Cap-and-Trade: A Fly in the Ointment? Not Really

For more than two decades, environmental law and regulation was dominated by command-and-control approaches — typically either mandated pollution control technologies or inflexible discharge standards on a smokestack-by-smokestack basis.  But in the 1980s, policy makers increasingly explored market-based environmental policy instruments, mechanisms that provide economic incentives for firms and individuals to carry out cost-effective pollution control.  Cap-and-trade systems, in which emission permits or allowances can be traded among potential polluters, continue today to be at the center of this action.

Most recently, this has been in the context of deliberations regarding possible U.S. actions to reduced carbon dioxide and other greenhouse gas emissions linked with global climate change, as in HR 2454, the Waxman-Markey bill approved by the U.S. House of Representatives, as well as in proposals developing in the Senate.  (I have written a number of blog posts on this topic.  If you’re interested, please see:  “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade:  A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness?  Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy:  A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009).  For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

But the transition from command-and-control regulation to market-based policy instruments has not always been easy.  Sometimes policy can outrun basic understanding, and the claims made for the cost-effectiveness of cap-and-trade systems can exceed what can be reasonably anticipated.  Among the factors that can adversely affect the performance of such systems are transaction costs.

In general, transaction costs — those costs that arise from the exchange, not the production, of goods and services — are ubiquitous in market economies.  They can arise from any exchange:  after all, parties to transactions must find one another, communicate, and exchange information.  It may be necessary to inspect and sometimes even measure goods to be transferred, draw up contracts, consult with lawyers or other experts, and transfer title.

In cap-and-trade markets, there are three potential sources of transaction costs. The first source, searching and information-collection, arises because it can take time for a potential buyer of a discharge permit to find a seller, though — for a fee — brokers can facilitate the process.  Although less obvious, a second source of transaction costs — bargaining and deciding — is potentially as important.  A firm entering into negotiations incurs real resource costs, including time and/or fees for brokerage, legal, and insurance services.  Likewise, the third source — monitoring and enforcing — can be significant, although these costs are typically borne by the responsible governmental authority and not by trading partners.

The cost savings that may be realized through cap-and-trade systems depend upon active trading.  But transaction costs are an impediment to trading, and such impediments thereby can limit savings.  So, transaction costs reduce the overall economic benefits of allowance trading, partly by absorbing resources directly and partly by suppressing exchanges that otherwise would have been mutually (indeed socially) beneficial.  But when transaction costs can be kept to a minimum, high levels of trading — and significant cost savings – are the result.

Since David Montgomery’s path-breaking work in 1972, economists have asserted that the post-trading allocation of control responsibility among sources and hence the aggregate costs of control are independent from the initial permit allocation.  This is an extremely important political property, but does this still hold in the presence of transaction costs?  This is a question I investigated in an article titled, “Transaction Costs and Tradable Permits,” which was published in the Journal of Environmental Economics and Management in 1995 (and which the publisher lists as one of the ten most cited articles in the journal’s history, going back to 1974).

The answer to this question is: “it depends.”  If incremental transaction costs are independent of the size of individual transactions, the initial allocation of permits has no effect on the post-trading allocation of control responsibility and aggregate control costs.  But if incremental transaction costs decrease with the size of individual trades, then the initial allocation will affect the post-trading outcome.

This is of great political importance, because it means that in the presence of transaction costs, the initial distribution of permits can matter not only in terms of distributional equity, but in terms of cost-effectiveness or efficiency.  This can reduce the discretion of the Congress (or other legislature or agency) to distribute allowances as they please (in order to generate a constituency of support for the program), and may thereby reduce the political attractiveness and feasibility of a cap-and-trade system.

Empirical evidence, however, indicates that transaction costs have been minimal, indeed trivial, in enacted and implemented cap-and-trade systems, including the U.S. EPA’s leaded-gasoline phasedown in the 1980s, and the well-known SO2 allowance trading system, enacted as part of the Clean Air Act amendments of 1990.

That’s good news, surely.  But nevertheless, going forward, choices between conventional, command-and-control environmental policies and market-based instruments should reflect the imperfect world in which these instruments are applied.  Such choices are not simple, because no policy panacea exists.

On the one hand, even if transaction costs prevent significant levels of trade from occurring, aggregate costs of control will most likely be less than those of a conventional command-and-control approach.  A trading system with no trading taking place will likely be less costly than a technology standard (because the trading system provides flexibility to firms regarding their chosen means of control) and no more costly than a uniform performance standard.

But the existence of transaction costs may make the choice between conventional approaches and cap-and-trade more difficult because of the ambiguities that are introduced.  With transaction costs — as with other departures from frictionless markets — greater attention is required to the details of designing specific systems.  This is the way to lessen the risk of over-selling such policy ideas and ultimately creating systems that stand the best chance of being implemented successfully.

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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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