of the elements of the apparently free allocation accrue to consumers and public purposes, not private industry.

First of all, let’s looks at the elements which will accrue to consumers and public purposes.  Next to each allocation element is the respective share of allowances over the period 2012-2050 (measured as share of the cap, after the removal – sale — of allowances to private industry from a “strategic reserve,” which functions as a cost-containment measure.):

a.  Electricity and natural gas local distribution companies (22.2%), minus share (6%) that benefits industry as consumers of electricity (note:  there is a consequent 3% reduction in the allocation to energy-intensive trade-exposed industries, below, which is then dedicated to broad-based consumer rebates, below), 22.2 – 6 = 16.2%

b.  Home heating oil/propane, 0.9%

c.  Protection for low- and moderate-income households, 15.0%

d.  Worker assistance and job training, 0.8%

e.  States for renewable energy, efficiency, and building codes, 5.8%

f.   Clean energy innovation centers, 1.0%

g.  International deforestation, clean technology, and adaptation, 8.7%

h.  Domestic adaptation, 5.0%

The following elements will accrue to private industry, again with average (2012-2050) shares of allowances:

i.   Merchant coal generators, 3.0%

j.   Energy-intensive, trade-exposed industries (minus reduction in allocation due to EITE benefits from LDC allocation above) 8.0% – 3% = 5%

k.  Carbon-capture and storage incentives, 4.1%

l.   Clean vehicle technology standards, 1.0%

m. Oil refiners, 1.0%

n.  Net benefits to industry as consumers of lower-priced electricity from allocation to LDCs, 6.0%

The split over the entire period from 2012 to 2050 is 53.4% for consumers and public purposes, and 20.1% for private industry.  This 20% is drastically different from the suggestions that 70%, 80%, or more of the allowances will be given freely to private industry in a “massive corporate give-away.”

All categories – (a) through (n), above – sum to 73.5% of the total quantity of allowances over the period 2012-2050.  The remaining allowances — 26.5% over 2012 to 2050 — are scheduled in Waxman-Markey to be used almost entirely for consumer rebates, with the share of available allowances for this purpose rising from approximately 10% in 2025 to more than 50% by 2050.  Thus, the totals become 79.9% for consumers and public purposes versus 20.1% for private industry, or approximately 80% versus 20% — the opposite of the “80% free allowance corporate give-away” featured in many press and blogosphere accounts.  Moreover, because some of the allocations to private industry are – for better or for worse – conditional on recipients undertaking specific costly investments, such as investments in carbon capture and storage, part of the 20% free allocation to private industry should not be viewed as a windfall.

Speaking of the conditional allocations, I should also note that some observers (who are skeptical about government programs) may reasonably question some of the dedicated public purposes of the allowance distribution, but such questioning is equivalent to questioning dedicated uses of auction revenues.  The fundamental reality remains:  the appropriate characterization of the Waxman-Markey allocation is that 80% of the value of allowances go to consumers and public purposes, and 20% to private industry.

Finally, it should be noted that this 80-20 split is roughly consistent with empirical economic analyses of the share that would be required – on average — to fully compensate (but no more) private industry for equity losses due to the policy’s implementation.  In a series of analyses that considered the share of allowances that would be required in perpetuity for full compensation, Bovenberg and Goulder (2003) found that 13 percent would be sufficient for compensation of the fossil fuel extraction sectors, and Smith, Ross, and Montgomery (2002) found that 21 percent would be needed to compensate primary energy producers and electricity generators.

In my work for the Hamilton Project in 2007, I recommended beginning with a 50-50 auction-free-allocation split, moving to 100% auction over 25 years, because that time-path of numerical division between the share of allowances that is freely allocated to regulated firms and the share that is auctioned is equivalent (in terms of present discounted value) to perpetual allocations of 15 percent, 19 percent, and 22 percent, at real interest rates of 3, 4, and 5 percent, respectively.  My recommended allocation was designed to be consistent with the principal of targeting free allocations to burdened sectors in proportion to their relative burdens, while being politically pragmatic with more generous allocations in the early years of the program.

So, the Waxman-Markey 80/20 allowance split turns out to be consistent  — on average, i.e. economy-wide — with independent economic analysis of the share that would be required to fully compensate (but no more) the private sector for equity losses due to the imposition of the cap, and consistent with my Hamilton Project recommendation of a 50/50 split phased out to 100% auction over 25 years.

Going forward, many observers and participants in the policy process may continue to question the wisdom of some elements of the Waxman-Markey allowance allocation.  There’s nothing wrong with that.

But let’s be clear that, first, for the most part, the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost.

Second, questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.

Third, we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled.  On the contrary, 80% of the value of allowances accrue to consumers and public purposes, and some 20% accrue to covered, private industry.  This split is roughly consistent with the recommendations of independent economic research.

Fourth and finally, it should not be forgotten that the much-lamented deal-making that took place in the House committee last week for shares of the allowances for various purposes was a good example of the useful, important, and fundamentally benign mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled (without reducing the policy’s effectiveness or driving up its cost).

Although there has surely been some insightful press coverage and intelligent public debate (including in the blogosphere) about the pros and cons of cap-and-trade, the Waxman-Markey legislation, and many of its design elements, it is remarkable (and unfortunate) how misleading so much of the coverage has been of the issues and the numbers surrounding the proposed allowance allocation.

Does economic analysis shortchange the future?

Decisions made today usually have impacts both now and in the future. In the environmental realm, many of the future impacts are benefits, and such future benefits — as well as costs — are typically discounted by economists in their analyses.  Why do economists do this, and does it give insufficient weight to future benefits and thus to the well-being of future generations?

This is a question my colleague, Lawrence Goulder, a professor of economics at Stanford University, and I addressed in an article in Nature.  We noted that as economists, we often encounter skepticism about discounting, especially from non-economists. Some of the skepticism seems quite valid, yet some reflects misconceptions about the nature and purposes of discounting.  In this post, I hope to clarify the concept and the practice.

It helps to begin with the use of discounting in private investments, where the rationale stems from the fact that capital is productive ­– money earns interest.  Consider a company trying to decide whether to invest $1 million in the purchase of a copper mine, and suppose that the most profitable strategy involves extracting the available copper 3 years from now, yielding revenues (net of extraction costs) of $1,150,000. Would investing in this mine make sense?  Assume the company has the alternative of putting the $1 million in the bank at 5 per cent annual interest. Then, on a purely financial basis, the company would do better by putting the money in the bank, as it will have $1,000,000 x (1.05)3, or $1,157,625, that is, $7,625 more than it would earn from the copper mine investment.

I compared the alternatives by compounding to the future the up-front cost of the project. It is mathematically equivalent to compare the options by discounting to the present the future revenues or benefits from the copper mine. The discounted revenue is $1,150,000 divided by (1.05)3, or $993,413, which is less than the cost of the investment ($1 million).  So the project would not earn as much as the alternative of putting the money in the bank.

Discounting translates future dollars into equivalent current dollars; it undoes the effects of compound interest. It is not aimed at accounting for inflation, as even if there were no inflation, it would still be necessary to discount future revenues to account for the fact that a dollar today translates (via compound interest) into more dollars in the future.

Can this same kind of thinking be applied to investments made by the public sector?  Since my purpose is to clarify a few key issues in the starkest terms, I will use a highly stylized example that abstracts from many of the subtleties.  Suppose that a policy, if introduced today and maintained, would avoid significant damage to the environment and human welfare 100 years from now. The ‘return on investment’ is avoided future damages to the environment and people’s well-being. Suppose that this policy costs $4 billion to implement, and that this cost is completely borne today.  It is anticipated that the benefits – avoided damages to the environment – will be worth $800 billion to people alive 100 years from now.  Should the policy be implemented?

If we adopt the economic efficiency criterion I have described in previous posts, the question becomes whether the future benefits are large enough so that the winners could potentially compensate the losers and still be no worse off?  Here discounting is helpful. If, over the next 100 years, the average rate of interest on ordinary investments is 5 per cent, the gains of $800 billion to people 100 years from now are equivalent to $6.08 billion today.  Equivalently, $6.08 billion today, compounded at an annual interest rate of 5 per cent, will become $800 billion in 100 years. The project satisfies the principle of efficiency if it costs current generations less than $6.08 billion, otherwise not.

Since the $4 billion of up-front costs are less than $6.08 billion, the benefits to future generations are more than enough to offset the costs to current generations. Discounting serves the purpose of converting costs and benefits from various periods into equivalent dollars of some given period.  Applying a discount rate is not giving less weight to future generations’ welfare.  Rather, it is simply converting the (full) impacts that occur at different points of time into common units.

Much skepticism about discounting and, more broadly, the use of benefit-cost analysis, is connected to uncertainties in estimating future impacts. Consider the difficulties of ascertaining, for example, the benefits that future generations would enjoy from a regulation that protects certain endangered species. Some of the gain to future generations might come in the form of pharmaceutical products derived from the protected species. Such benefits are impossible to predict. Benefits also depend on the values future generations would attach to the protected species – the enjoyment of observing them in the wild or just knowing of their existence. But how can we predict future generations’ values?  Economists and other social scientists try to infer them through surveys and by inferring preferences from individuals’ behavior.  But these approaches are far from perfect, and at best they indicate only the values or tastes of people alive today.

The uncertainties are substantial and unavoidable, but they do not invalidate the use of discounting (or benefit-cost analysis).  They do oblige analysts, however, to assess and acknowledge those uncertainties in their policy assessments, a topic I discussed in my last post (“What Baseball Can Teach Policymakers”), and a topic to which I will return in the future.

Moving Beyond Vintage-Differentiated Regulation

A common feature of many environmental policies in the United States is vintage-differentiated regulation (VDR), under which standards for regulated units are fixed in terms of the units’ respective dates of entry, with later vintages facing more stringent regulation.  In the most common application, often referred to as “grandfathering,” units produced prior to a specific date are exempted from a new regulation or face less stringent requirements.

As I explain in this post, an economic perspective suggests that VDRs are likely to retard turnover in the capital stock, and thereby to reduce the cost-effectiveness of regulation in the long-term, compared with equivalent undifferentiated regulations.  Further, under some conditions the result can be higher levels of pollutant emissions than would occur in the absence of regulation.  Thus, economists have long argued that age-discriminatory environmental regulations retard investment, drive up the cost of environmental protection, and may even retard pollution abatement.

Why have VDRs been such a common feature of U.S. regulatory policy, despite these problems?  Among the reasons frequently given are claims that VDRs are efficient and equitable.  These are not unreasonable claims.  In the short-term, it is frequently cheaper to control a given amount of pollution by adopting some technology at a new plant than by retrofitting that same or some other technology at an older, existing plant.  Hence, VDRs appear to be cost-effective, at least in the short term.  But this short-term view ignores the perverse incentive structure that such a time-differentiated standard puts in place.  By driving up the cost of abatement with new vintages of plant or technology relative to older vintages, investments (in plants and/or technologies) are discouraged.

In terms of equity, it may indeed appear to be fair or equitable to avoid changing the rules for facilities that have already been built or products that have already been manufactured, and to focus instead only on new facilities and products.  But, on the other hand, the distinct “lack of a level playing field” – an essential feature of any VDR – hardly appears equitable from the perspective of those facing the more stringent component of an age-differentiated regulation.

An additional and considerably broader explanation for the prevalence of VDRs is fundamentally political.  Existing firms seek to erect entry barriers to restrict competition, and VDRs drive up the costs for firms to construct new facilities.  And environmentalists may support strict standards for new sources because they represent environmental progress, at least symbolically.  Most important, more stringent standards for new sources allow legislators to protect existing constituents and interests by placing the bulk of the pollution control burden on unbuilt factories.

Surely the most prominent example of VDRs in the environmental realm is New Source Review (NSR), a set of requirements under the Clean Air Act that date back  to  the  1970s.  The lawyers and engineers who wrote the law thought they could secure faster environmental progress by imposing tougher emissions standards on new power plants (and certain other emission sources) than on existing ones.  The theory was that emissions would fall as old plants were retired and replaced by new ones.  But experience over the past 25 years has shown that this approach has been both excessively costly and environmentally counterproductive.

The reason is that it has motivated companies to keep old (and dirty) plants operating, and to hold back investments in new (and cleaner) power generation technologies.  Not only has New Source Review deterred investment in newer, cleaner technologies; it has also discouraged companies from keeping power plants maintained.  Plant owners contemplating maintenance activities have had to weigh the possible loss of considerable regulatory advantage if the work crosses a murky line between upkeep and new investment.  Protracted legal wrangling has been inevitable over whether maintenance activities have crossed a threshold sufficient to justify forcing an old plant to meet new plant standards.  Such deferral of maintenance has compromised the reliability of electricity generation plants, and thereby increased the risk of outages.

Research has demonstrated that the New Source Review process has driven up costs  tremendously (not just for the electricity companies, but for their customers and shareholders, that is, for all of us) and has resulted in worse environmental quality than would have occurred if firms had not faced this disincentive to invest in new, cleaner technologies.  In an article that appeared in 2006 in the Stanford Environmental Law Journal, I summarized and sought to synthesize much of the existing, relevant economic research.

The solution is a level playing field, where all electricity generators would have the same environmental requirements, whether plants are old or new.  A sound and simple approach would be to cap total pollution, and use an emissions trading system to assure that any emissions increases at one plant are balanced by offsetting reductions at another.  No matter how emissions were initially allocated across plants, the owners of existing plants and those who wished to build new ones would then face the correct incentives with respect to retirement decisions, investment decisions, and decisions regarding the use of alternative fuels and technologies to reduce pollution.

In this way, statutory environmental targets can be met in a truly cost-effective manner, that is, without introducing perverse incentives that discourage investment, drive up costs in the long run, and have counter-productive effects on environmental protection.

It is not only possible, but eminently reasonable to be both a strong advocate for  environmental protection and an advocate for the elimination of vintage differentiated regulations, such as New Source Review.  That is where an economic perspective and the available evidence leads.

The Myths of Market Prices and Efficiency

In my two previous posts I described a pair of prevalent myths regarding how economists think about the environment: “the myth of the universal market” ­– the notion that economists believe that the market solves all problems; and “the myth of simple market solutions” — the notion that economists always recommend simple market solutions for social problems. In response to those two myths, I noted that in the environmental domain, perfectly functioning markets are the exception, not the rule; and that no particular form of government intervention is appropriate for all environmental problems.

A third myth is that when non-market solutions are considered, economists use only market prices to evaluate them. No matter what policy instrument is chosen, the environmental goal must be identified. Should vehicle emissions be reduced by 10, 20, or 50 percent? Economists frequently try to identify the most efficient degree of control — that which provides the greatest net benefits. This means that both benefits and costs need to be evaluated. True enough, economists typically favor using market prices whenever possible to carry out such evaluations, because these prices reveal how people actually value scarce amenities and resources. Economists are wary of asking people how much they value something, because respondents may not provide honest assessments of their own valuations. Instead, economists prefer to “watch what they do, not what they say,” as when individuals reveal their preferences by paying more for a house in a neighborhood with cleaner air, all else equal.

But economists are not concerned only with the financial value of things. Far from it. The financial flows that make up the gross national product represent only a fraction of all economic flows. The scope of economics encompasses the allocation and use of all scarce resources. For example, the economic value of the human-health damages of environmental pollution is greater than the sum of health-care costs and lost wages (or lost productivity), as it includes what lawyers call “pain and suffering.” Economists might use a market price indirectly to measure revealed rather than stated preferences, but the goal is to measure the total value of the loss that individuals incur.

For another example, the economic value of some parcel of the Amazon rain forest is not limited to its financial value as a repository of future pharmaceutical products or as a location for ecotourism. Such “use value” may only be a small part of the properly defined economic valuation. For decades, economists have recognized the importance of “non-use value” of environmental amenities such as wilderness areas or endangered species. The public nature of these goods makes it particularly difficult to quantify the values empirically, as we cannot use market prices. Benefit-cost analysis of environmental policies, almost by definition, cannot rely exclusively on market prices.

Economists try to convert all of these disparate values into monetary terms because a common unit of measure is needed in order to add them up. How else can we combine the benefits of ten extra miles of visibility plus some amount of reduced morbidity, and then compare these total benefits with the total cost of installing scrubbers to clean stack gases at coal-fired power plants? Money, after all, is simply a medium of exchange, a convenient way to compare disparate goods and services. The dollar in a benefit-cost analysis is nothing more than a yardstick for measurement and comparison.

A fourth and final myth is that economic analyses are concerned only with efficiency rather than distribution. Many economists do give more attention to aggregate social welfare than to the distribution of the benefits and costs of policies among members of society. The reason is that an improvement in economic efficiency can be determined by a simple and unambiguous criterion C an increase in total net benefits. What constitutes an improvement in distributional equity, on the other hand, is inevitably the subject of much dispute. Nevertheless, many economists do analyze distributional issues thoroughly. Although benefit-cost analyses often emphasize the overall relation between benefits and costs, many analyses also identify important distributional consequences. Indeed, within the realm of global climate change policy, much of the economic analysis is dedicated to assessing the distributional implications of alternative policy measures.

So where does this leave us? First, economists do not believe that the market solves all problems. Indeed, many economists make a living out of analyzing Amarket failures@ such as environmental pollution in which laissez faire policy leads not to social efficiency, but to inefficiency. Second, when economists identify market problems, their tendency is to consider the feasibility of market solutions because of their potential cost-effectiveness, but market-based approaches to environmental protection are no panacea. Third, when market or non-market solutions to environmental problems are assessed, economists do not limit their analysis to financial considerations, but use monetary equivalents in benefit-cost calculations in the absence of a more convenient unit. Fourth and finally, although the efficiency criterion is by definition aggregate in nature, economic analysis can reveal much about the distribution of the benefits and the costs of environmental policies.

Having identified and sought to dispel four prevalent myths about how economists think about the natural environment, I want to acknowledge that my profession bears some responsibility for the existence of such misunderstandings about economics. Like our colleagues in the other social and natural sciences, academic economists focus their greatest energies on communicating to their peers within their own discipline. Greater effort can certainly be given by economists to improving communication across disciplinary boundaries. And that is one of my key goals in this blog in the weeks and months ahead.