Policies Can Work in Strange Ways

Whether the policy domain is global climate change or local hazardous waste, it’s exceptionally important to understand the interaction between public policies and technological change in order to assess the effects of laws and regulations on environmental performance.  Several years ago, my colleagues ­- Professor Lori Bennear of Duke University and Professor Nolan Miller of the University of Illinois – examined with me the effects of regulation on technological change in chlorine manufacturing by focusing on the diffusion of membrane-cell technology, widely viewed as environmentally superior to both mercury-cell and diaphragm-cell technologies.  Our results were both interesting and surprising, and merit thinking about in the context of current policy discussions and debates in Washington.

The chlorine manufacturing industry had experienced a substantial shift over time toward the membrane technology. Two different processes drove this shift:  adoption of cleaner technologies at existing plants (that is, adoption), and the closing of facilities using diaphragm and mercury cells (in other words, exit).  In our study, we considered the effects of both direct regulation of chlorine manufacturing and regulation of downstream uses of chlorine.    (By the way, you can read a more detailed version of this story in our article in the American Economic Review Papers and Proceedings, volume 93, 2003, pp. 431-435.)

In 1972, a widely publicized incident of mercury poisoning in Minamata Bay, Japan, led the Japanese government to prohibit the use of mercury cells for chlorine production. The United States did not follow suit, but it did impose more stringent constraints on mercury-cell units during the early 1970’s. Subsequently, chlorine manufacturing became subject to increased regulation under the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, and the Comprehensive Environmental Response, Compensation, and Liability Act.  In addition, chlorine manufacturing became subject to public-disclosure requirements under the Toxics Release Inventory.

In addition to regulation of the chlorine manufacturing process, there was also increased environmental pressure on industries that used chlorine as an input. This indirect regulation was potentially important for choices of chlorine manufacturing technology because a large share of chlorine was and is manufactured for onsite use in the production of other products. Changes in regulations in downstream industries can have substantial impacts on the demand for chlorine and thereby affect the rate of entry and exit of chlorine production plants.

Two major indirect regulations altered the demand for chlorine. One was the Montreal Protocol, which regulated the production of ozone-depleting chemicals, such as chlorofluorocarbons (CFCs), for which chlorine is a key ingredient. The other important indirect regulation was the “Cluster Rule,” which tightened restrictions on the release of chlorinated compounds from pulp and paper mills to both water and air. This led to increased interest by the industry in non-chlorine bleaching agents, which in turn affected the economic viability of some chlorine plants.

In our econometric (statistical) analysis, we analyzed the effects of economic and regulatory factors on adoption and exit decisions by chlorine manufacturing plants from 1976 to 2001.  For our analysis of adoption, we employed data on 51 facilities, eight of which had adopted the membrane technology during the period we investigated.

We found that the effects of the regulations on the likelihood of adopting membrane technology were not statistically significant.  Mercury plants, which were subject to stringent regulation for water, air, and hazardous-waste removal, were no more likely to switch to the membrane technology than diaphragm plants. Similarly, TRI reporting appeared to have had no significant effect on adoption decisions.

We also examined what caused plants to exit the industry, with data on 55 facilities, 21 of which ceased operations between 1976 and 2001. Some interesting and quite striking patterns emerged. Regulations clearly explained some of the exit behavior.  In particular, indirect regulations of the end-uses of chlorine accelerated shutdowns in some industries. Facilities affected by the pulp and paper cluster rule and the Montreal Protocol were substantially more likely to shut down than were other facilities.

It is good to remember that the diffusion of new technology is the result of a combination of adoption at existing facilities and entry and exit of facilities with various technologies in place. In the case of chlorine manufacturing, our results indicated that regulatory factors did not have a significant effect on the decision to adopt the greener technology at existing plants. On the other hand, indirect regulation of the end-uses of chlorine accelerated facility closures significantly, and thereby increased the share of plants using the cleaner, membrane technology for chlorine production.

Environmental regulation did affect technological change, but not in the way many people assume it does. It did so not by encouraging the adoption of some technology by existing facilities, but by reducing the demand for a product and hence encouraging the shutdown of facilities using environmentally inferior options.  This is a legitimate way for policies to operate, although it’s one most politicians would probably prefer not to recognize.

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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).

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Straight Talk about Corporate Social Responsibility

Critical thinking about “corporate social responsibility” (CSR) is needed, because there are few topics where discussions feature greater ratios of heat to light.  With this in mind, two of my Harvard colleagues – law professor Bruce Hay and business school professor Richard Vietor – and I co-edited a book, Environmental Protection and the Social Responsibility of Firms: Perspectives from Law, Economics, and Business.

At issue is the appropriate role of business with regard to environmental protection.  Everyone agrees that firms should obey the law. But beyond the law – beyond compliance with regulations – do firms have additional responsibilities to commit resources to environmental protection?  How should we think about the notion of firms sacrificing profits in the social interest?

Much of what has been written on this question has been both confused and confusing.  Advocates, as well as academics, have entangled what ought to be four distinct questions about corporate social responsibility:  may they, can they, should they, and do they.

First, may firms sacrifice profits in the social interest – given their fiduciary responsibilities to shareholders?  Does management have a fiduciary duty to maximize corporate profits in the interest of shareholders, or can it sacrifice profits by voluntarily exceeding the requirements of environmental law?  Einer Elhauge, a professor at Harvard Law School, challenges the conventional wisdom that managers have a simple legal duty to maximize corporate profits.  He argues that managers have freedom to diverge from the goal of profit maximization, partly because their legal duties to shareholders are governed by the “business judgment rule,” which gives them broad discretion to use corporate resources as they see fit.

If a company’s managers decide, for example, to use “green” inputs, devise cleaner production technologies, or dispose of their waste more safely, courts will not stop them from doing so, no matter how disgruntled shareholders may be at such acts of public charity.  The reason is that for all a judge knows, such measures – particularly when they are well publicized – will add to the firm’s bottom line in the long run by increasing public goodwill.  But this line of argument contradicts the very premise, since it is based upon the notion that the actions are not sacrificing profits, but contributing to them.

This leads directly to the second question.  Can firms sacrifice profits in the social interest on a sustainable basis, or will the forces of a competitive market render such efforts transient at best?  Paul Portney, Dean of the Eller College of Management at the University of Arizona, notes that for firms that enjoy monopoly positions or produce products for well-defined niche markets, such extra costs can well be passed on to customers.  But for the majority of firms in competitive industries – particularly firms that produce commodities – it is difficult or impossible to pass on such voluntarily incurred costs to customers.  Such firms have to absorb those extra costs in the form of reduced profits, reduced shareholder dividends, and/or reduced compensation, suggesting that, in the face of competition, such behavior is not sustainable.

This leads to the third question of CSR:  even if firms may carry out such profit-sacrificing activities, and can do so, should they – from society’s perspective?  Is this likely to lead to an efficient use of social resources?  To be more specific, under what conditions are firms’ CSR activities likely to be welfare-enhancing?  Portney finds that this is most likely to be the case if firms pursuing CSR strategies are doing so because it is good business – that is, profitable.  Once again, a positive response violates the premise of the question.  But for more costly CSR investments, concern exists about the opportunity costs that will be involved for firms. Further, in the case of companies that behave strategically with CSR to anticipate and shape future regulations, welfare may be reduced if the result is less stringent standards (that would have been justified).

Finally, do firms behave this way?  Do some firms reduce their earnings by voluntarily engaging in environmental stewardship?  Forest Reinhardt of the Harvard Business School addresses this question by surveying the performance of a broad cross-section of firms, and finds that only rarely does it pay to be green.  That said, situations do exist in which it does pay. Where one can increase customers’ willingness to pay, reduce one’s costs, manage future risk, or anticipate and defer costly governmental regulation, then it may pay to be green.  Overall, Reinhardt acknowledges the existence of these opportunities for some firms – examples such as Patagonia and DuPont stand out – but the empirical evidence does not support broad claims of pervasive opportunities.

So, where does this leave us?  May firms engage in CSR, beyond the law? An affirmative though conditional answer seems appropriate.  Can firms do so on a sustainable basis?  Outside of monopolies and limited niche markets, the answer is probably negative.  Should they carry out such beyond-compliance efforts, even when doing so is not profitable?  Here – if the alternative is sound and effective government policy – the answer may not be encouraging.  And the last question – do firms generally carry out such activities – seems to lead to a negative assessment, at least if we restrict our attention to real cases of “sacrificing profits in the social interest.”

But definitive answers to these questions await the results of rigorous, empirical research.  In the meantime, we ought to prevent muddled thinking by keeping separate these four questions of corporation social responsibility.

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