Tag Archives: economic valuation

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.

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.

Unintended Consequences of Government Policies: The Depletion of America’s Wetlands

Private land-use decisions can be affected dramatically by public investments in highways, waterways, flood control, or other infrastructure.  The large movement of jobs from central cities to suburbs in the postwar United States and the ongoing destruction of Amazon rain forests have occurred with major public investment in supporting infrastructure.  As these examples suggest, private land-use decisions can generate major environmental and social externalities – or, in common language, unintended consequences.

In an analysis that appeared in 1990 in the American Economic Review, Adam Jaffe of Brandeis University and I demonstrated that the depletion of forested wetlands in the Mississippi Valley – an important environmental problem and a North American precursor to the loss of South American rain forests – was exacerbated by Federal water-project investments, despite explicit Federal policy to protect wetlands.

Wetland Losses

Forested wetlands are among the world’s most productive ecosystems, providing improved water quality, erosion control, floodwater storage, timber, wildlife habitat, and recreational opportunities.  Their depletion globally is a serious problem; and preservation and protection of wetlands have been major Federal environmental policy goals for forty years.

From the 1950s through the mid-1970s, over one-half million acres of U.S. wetlands were lost each year.  This rate slowed greatly in subsequent years, averaging approximately 60 thousand acres lost per year in the lower 48 states from 1986 through 1997.  And by 2006, the Bush administration’s Secretary of the Interior, Gale Norton, was able to announce a net gain in wetland acreage in the United Sates, due to restoration and creation activities surpassing wetland losses.

What Caused the Observed Losses?

What were the causes of the huge annual losses of wetlands in the earlier years?  That question and our analysis are as germane today as in 1990, because of lessons that have emerged about the unintended consequences of public investments.

The largest remaining wetland habitat in the continental United States is the bottomland hardwood forest of the Lower Mississippi Alluvial Plain.  Originally covering 26 million acres in seven states, this resource was reduced to about 12 million acres by 1937.  By 1990, another 7 million acres had been cleared, primarily for conversion to cropland.

The owner of a wetland parcel faces an economic decision involving revenues from the parcel in its natural state (primarily from timber), costs of conversion (the cost of clearing the land minus the resulting forestry windfall), and expected revenues from agriculture.  Agricultural revenues depend on prices, yields, and, significantly, the drainage and flooding frequency of the land.  Needless to say, landowners typically do not consider the positive environmental externalities generated by wetlands; thus conversion may occur more often than is socially optimal.

Such externalities are the motivation for Federal policy aimed at protecting wetlands, as embodied in the Clean Water Act.  Nevertheless, the Federal government engaged in major public investment activities, in the form of U.S. Army Corps of Engineers and U.S. Soil Conservation Service flood-control and drainage projects, which appeared to make agriculture more attractive and thereby encourage wetland depletion.  The significance of this effect had long been disputed by the agencies which construct and maintain these projects; they attributed the extensive conversion exclusively to rising agricultural prices.

In an econometric (statistical) analysis of data from Arkansas, Mississippi, and Louisiana, from 1935 to 1984, Jaffe and I sought to sort out the effects of Federal projects and other economic forces.  We discovered that these public investments were a very substantial factor causing conversion of wetlands to agriculture, with between 30 and 50 percent of the total wetland depletion over those five decades due to the Federal projects.

More broadly, four conclusions emerged from our analysis.  First, landowners had responded to economic incentives in their land-use decisions.  Second, construction of Federal flood-control and drainage projects caused a higher rate of conversion of forested wetlands to croplands than would have occurred in the absence of projects, leading to the depletion of an additional 1.25 million acres of wetlands.  Third, Federal projects had this impact because they made agriculture feasible on land where it had previously been infeasible, and because, on average, they improved the quality of feasible land.  Fourth, adjustment of land use to economic conditions was gradual.

Government Working at Cross-Purposes

The analysis highlighted a striking inconsistency in the Federal government’s approach to wetlands.  In articulated policies, laws, and regulations, the government recognized the positive externalities associated with some wetlands, with the George H.W. Bush administration first enunciating a “no net loss of wetlands” policy.  But public investments in wetlands – in the form of flood-control and drainage projects – had created major incentives to convert these areas to alternative uses.  The government had been working at cross-purposes.

The conclusion that major public infrastructure investments affect private land-use decisions (thereby often generating negative externalities) may not be a surprise to some readers, but it was the 1990 analysis described here that first provided rigorous evidence which contrasted sharply with the accepted wisdom among policy makers.

The Ongoing Importance of Induced Land-Use Changes

As wetlands, tropical rain forests, barrier islands, and other sensitive environmental areas become more scarce, their marginal social value rises.  In general, if induced land-use changes are not considered, the country will engage in more public investment programs whose net social benefits are negative.

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).

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.

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.