regulation Archives - Page 20 of 20 - An Economic View of the Environment

The Making of a Conventional Wisdom

Despite the potential cost-effectiveness of market-based policy instruments, such as pollution taxes and tradable permits, conventional approaches – including design and uniform performance standards – have been the mainstay of U.S. environmental policy since before the first Earth Day in 1970. Gradually, however, the political process has become more receptive to innovative, market-based strategies. In the 1980s, tradable-permit systems were used to accomplish the phasedown of lead in gasoline (at a savings of about $250 million per year), and to facilitate the phaseout of ozone-depleting chloroflourocarbons (CFCs); and in the 1990’s, tradable permits were used to implement stricter air pollution controls in the Los Angeles metropolitan region, and – most important of all – a cap-and-trade system was adopted to reduce sulfur dioxide (SO₂) emissions and consequent acid rain by 50 percent under the Clean Air Act amendments of 1990 (saving about $1 billion per year in abatement costs). Most recently, cap-and-trade systems have emerged as the preferred national and regional policy instrument to address carbon dioxide (CO₂) emissions linked with global climate change (see my previous posts of February 6^th on an “Opportunity for a Defining Moment” and March 7^th on “Green Jobs”).

Why has there been a relatively recent rise in the use of market-based approaches? For academics like me, it would be gratifying to believe that increased understanding of market-based instruments had played a large part in fostering their increased political acceptance, but how important has this really been? In 1981, my Harvard colleague, political scientist Steven Kelman surveyed Congressional staff members, and found that support and opposition to market-based environmental policy instruments was based largely on ideological grounds: Republicans, who supported the concept of economic-incentive approaches, offered as a reason the assertion that “the free market works,” or “less government intervention” is desirable, without any real awareness or understanding of the economic arguments for market-based programs. Likewise, Democratic opposition was based largely upon ideological factors, with little or no apparent understanding of the real advantages or disadvantages of the various instruments. What would happen if we were to replicate Kelman’s survey today? My refutable hypothesis is that we would find increased support from Republicans, greatly increased support from Democrats, but insufficient improvements in understanding to explain these changes. So what else has mattered?

First, one factor has surely been increased pollution control costs, which have led to greater demand for cost-effective instruments. By the late 1980’s, even political liberals and environmentalists were beginning to question whether conventional regulations could produce further gains in environmental quality. During the previous twenty years, pollution abatement costs had continually increased, as stricter standards moved the private sector up the marginal abatement-cost curve. By 1990, U.S. pollution control costs had reached $125 billion annually, nearly a 300% increase in real terms from 1972 levels.

Second, a factor that became important in the late 1980’s was strong and vocal support from some segments of the environmental community. By supporting tradable permits for acid rain control, the Environmental Defense Fund seized a market niche in the environmental movement, and successfully distinguished itself from other groups. Related to this, a third factor was that the SO₂ allowance trading program, the leaded gasoline phasedown, and the CFC phaseout were all designed to reduce emissions, not simply to reallocate them cost-effectively among sources. Market-based instruments are most likely to be politically acceptable when proposed to achieve environmental improvements that would not otherwise be achieved.

Fourth, deliberations regarding the SO₂ allowance system, the lead system, and CFC trading differed from previous attempts by economists to influence environmental policy in an important way: the separation of ends from means, that is, the separation of consideration of goals and targets from the policy instruments used to achieve those targets. By accepting – implicitly or otherwise – the politically identified (and potentially inefficient) goal, the ten-million ton reduction of SO₂ emissions, for example, economists were able to focus successfully on the importance of adopting a cost-effective means of achieving that goal.

Fifth, acid rain was an unregulated problem until the SO₂ allowance trading program of 1990; and the same can be said for leaded gasoline and CFC’s. Hence, there were no existing constituencies – in the private sector, the environmental advocacy community, or government – for the status quo approach, because there was no status quo approach. We should be more optimistic about introducing market-based instruments for “new” problems, such as global climate change, than for existing, highly regulated problems, such as abandoned hazardous waste sites.

Sixth, by the late 1980’s, there had already been a perceptible shift of the political center toward a more favorable view of using markets to solve social problems. The George H. W. Bush Administration, which proposed the SO₂ allowance trading program and then championed it through an initially resistant Democratic Congress, was (at least in its first two years) “moderate Republican;” and phrases such as “fiscally responsible environmental protection” and “harnessing market forces to protect the environment” do have the sound of quintessential moderate Republican issues. But, beyond this, support for market-oriented solutions to various social problems had been increasing across the political spectrum for the previous fifteen years, as was evidenced by deliberations on deregulation of the airline, telecommunications, trucking, railroad, and banking industries. Indeed, by the mid-1990s, the concept (or at least the phrase), “market-based environmental policy,” had evolved from being politically problematic to politically attractive.

Seventh and finally, the adoption of the SO₂ allowance trading program for acid rain control – like any major innovation in public policy – can partly be attributed to a healthy dose of chance that placed specific persons in key positions, in this case at the White House, EPA, the Congress, and environmental organizations. The result was what remains the golden era in the United States for market-based environmental strategies.

_____________________________________________________________________________________

If you would like to read more about the factors that have brought about the changes that have occurred in the political reception given to market-based environmental policy instruments over the past two decades, here are some references:

Stavins, Robert N. “What Can We Learn from the Grand Policy Experiment? Positive and Normative Lessons from SO2 Allowance Trading.” Journal of Economic Perspectives, Volume 12, Number 3, pages 69-88, Summer 1998.

Keohane, Nathaniel O., Richard L. Revesz, and Robert N. Stavins. “The Choice of Regulatory Instruments in Environmental Policy.” Harvard Environmental Law Review, volume 22, number 2, pp. 313-367, 1998.

Hahn, Robert W. “The Impact of Economics on Environmental Policy.” Journal of Environmental Economics and Management 39(2000):375-399.

Hahn, Robert W., Sheila M. Olmstead, and Robert N. Stavins. “Environmental Regulation During the 1990s: A Retrospective Analysis.” Harvard Environmental Law Review, volume 27, number 2, 2003, pp. 377-415.

Moving Beyond Vintage-Differentiated Regulation

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

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

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

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

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

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

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

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

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

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

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

The 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.