Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal

The potential impacts of proposed U.S. climate policies on the competitiveness of U.S. industries is a major political issue, and it was one of the key issues in the Energy and Commerce Committee of the House of Representatives in the design of Henry Waxman and Edward Markey’s H.R. 2454 (the American Clean Energy and Security Act of 2009). In the floor debate that will soon take place as the full House considers the bill, it will be an important issue. It promises to be an equally important topic when the Senate takes up its own climate legislation, although the debate in that body on this issue will likely be quite different.

The ultimate answer to the question of how best to address concerns about international competitiveness is to bring all countries – both the industrialized nations and the developing world’s large, rapidly-growing economies (China, India, Brazil, Korea, Mexico, South Africa, and Indonesia) – into a meaningful (post-Kyoto) international climate change agreement (a topic on which I’ve spent much time over the past several years).  But – for the most part — that long-term objective is outside of the reach of the domestic policy of any single nation, even the United States.

Can Domestic Climate Policy Address Competitiveness Concerns?

A range of approaches has been considered for implementing sound, domestic climate policy while seeking to “level the economic playing field” with other countries. While no approach is without its flaws (as I describe below), the approach taken in the Waxman-Markey legislation is sensible and pragmatic:  in the short term, output-based updating allocations of allowances are employed for a few energy-intensive, trade-sensitive sectors; and in the long term, the President is given the option to put in place (under specific, stringent conditions) import-allowance-requirements in selected cases.

In order to explain my reasoning for coming to this conclusion, let’s back up for a moment and reflect on the reasons for the high level of political attention and receptiveness in the United States toward employing a cap-and-trade system nationally to address emissions of greenhouse gases.

It is because of the significant economic and political advantages of cap-and-trade systems to address carbon dioxide and other greenhouse gas emissions that most (but not all) attention by policy makers has been focused on this policy approach. First, it provides a cost-effective means of achieving meaningful reductions in emissions over relevant time horizons. Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by virtually any climate policy. Third, it is less likely than alternative approaches (such as a carbon tax) to be degraded – in terms of environmental performance and cost-effectiveness – by political forces. Fourth, it has a history of successful adoption and implementation over two decades. And fifth, it provides a straightforward means to link and harmonize with other countries’ climate policies.

The Waxman-Markey bill, H.R. 2454, would establish such a U.S. cap-and-trade system to reduce emissions that contribute to global climate change. The bill would put a declining cap on emissions and create a corresponding number of emission permits. Regulated firms could trade these permits at a price determined by the market – creating powerful incentives to reduce emissions cost-effectively.

But imposing a price (cost) on carbon in the United States at a time when some other countries (in the developing world) are not taking comparable actions raises concerns about negative impacts on the competitiveness of U.S. industry, particularly in energy-intensive, trade-sensitive sectors. This heightens worries about possible job losses, a particularly troubling concern when the United States find itself in the worst global recession in a generation.

The environmental side of the same coin is “carbon leakage.” Again, imposing a cost on the production of carbon-intensive goods and services shifts comparative advantage in the production of those same goods and services in the direction of countries not taking on such costs.  Also, reduced demand in the United States for carbon-intensive fuels such as coal can be expected to reduce worldwide demand enough that the world price of coal would fall, thereby making it more attractive for use in countries that are not participating in a meaningful international climate agreement (or otherwise taking significant domestic climate actions).

Both routes can result in a shift of carbon-intensive production to countries without climate controls, and therefore an increase in their CO2 emissions. This is carbon leakage, which reduces the environmental benefits of mitigating emissions and reduces cost-effectiveness of any actions (properly measured in terms of net changes in CO2 atmospheric concentrations).  Given that the United States, the European Union, and Japan are net importers of embodied CO2, while China and India are net exporters, the environmental – as well as the economic – impacts of carbon leakage are a natural concern of lawmakers.

Despite the high levels of attention that international competitiveness therefore receives in debates about domestic climate policies, economic research has consistently found that the actual competitiveness impacts of proposed domestic climate policies would not — in quantitative terms — constitute a major economy-wide economic issue for the United States, partly because differences in other costs of production (including labor and energy costs, without accounting for carbon constraints) across countries swamp differences in costs due to environmental policies, including prospective climate policies.

On the other hand, this is a real issue for some specific sectors, in particular, energy-intensive industries subject to international competition, such as aluminum, cement, fossil fuels, glass, iron and steel, and paper. More importantly, it is in any event a major (economy-wide) political issue.  So, it needs to be addressed in any domestic climate policy which is to be both meaningful and politically pragmatic.

How About Free Allowance Allocations?

The approach frequently proposed by policy makers and the approach utilized in the European Union for its Emission Trading Scheme, and discussed in a number of other countries for their planned cap-and-trade programs is generous and free allocation of allowances to specific sectors and companies.  This makes the receiving companies happy, but has no effect on their international competitiveness. This is because such a free grant of allowances is no different than cash, that is, a fixed subsidy. The allowances can be sold by the receiving companies, are as good as cash, and represent a lump-sum transfer from the government, not tied to carbon abatement efforts or production (and hence, in the language of economics, are infra-marginal subsidies rather than marginal incentives).

Since the subsidy has no effect on the company’s marginal cost of production (its supply function), it has no effect on international competitiveness. The company will continue to find it as challenging as it did without the subsidy to produce cement, steel, or whatever at a price that can compete with companies located in countries without climate policies (apart from liquidity effects, which are minor in most cases). And the domestic company will have the same incentives as previously to locate its next production facility in a country without a climate policy.

A Potentially Effective Approach:  Output-Based Updating Allocations

With proper design, allowance allocations can be used effectively to address leakage and competitiveness.  If the free allocation of allowances is tied to the company’s production level, then it does affect marginal production costs, and therefore does affect competitiveness. Such a “home rebate” can thereby reduce leakage. This is, in fact, the approach taken in the Waxman-Markey legislation, and it is a potentially effective means to address concerns about international competitiveness for a select set of energy-intensive trade-sensitive sectors.

There are, however, some legitimate concerns about this approach of linking annual allowance allocations with production levels, as I wrote in my previous post, “The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey.” Such output-based updating allocations can provide perverse incentives and thereby drive up the costs of achieving a cap. This is because an output-based updating allocation is essentially a production subsidy. This distorts firms’ pricing and production decisions in ways that can increase the cost of meeting an emissions target.

Think of it this way. On the one hand, the cap-and-trade system is (sensibly) increasing the cost of using carbon-intensive fuels and emitting CO2 into the atmosphere. An aluminum producer, for example, is therefore paying more for the (fossil-fuel generated) electricity it uses, driving up its cost of production. At the same time, the government hands a subsidy to the company for each unit of aluminum it produces, working at cross-purposes with the energy-pricing incentive, and thereby driving up the aggregate social costs of achieving the cap. In addition, these home rebates do not distinguish between competition from countries with and without domestic climate policies.

The Key Question

So, there are problems with output-based updating allocations, but the key question in the real world of legislative design is whether better approaches are available?  The answer – in my view – is that there are several other available approaches, but they are not any better; and indeed, they appear to be significantly worse.

An Alternative Approach:  Import Allowance Requirements

One alternative approach is an import allowance requirement, whereby imports of highly carbon-intensive goods (in terms of their manufacture) must hold allowances for the U.S. cap-and-trade system, mirroring requirements on U.S. sources, if those imports come from countries which have not taken comparable climate policy actions. Note that this approach – which is referred to as a border adjustment, and is an implicit border tax – differentiates according to the country of origin.  In principle, this approach can maintain a level playing-field between imports and domestic production, reduce leakage, and possibly help induce key developing countries to take domestic action to avoid the implicit border tax on their products.

The import allowance requirement approach has its own problems, however. First, it focuses exclusively on imports into the United States, and has no effect on the competitiveness of U.S. exports. Second, it may not be compliant with World Trade Organization (WTO) rules, because it would discriminate among trading nations (I’ll leave that issue for trade economists and trade lawyers to analyze and debate).

Third, it is questionable whether it would be effective as an inducement for developing countries to join an international agreement to reduce emissions. Why is that? Think about China, for example. China is the largest producer of cement in the world, accounting for almost 50% of world output. It is also the world’s largest exporter of cement. This may sound as though the threat of import allowance requirements in the U.S. and European cap-and-trade systems would be a powerful incentive for China to undertake emission reductions at home in order to avoid the border tax on its cement exports.  But China consumes 97% of its cement domestically, exporting only 3%, and much of that to developing countries. So, would a country such as China be willing to increase the costs of producing 97% of its output in order to protect a market for 1% or 2% of its production?(To be fair, for small developing countries for which their exports of a given product are a large share of their total output, the message could potentially be quite different.)

Despite these three problems with the import-allowance-requirement approach, note that it was a key part of the Lieberman-Warner Climate Security Act in the U.S. Senate in 2008, and may re-appear when serious debate commences in the Senate on climate legislation later this year. Also, it should be noted that this approach of import-allowance-requirements is included as a long-term backstop in Waxman-Markey if the President determines by 2022 that the output-based allocation mechanism is insufficient for some of the energy-intensive trade-sensitive sectors (and if a number of stringent conditions are met; see the “International Reserve Allowance Program” in the bill).

Other Possible Approaches

Another potential approach is a border rebate for exports to level the playing field abroad, whereby the government rebates the value of emissions embodied in exports. Imports, however, would retain their competitive advantage at home, and there are problems with WTO compliance. Finally, there is full boarder adjustment, meaning a border (import) tax plus a border (export) subsidy. Here there are questions not only about consistency with international trade law, but also concerns about feasibility. In some cases, there are tremendous challenges of calculating the embodied emissions of foreign products, and more generally, there are difficulties of defining and enforcing reliable rules of origin.

The Good, the Bad, and the Ugly

Thus, none of these approaches are ideal, not home rebates as in Waxman-Markey, nor implicit border taxes on exports as in Lieberman-Warner, nor border rebates, nor full border adjustments.  As I said at the outset, the only real solution to the international competitiveness issue in the long term is to bring non-participating countries within an international climate regime in meaningful ways. (On this, please see the work of the Harvard Project on International Climate Agreements.) But that solution is fundamentally outside of the scope of the domestic policy action of any individual nation, including the United States.

So, among the feasible set of options to address international competitiveness concerns – if only imperfectly and at some cost – which is best? The two live political options appear to be the output-based updating allocation mechanism in the Waxman-Markey legislation and the import allowance requirement, typically associated with the former Lieberman-Warner bill. At this time, meaning in the short term, I would be more worried about the potential damage to the international trade regime that import allowance requirements could foster than about the incremental social costs that an output-based updating allocation mechanism will create.

This is a political problem without a perfect solution (other than bringing all key countries into a meaningful international climate agreement).  For now, the domestic political process has done a credible job of patching together a set of interim solutions. Among the range of possible approaches of trying to level the international economic playing field, none is without its flaws, but the approach taken in the Waxman-Markey legislation appears best.  Subject to possible improvements on the House floor or in the Senate, the Waxman-Markey approach of combining output-based updating allocations in the short term for select sectors with the option in the long term of a Presidential determination (under stringent conditions) for import allowance requirements for specific countries and sectors seems both sensible and pragmatic.

A Broader Question:  Should the U.S. Enact a Domestic Climate Policy without a New, Sound International Climate Agreement in Place?

Stepping back from the specific policy design question, the broader argument has been made (indeed until a few years ago I was among those making it) that there should be no serious movement on a U.S. domestic climate policy until a meaningful and sensible (post-Kyoto) international agreement has been negotiated and ratified.  It is natural for questions to be raised about the very notion of the U.S. adopting a policy to help address a global problem. The environmental benefits of any single nation’s reductions in greenhouse gas emissions are spread worldwide, unlike the costs. This creates the possibility that some countries will want to “free ride” on the efforts of others. It’s for this very reason that international cooperation is required.

That is the why the U.S. is now vigorously engaged in international negotiations, and the credibility of the U.S. as a participant, let alone as a leader, in shaping the international regime is dependent upon our demonstrated willingness to take actions at home. Europe has already put its climate policy in place, and Australia, New Zealand, and Japan are moving to have their policies in place within a year. If the United States is to play a leadership role in international negotiations for a sensible post-Kyoto international climate regime, the country must begin to move towards an effective domestic policy – with legislation that is timed and structured to coordinate with the emerging post-Kyoto climate regime.

Without evidence of serious action by the U.S., there will be no meaningful international agreement, and certainly not one that includes the key, rapidly-growing developing countries.  U.S. policy developments can and should move in parallel with international negotiations.

The Bottom Line

So, like any legislation, the Waxman-Markey bill has its share of flaws. But it represents a solid foundation for a domestic climate policy that can help place the United States where it ought to be – in a position of international leadership to develop a global climate agreement that is scientifically sound, economically rational, and politically acceptable to the key nations of the world.

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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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The Myth of the Universal Market

Communication among economists, other social scientists, natural scientists, and lawyers is far from perfect. When the topic is the environment, discourse across disciplines is both important and difficult. Economists themselves have likely contributed to some misunderstandings about how they think about the environment, perhaps through enthusiasm for market solutions, perhaps by neglecting to make explicit all of the necessary qualifications, and perhaps simply by the use of technical jargon.

So it shouldn’t come as a surprise that there are several prevalent and very striking myths about how economists think about the environment. Because of this, my colleague Don Fullerton, a professor of economics at the University of Illinois, and I posed the following question in an article in Nature:  how do economists really think about the environment? In this and several succeeding postings, I’m going to answer this question, by examining — in turn — several of the most prevalent myths.

One myth is that economists believe that the market solves all problems. Indeed, the “first theorem of welfare economics” states that private markets are perfectly efficient on their own, with no interference from government, so long as certain conditions are met. This theorem, easily proven, is exceptionally powerful, because it means that no one needs to tell producers of goods and services what to sell to which consumers. Instead, self-interested producers and self-interested consumers meet in the market place, engage in trade, and thereby achieve the greatest good for the greatest number, as if “guided by an invisible hand,” as Adam Smith wrote in 1776 in The Wealth of Nations. This notion of maximum general welfare is what economists mean by the “efficiency” of competitive markets.

Economists in business schools may be particularly fond of identifying markets where the necessary conditions are met, where many buyers and many sellers operate with very good information and very low transactions costs to trade well-defined commodities with enforced rights of ownership. These economists regularly produce studies demonstrating the efficiency of such markets (although even in this sphere, problems can obviously arise).

For other economists, especially those in public policy schools, the whole point of the first welfare theorem is very different. By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not. Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

Those conditions are obviously very restrictive, and they are usually not all satisfied simultaneously. When a market thus “fails,” this same theorem offers us guidance on how to “round up the usual suspects.” For any particular market, the interesting questions are whether the number of sellers is sufficiently small to warrant antitrust action, whether the returns to scale are great enough to justify tolerating a single producer in a regulated market, or whether the benefits from the good are “public” in a way that might justify outright government provision of it. A public good, like the light from a light house, is one that can benefit additional users at no cost to society, or that benefits those who “free ride” without paying for it.

Environmental economists, of course, are interested in pollution and other externalities, where some consequences of producing or consuming a good or service are external to the market, that is, not considered by producers or consumers. With a negative externality, such as environmental pollution, the total social cost of production may thus exceed the value to consumers. If the market is left to itself, too many pollution-generating products get produced. There’s too much pollution, and not enough clean air, for example, to provide maximum general welfare. In this case, laissez-faire markets — because of the market failure, the externalities — are not efficient.

Similarly, natural resource economists are particularly interested in common property, or open-access resources, where anyone can extract or harvest the resource freely. In this case, no one recognizes the full cost of using the resource; extractors consider only their own direct and immediate costs, not the costs to others of increased scarcity (called “user cost” or “scarcity rent” by economists). The result, of course, is that the resource is depleted too quickly. These markets are also inefficient.

So, the market by itself demonstrably does not solve all problems. Indeed, in the environmental domain, perfectly functioning markets are the exception, rather than the rule. Governments can try to correct these market failures, for example by restricting pollutant emissions or limiting access to open-access resources. Such government interventions will not necessarily make the world better off; that is, not all public policies will pass an efficiency test. But if undertaken wisely, government interventions can improve welfare, that is, lead to greater efficiency. I will turn to such interventions in a subsequent posting.

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