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Paris Can Be a Key Step

I returned from a brief trip to Paris two days before the horrific events of November 13th, which have shocked and saddened civilized people everywhere. I was in Paris for discussions regarding climate change policy at OECD headquarters. Now, I’m preparing to return to Paris in less than two weeks with my colleagues from the Harvard Project on Climate Agreements (I’ve inserted a list of our forthcoming “public” activities at the Paris climate talks at the end of this blog post).

My purpose today, in this essay, is to explain why I believe that the Paris talks may turn out to be a key step in the international negotiations, and more important, a significant step in efforts to address the threat of climate change.

Background on the Paris Climate Talks

The international climate change negotiations that will take place in Paris the first two weeks of December, 2015, are officially the 21st Conference of the Parties of the United Nations Framework Convention on Climate Change.   It will be many years before any of us can truly assess the impact of the Paris talks, but it is clear now that they represent – at the very least – an important attempt to break with the past thrust of international climate policy and start anew with a much more promising approach.

The Kyoto Protocol, which has been the primary international agreement to reduce the greenhouse-gas emissions that cause global climate change, included mandatory emissions-reduction obligations only for developed countries. Developing countries had no emissions-reduction commitments. The stark demarcation in the Kyoto Protocol between developed and developing countries was one approach to realizing a principle in the underlying United Nations Framework Convention on Climate Change (UNFCCC), that countries should act to “protect the climate system … on the basis of equity and in accordance with their common but differentiated responsibilities and respective capabilities.”

The dichotomous distinction between the developed and developing countries in the Kyoto Protocol has made progress on climate change impossible, because growth in emissions since the Protocol came into force in 2005 is entirely in the large developing countries—China, India, Brazil, Korea, South Africa, Mexico, and Indonesia. The big break came at the annual UNFCCC negotiating session in Durban, South Africa in 2011, where a decision was adopted by member countries to “develop [by December 2015, in Paris] a protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all Parties.” This “Durban Platform for Enhanced Action” broke with the Kyoto Protocol and signaled a new opening for innovative thinking (which we, at the Harvard Project on Climate Agreements, took to heart).

The Road to Paris

In Paris next month, countries will likely adopt a new hybrid international climate policy architecture that includes: bottom-up elements in the form of “Intended Nationally Determined Contributions” (INDCs), which are national targets and actions that arise from national policies; and top-down elements for oversight, guidance, and coordination. Now, all countries will be involved.

The current commitment period of the Kyoto Protocol covers countries (Europe and New Zealand) accounting for no more than 14% of global emissions (and 0% of global emissions growth). But as of November 9th, 156 of the 196 members of the UNFCCC had submitted INDCs, representing some 87% of global emissions (and this will likely reach 90% or 95% by the time of the Paris talks)!

Such broad scope of participation is a necessary condition for meaningful action, but it is not a sufficient condition. Also required is adequate ambition of the individual contributions. But keep in mind that this is only the first step with this new approach. The INDCs will likely be assessed and revised every five years, with their collective ambition ratcheted up over time. That said, even this initial set of contributions could cut anticipated temperature increases this century to about 2.7-3.5 degrees Centigrade, more than the frequently-discussed aspirational goal of limiting temperature increases to 2 degrees C, but much less than the 5-6 degrees C increase that would be expected without this action. (An amendment to the Montreal Protocol to address hydrofluorocarbons (HFCs) will quite possibly shave an addition 0.5 C of warming.)

The problem has not been solved, and it will not be for years to come, but the new approach being taken in the forthcoming Paris Agreement can be a key step toward reducing the threat of global climate change. Only time will tell.

A Paris Scorecard

I’ve been asked many times what success will look like in Paris. Here’s my scorecard and my predictions of five key elements that – if all were achieved — would constitute an exceptionally successful 21st Conference of the Parties:

  1. Include approximately 90% of global emissions in the set of INDCs that are submitted and part of the Paris Agreement (compared with 14% in the current commitment period of the Kyoto Protocol). This will definitely be achieved.
  1. Establish credible reporting and transparency requirements. It is likely that this will be achieved.
  1. Begin to set up a system to finance climate adaptation (and mitigation) — the famous $100 billion commitment.  A key question is whether it includes private-sector finance, in addition to public-sector finance (that is, foreign aid). This is likely to be achieved.
  1. Agree to return to negotiations periodically, such as every 5 years, to revisit the ambition and structure of the INDCs. It is likely this will be achieved.
  1. Put aside unproductive disagreements, such as on so-called “loss and damage,” which looks to rich countries like unlimited liability for bad weather events in developing countries. Another unproductive disagreement is the insistence by some parties that the INDCs themselves be binding under international law. This would probably mean that the Paris Agreement would require Senate ratification in the United States, which means that the United States would not be a party to the Agreement. I can only hope that the delegates will realize the futility of pursuing such unproductive elements.

As you can see, I anticipate that elements #1 through #4 will be achieved in the Paris Agreement, and hopefully #5 as well. So, my fundamental prediction for Paris is success. (Unfortunately, some greens and some members of the press will mistakenly characterize this same outcome as “failure,” because the 2 degree C target has not been achieved immediately.)

Finally, for those of you who will be in Paris and/or like to keep up on the work of the Harvard Project on Climate Agreements, here is a partial schedule of our activities there (“partial” only because some of our engagements, including numerous bilateral meetings with national negotiating teams, press engagements, and other private meetings, are not included):

Harvard Project on Climate Agreements

Robert Stavins, Director, Robert Stowe, Executive Director, Jason Chapman, Program Manager, Harvard Environmental Economics Program

Events at the Twenty-First Conference of the Parties of the United Nations Framework Convention on Climate Change, November 30 – December 11, 2015, Paris, France

Events Co-Sponsored by the Harvard Project on Climate Agreements:

“Dialogue on the Comparison of Climate Change Policies”

Friday, December 4; 1:00 -3:00 pm; Pavilion of the People’s Republic of China (“Blue Zone”) — Co-host: National Center for Climate Change Strategy and International Cooperation (NCSC; Beijing) — Participants: Robert Stavins; Zou Ji, Fu Sha, Qi Yue, Chen Ji (NCSC); Duan Maosheng (Tsinghua University); Thomas Brewer (International Centre for Trade and Sustainable Development); Wang Mou (Chinese Academy of Social Sciences).

“Comparison and Linkage of Mitigation Efforts in a New Paris Regime”

Monday, December 7; 11:45 am – 1:00 pm; Pavilion of the International Emissions Trading Association (IETA) (“Blue Zone”) — Co-Hosts: International Emissions Trading Association (IETA), World Bank Group Networked Carbon Markets initiative — Participants: Robert Stavins; Dirk Forrister (IETA); David Hone (IETA and Shell); Andrei Marcu (Centre for European Policy Studies); Gilbert Metcalf (Tufts University); Vikram Widge (World Bank Group)

“The IPCC at a Crossroads: Enhancing the Usefulness of IPCC to the UNFCCC Process”

Wednesday, December 9; 11:30 am – 1:00 pm; Observer Room 12 (“Blue Zone”) — Co-Hosts: Fondazione Eni Enrico Mattei (FEEM; Venice and Milan), Mercator Research Institute on Global Commons and Climate Change (MCC; Berlin), Stanford Environmental and Energy Policy Analysis Center (SEEPAC) — Participants: Robert Stavins; Carlo Carraro (FEEM); Ottmar Edenhofer (MCC); Charles Kolstad (SEEPAC); Hoesung Lee (Chair, Intergovernmental Panel on Climate Change)

“Key Elements of the Paris Agreement and Implications for Business”

Wednesday, December 9; 3:30 – 5:00 pm; Room 9, Climate Generations Area (“Green Zone”) — Co-Host: Enel Foundation — Participants: Robert Stavins; Joseph Aldy (Harvard Kennedy School, by Skype); Dirk Forrister (IETA); Simone Mori (Enel SpA)

Other public events at which Robert Stavins is speaking:

“International Carbon Markets in a Post 2020 Climate Regime”

Thursday, December 3; 4:00 – 5:30 pm; Africa Pavilion (“Blue Zone”) — Hosts: African Development Bank Group, European Commission

“China-California Low Carbon and Climate Change Cooperation”

Monday, December 7; 2:00 – 4:00 pm; Pavilion of the People’s Republic of China (“Blue Zone”) — Hosts: State of California and the National Development and Reform Commission (Government of the People’s Republic of China)

“Can National Policies and INDCs Alone Lead to a Workable and Effective Climate Regime?”

Based on new book, Towards a Workable and Effective Climate Regime (available for free here), edited by Scott Barrett, Carlo Carraro, and Jaime de Melo — Tuesday, December 8; 11:30 am – 1:00 pm; Observer Room 4 (“Blue Zone”) — Hosts: Fondation pour les Etudes et Recherches sur le Développement International (FERDI), University of Venice, ClimateWorks Foundation — Participants: Carlo Carraro (University of Venice and Fondazione Eni Enrico Mattei), Surabi Menon (ClimateWorks Foundation), Roger Guesnerie (Collège de France), Jaime de Melo (University of Geneva), Scott Barrett (Columbia University), Robert Stavins

“Exploring the Potential for International Trading Partnerships in Emissions Permits”

Thursday, December 10; 12:00 – 1:30 pm; Pavilion of the International Emissions Trading Association (IETA) (“Blue Zone”) — Host: Electric Power Research Institute

“Building a Low-Carbon Society: Think Tank Views on Long-term Action”

Thursday, December 10; 1:00 – 3:00 pm; Pavilion of the People’s Republic of China (“Blue Zone”) — Host: Government of the People’s Republic of China

I’m exhausted just reading that list, but I promise to report on some of the highlights from Paris during and after COP-21.

The Papal Encyclical and Climate Change Policy

On June 18, 2015, Coral Davenport, writing in the New York Times, was the first in the press to note that the encyclical on the environment, Laudato Si’, released by Pope Francis that same day, with tremendous praise from diverse quarters, “is as much an indictment of the global economic order as it is an argument for the world to confront climate change.”

The New York Times and a Couple of Asia Trips

The Times article included the following: “…environmental economists criticized the encyclical’s condemnation of carbon trading, seeing it as part of a radical critique of market economies. ‘I respect what the pope says about the need for action, but this is out of step with the thinking and the work of informed policy analysts around the world, who recognize that we can do more, faster, and better with the use of market-based policy instruments — carbon taxes and/or cap-and-trade systems,’ Robert N. Stavins, the director of the environmental economics program at Harvard, said in an email. The approach by the pope, an Argentine who is the first pontiff from the developing world, is similar to that of a ‘small set of socialist Latin American countries that are opposed to the world economic order, fearful of free markets, and have been utterly dismissive and uncooperative in the international climate negotiations, Dr. Stavins said.”

Those are accurate quotes from an email I sent to Coral Davenport in response to her inquiry the same day. The reason why I sent an email, rather than calling was that I was, at that moment, approximately 37,000 feet over the Pacific Ocean, flying from Seoul (where I had spoken at the third annual Future Energy Forum) to San Francisco, on my way home to Boston.

The following week, I was flying back to Asia (this time to Beijing for a workshop jointly sponsored by the Harvard Project on Climate Agreements and China’s National Development and Reform Commission – a topic for a future blog post, but not for today). As I sat in the departure lounge at Chicago’s O’Hare International, I began to see on my iPhone a small flood of hostile commentary from the blogosphere, indicating that I had unfairly “attacked the Pope.”

Well, writing an email rather than chatting on the phone with a reporter may eliminate some spontaneity, but it does have the advantage of preserving a record. So, I’m pleased to be able to share with readers today the views I offered on June 18th, long before the Pope’s recent visit to Cuba and the United States. My views have not changed.

Why Write About This Now?

That’s a reasonable question. In part, I’m inspired by a marvelous essay by Yale professor William Nordhaus, “The Pope & the Market,” which appears in the October 8, 2015 issue of The New York Review of Books. However, my thoughts are completely independent from his, and so he should not be indicted for anything I have to say. But I do heartily recommend his essay, and urge readers to take a look at his commentary (as well as mine).

With that preamble out of the way, here are the reactions of one environmental economist, yours truly, to Laudato Si’, nearly verbatim from my June 18th message from 37,000 feet over the Pacific Ocean, with some additional text and links for this blog essay.

An Environmental Economist Reflects on the Papal Encyclical

The Pope is to be commended for taking global climate change seriously, and for drawing more world attention to the issue. There is much about the encyclical that is commendable, but where it drifts into matters of public policy, I fear that it is – unfortunately – not helpful.

The long encyclical ignores the causes of global climate change: it is an externality, an unintended negative consequence of otherwise meritorious activity by producers producing the goods and services people want, and consumers using those goods and services. That’s why the problem exists in the first place. There may well be ethical dimensions of the problem, but it is much more than a simple consequence of some immoral actions by corrupt capitalists.

The document also ignores the global commons nature of the problem, which is why international cooperation is necessary. If the causes of the problem are not recognized, it is very difficult – or impossible – to come up with truly meaningful and feasible policy solutions.

So, yes, the problem is indeed caused by a failure of markets, as the Pope might say, or – in the language of economics – a “market failure”. But that is precisely why sound economic analysis of the problem is important and can be very helpful. Such analysis points the way to working through the market for solutions, rather than condemning global capitalism per se.

Should Carbon Markets be Condemned?

In surprisingly specific and unambiguous language, the encyclical rejects outright “carbon credits” as part of a solution to the problem. It says they “could give rise to a new form of speculation and would not help to reduce the overall emission of polluting gases”. The encyclical asserts that such an approach would help “support the super-consumption of certain countries and sectors”.

That misleading and fundamentally misguided rhetoric is straight out of the playbook of the ALBA countries, the small set of socialist Latin American countries that are opposed to the world economic order, fearful of free markets, and have been utterly dismissive and uncooperative in the international climate negotiations. Those countries have been strongly opposed to any market-based approaches to climate change, including carbon taxes, cap-and-trade, and offset systems, as well as any approaches that would allow – through appropriate linkage – the financing by one country of emissions reductions in another country (see my previous essay at this blog on A Key Element for the Forthcoming Paris Climate Agreement).

If the references to “carbon credits” were intended to refer only to offset systems (such as the Clean Development Mechanism) and not to cap-and-trade systems, then I would be much less concerned about the Pope’s complaints. However, the encyclical does not make the distinction. Indeed, I doubt that the authors of the encyclical recognize the difference, and unfortunately, readers of the encyclical will likewise lump together all carbon markets, which is what some policy makers also do, unfortunately.

Out of Step

I respect what the Pope says about the need for action, but his unfortunate attack on the use of the market to address climate change is out of step with the thinking and the work of informed policy analysts and policy makers around the world, who recognize that we can do more, faster, and better with the use of market-based policy instruments – carbon taxes and/or cap-and-trade systems. UN Secretary General Ban Ki-moon has been outspoken in precisely this regard.

Furthermore, the United Nations Framework Convention on Climate Change itself (Article 3.3) explicitly states that “policies and measures to deal with climate change should be cost-effective so as to ensure global benefits at the lowest possible cost” and thereby be more ambitious. That is why market-based climate policy instruments are an important option for many countries. Keeping costs down will help inspire greater action.

Concluding Thoughts

The Papacy is to be commended for having drawn attention to climate change as a major issue. But, sadly, the encyclical fails to recognize that because externalities (such as CO2 emissions) are a type of market failure and because the global commons nature of the problem and consequent free riding are also a profound market failure, it is for these reasons that working through the market is absolutely necessary – in order to address the climate problem in ways that are scientifically meaningful, economically sensible, and ultimately politically pragmatic.

By incorporating the anti-market rhetoric of the ALBA countries, the encyclical unfortunately goes beyond these errors of omission to incorporate significant errors of commission by emphasizing a perspective that is not progressive and enlightened, and would – I fear – ultimately work against meaningful climate policy at the international, regional, national, and sub-national levels.

That is why I said that although there is much about the encyclical that is commendable, where it drifts into matters of public policy it is – unfortunately – not helpful.

Crude Oil Prices, Climate Change, and Global Welfare

A few weeks ago, I participated in a panel session titled, “The Remarkable Transformation of the Energy Sector: Does it Also Transform Our World.” The motivating question was: “Is the dramatic decline in oil prices a complete gift to the West because of the enormous funds being saved, or is it an unintended Trojan horse because development of renewable energy as well as new fossil-fuel sources will decline in the West, posing longer new challenges?”

The other members of the panel – from private industry – had vastly more expertise (and relevant insights) on fossil-fuel markets, but here’s what I had to say. This is hardly at the sweet spot of my professional competence, so I welcome your comments and corrections! In general, how would you answer that question?


I start (and started) from the premise that the dramatic decline in crude oil prices that took place from August, 2014 ($96/barrel), to March, 2015 ($44/barrel), was due – on the one hand – to decreased demand, a function of slow economic growth in Asia, Europe, and elsewhere, endogenous, price-driven technological change leading to greater fuel efficiency, and policy-driven technological change that also has been leading to greater fuel efficiency, such as more stringent Corporate Average Fuel Economy (CAFE) standards in the United States; and – on the other hand – was due to increased supply, partly a function of the growth of unconventional (tight) U.S. oil production (a product of the combination of two technologies – horizontal drilling and hydraulic fracturing).  And, in the presence of all of this, Saudi Arabia decided not to restrict its output to prop up prices.

[Before proceeding, I should note that since May of this year, crude oil prices have increased by about 30% from their March low, but as of May ($60/barrel) are still far below their August 2014 level.]


When one examines virtually any significant price change from an economic perspective, there inevitably seems to be both good news and bad news. So with the fall in crude oil prices.

The Bad News

First of all, I assume that low crude oil prices are problematic for the economic and political stability of some of the oil-producing/exporting countries, including Saudi Arabia, Russia, Venezuela, and Nigeria.  (For details, see Bordoff and Losz 2015, below.)

Second, it’s frequently been asserted that low oil prices are bad news for the development of alternative forms of energy, including renewable sources. Of course, in the United States, there isn’t much effect on electricity generation from renewable (wind and solar), because in the U.S. electricity sector, renewable supplies compete with coal and natural gas, not with fuel oil (but in other countries, which use more fuel oil for electricity generation than we do, there can be a disincentive for renewable dispatch – and hence development).

Third, there can be – indeed, has been – a major impact in the U.S. motor fuels sector, where the market for biofuels (mainly ethanol) is negatively affected by low conventional gasoline prices. However, these impacts must be somewhat muted by public policies, which directly or indirectly subsidize (or, in fact, require) the use of biofuels.

Fourth, low gasoline prices have resulted in decreased demand by consumers for motor vehicles with high fuel efficiency, and SUV and pickup truck sales have rebounded from previous lows. But these effects are also muted, to some degree, by public policies, including U.S. CAFE standards.   Finally, low gasoline prices also have short-term effects in the form of more driving and fuel use by the existing fleet of motor vehicles, which is bad news in terms of emissions (and congestion).

Differences across Sectors

Before turning to the “good news” about low crude oil prices (and there surely is good news), it’s worthwhile noting that whether individual businesses find these low prices to be good or bad depends largely upon the economic sector in which they operate. For example, whereas commercial airlines are finally making profits, due to the low price of jet fuel (their most important variable operating cost), manufacturers of commercial aircraft will see lower demand for new planes if low jet fuel prices become the long-term norm. The primary factor driving the larger airlines to replace aircraft in their fleets is the lower operating costs due to the much greater fuel efficiency of new models.

And, of course, low oil prices are systematically bad news for oil producers, including the major U.S. companies.

The Good News

Finally, here is the upside of these significant changes in crude oil markets.

Low oil prices are unambiguously good for aggregate global welfare. This includes consumers in the United States, Europe, Japan, and South Korea. And, at least temporarily, OPEC seems to have lost its ability to set a price floor.

Low oil prices mean an increase in consumers’ disposable income, amounting to nearly $2,500 per U.S. household annually, according to Stephen Brown (see below).  If we subtract the income losses to U.S. oil producers, the net gain per U.S. household amounts to a bit more than $800 per year, with gains accruing disproportionately to low-income households.

Turning to the environmental realm, there is also good news, or at least the possibility of good news. An opportunity for new, sensible energy and climate change policies has emerged with these low oil prices.

First, now is the time to reduce – or better yet, phase out – costly and inefficient fuel subsidies, which exist in many parts of the world, particularly in developing countries.

Second, with gasoline prices relatively low – and natural gas supplies holding down electricity prices, at least in the United States – there has never been a better time to introduce progressive climate policies in the form of carbon-pricing, whether via carbon taxes or through carbon cap-and-trade. Unfortunately, none of us should hold our breath waiting for that to happen.


For further reading, I recommend:

Bordoff, Jason, and Akos Losz.  “Oil Shock: Decoding the Causes and Consequences of the 2014 Oil Price Drop.”  Horizons, Spring 2015, Issue No. 3, pp. 190-206.

Brown, Stephen P. A.  “Falling Oil Prices: Implications in the United States.” Resources, Number 189.  Washington:  Resources for the Future, 2015, pp. 40-44.

A Challenge for the 2015 Paris Climate Agreement

At the recent climate negotiations at the 20th Conference of the Parties (COP-20) of the United Nations Framework Convention on Climate Change (UNFCCC) in Lima, Peru, a very important issue was left on the table, unresolved: Will the 2015 Paris Agreement (scheduled to be signed in December of this year at COP-21) facilitate – or at least avoid inhibiting – international linkage of national (and for that matter, sub-national) climate policies?

Brief History

In the Durban Platform for Enhanced Action, adopted by COP-17 in 2011, negotiators agreed to develop a new legal instrument “under the Convention applicable to all Parties,” for adoption at COP-21 in December, 2015, in Paris. With the Lima talks now behind us, it appears that the 2015 agreement will reflect a hybrid climate policy architecture—one that combines top-down elements, such as for monitoring, reporting, and verification, with bottom-up elements, including “Intended Nationally Determined Contributions” (INDCs), describing what a country intends to do to reduce emissions, based on domestic political feasibility and other factors. (I wrote about this in Assessing the Outcome of the Lima Climate Talks, posted on December 14, 2014.)

Can the Aggregation of INDCs be Cost-Effective?

A major question facing negotiators is how can the new hybrid policy architecture encourage greater ambition, while remaining true to the principle of “common but differentiated responsibilities.” A key answer to that question is to allow for the linkage of heterogeneous national policy instruments. Why do I say that?

Here’s the reason. An attribute of the Paris architecture that will encourage greater ambition over time is cost-effectiveness. (Another key attribute to encourage greater ambition is comparability of INDCs, a topic on which we’re also working at the Harvard Project on Climate Agreements, about which I will write in the future.) To enhance the cost-effectiveness of the new system, a key feature will be linkages among regional, national, and sub-national climate policies. By linkage, I mean formal recognition by a greenhouse gas (GHG) mitigation program in one jurisdiction (a regional, national, or sub-national government) of emission reductions undertaken in another jurisdiction for purposes of complying with the first jurisdiction’s mitigation program.

Linkage can be straightforward, as with the bilateral recognition of allowances under two cap-and-trade regimes, but – importantly — linkage can also take place among a heterogeneous set of policy instruments, such as between systems of performance standards, carbon taxes, and cap-and-trade.

Linkage in the Paris 2015 Agreement

In a new paper that was released by the Harvard Project on Climate Agreements at a packed “side event” in Lima, my co-authors – Daniel Bodansky of Arizona State University, Seth Hoedl of Harvard Law School, and Gilbert Metcalf of Tufts University – and I analyze theoretical issues relating to linkage among heterogeneous climate policy instruments and apply this analysis concretely to the 2015 Paris agreement. In “Facilitating Linkage of Heterogeneous Regional, National, and Sub-National Climate Policies Through a Future International Agreement,” we examine how the agreement can help facilitate the growth and operation of a robust system of international linkages of regional, national, and sub-national policies, as well as how inappropriate or excessive rules could obstruct effective, bottom-up linkage. Importantly, both economic and legal perspectives are represented in this research (which was supported by the International Emissions Trading Association (IETA) and six of its member companies: Chevron, GDF-Suez, Global CCS Institute, Rio Tinto, Shell, and TransCanada)

Key Findings from Research

I encourage you to take a look at the full paper or, at least, its executive summary, but here – in very brief form — are the key findings.

First, there are a number of design elements the 2015 agreement should avoid, because they would inhibit linkage. These include “supplementarity requirements” that require parties to accomplish all or most of their emissions-reduction commitments within their national borders. The 2015 agreement also should avoid including detailed linkage rules in the core agreement; an agreement with more flexibility would allow rules to evolve on the basis of experience.

Second, to advance linkage, the 2015 agreement should: define key terms, in particular the units that are used for compliance purposes; establish registries and tracking mechanisms; and include default or model rules, from which nations are free to deviate at their discretion.

The most valuable outcome of the Paris Agreement regarding linkage may simply be including an explicit statement that parties may transfer portions of their emissions-reduction contributions to other parties—and that these transferred units may be used by the transferees to implement their own commitments.

It sounds simple, but a small but vocal set of (largely socialist) countries – including Bolivia, Venezuela, and Cuba – have vehemently opposed in the climate negotiations anything that looks remotely like a market, and will try hard to prevent such provisions from appearing in the 2015 agreement.

Next Steps

As the negotiating teams from 195 countries prepare to meet this month in Geneva, Switzerland, and in June in Bonn, Germany, the question remains of whether the 2015 Paris Climate Agreement will allow for and indeed facilitate international linkage of national and sub-national policies, and thereby encourage cost-effectiveness and greater environmental ambition. Over the next several months, the answer to this question will become clear.

The UN Climate Summit and a Key Issue for the 2015 Paris Agreement

World leaders converged at the United Nations in New York City this past week for Secretary-General Ban Ki-moon’s much anticipated Climate Summit, a lead-up to global negotiations that will take place in Lima, Peru, in December of this year, and culminate a year later in Paris.  The challenge before negotiators is great, because there are significant obstacles to reaching a meaningful agreement, as I describe in an Op-Ed that appeared in The New York Times on Sunday, September 21st, “Climate Realities.”

However, partly because of the new path that is being taken under the Durban Platform for Enhanced Action, in which all countries will be included under a common legal framework in a politically realistic hybrid policy architecture, the prognosis for a meaningful international agreement is better now than it has been in decades.  I discuss this briefly at the end of the Times article, and emphasize it in a follow-up Op-Ed that appeared in The Boston Globe on September 23rd, “UN summit can accelerate momentum to a new approach to climate change.”  (Also, for my overall assessment of the UN Climate Summit, see this interview carried out by the Harvard Kennedy School’s Doug Gavel.)

A New Development at the UN Climate Summit

The most significant development at the UN Climate Summit this past week was the degree to which carbon pricing became central to so many discussions, including with leaders from the business community.  As carbon pricing – in particular, cap-and-trade systems – have emerged as the policy instrument of choice in many parts of the world, interest in linking these systems together has grown.  Linkage (unilateral or bilateral recognition of allowances) among carbon markets — and, for that matter links with non-market-based systems — can reduce the aggregate cost of achieving climate targets.  And lower compliance costs can in turn encourage countries to increase the ambition of their contributions under the 2015 Paris agreement.

New Research from Harvard

Because of this, the Harvard Project on Climate Agreements has been collaborating with the International Emissions Trading Association (IETA) to explore the role of linkage in the new international climate change agreement to be completed in Paris.  In this new research, my co-authors (Daniel Bodansky of Arizona State University, Seth Hoedl of Harvard Law School, and Gilbert Metcalf of Tufts University) and I examine linkage — not only among cap-and-trade systems, but among cap-and-trade, carbon tax, and non-market regulatory systems — and the role that linkage should play in the 2015 agreement.  We look both at what would inhibit or even prevent linkage and should therefore be avoided in the 2015 agreement, and what – in a positive sense – should be included in the agreement to facilitate effective linkage of regional, national, and sub-national climate policies.

We released an Executive Summary of our research paper (“Facilitating Linkage of Heterogeneous Regional, National, and Sub-National Policies Through a Future International Agreement”) in New York City on September 22nd at an event co-sponsored by IETA and the Harvard Project, on the sidelines of UN Climate Summit, “Carbon Pricing and the 2015 Agreement” (the agenda of the event is available here).

In the executive summary (which can be downloaded in full here), we conclude that among the design elements the 2015 agreement should avoid because they would inhibit linkage are so-called “supplementarity requirements” that require parties to accomplish all (or a large, specified share) of their emissions-reduction commitments within their national borders. The 2015 agreement also should avoid including detailed linkage rules in the core agreement; an agreement with more flexibility would allow rules to evolve on the basis of experience.

Importantly, we also find that, to advance linkage, the 2015 agreement should:  define key terms, in particular the units that are used for compliance purposes; establish registries and tracking mechanisms; and include default or model rules, from which nations are free to deviate at their discretion.  Overall, the most valuable outcome of the Paris Agreement regarding linkage may simply be including an explicit statement that parties may transfer portions of their emissions-reduction contributions to other parties — and that these transferred units may be used by the transferees to implement their own commitments.

Looking Forward

We will release the complete research paper in November of this year, prior to the Twentieth Conference of the Parties (COP-20) of the United Nations Framework Convention on Climate Change in Lima, Peru, in December 2014, where the Harvard Project and IETA plan to conduct a side-event that will focus on this work.

When the full paper is released in November, I will provide a more complete description at this blog of our research methods and our findings.

[Additional press coverage is here, here, here, here, here, here, here, here, here, and here.]

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.

The Second Term of the Obama Administration

In his inaugural address on January 21st, President Obama surprised many people – including me – by the intensity and the length of his comments on global climate change.  Since then, there has been a great deal of discussion in the press and in the blogosphere about what climate policy initiatives will be forthcoming from the administration in its second term.

Given all the excitement, let’s first take a look at the transcript of what the President actually said on this topic:

            We will respond to the threat of climate change, knowing that the failure to do so would betray our children and future generations. Some may still deny the overwhelming judgment of science, but none can avoid the devastating impact of raging fires, and crippling drought, and more powerful storms.  The path towards sustainable energy sources will be long and sometimes difficult. But American cannot resist this transition.  We must lead it.  We cannot cede to other nations the technology that will power new jobs and new industries.  We must claim its promise. That’s how we will maintain our economic vitality and our national treasure, our forests and waterways, our crop lands and snow capped peaks.  That is how we will preserve our planet, commanded to our care by God.

Strong and plentiful words.  Although I was certainly surprised by the strength and length of what the President said in his address, I confess that it did not change my thinking about what we should expect from the second term.  Indeed, I will stand by an interview that was published by the Harvard Kennedy School on its website five days before the inauguration (plus something I wrote in a previous essay at this blog in December, 2012).  Here it is, with a bit of editing to clarify things, and some hyperlinks inserted to help readers.

The Second Term: Robert Stavins on Energy and Environmental Policy

January 16, 2013

By Doug Gavel, Harvard Kennedy School Communications

President Obama’s second term in office began on Inauguration Day, January 21st, and the list of policy challenges facing his administration is daunting. Aside from the difficult task of addressing the nation’s economic woes, the president and his administration will also deal with the increasing complexities of global climate change, a rapidly changing energy market, entitlement and tax reform, healthcare reform, and the repercussions from the still simmering “Arab Spring.” Throughout this month, we will solicit the viewpoints of a variety of HKS faculty members to provide a range of perspectives on the promise and pitfalls of The Second Term.

We spoke with Robert Stavins, Albert Pratt Professor of Business and Government, and Director of the Harvard Environmental Economics Program, about energy and environmental policy issues the president will face in the next four years.

Q: What are the top priorities for a second Obama administration in energy and environmental policy?

A: The Obama administration faces a number of impending challenges in the energy and environmental policy realm in its second term, which I would characterize – in very general terms – as finding balance among three competing factors: (1) demands from some constituencies for more aggressive environmental policies; (2) demands from other constituencies – principally in the Congress – for progress on so-called “energy security;” and (3) recognition that nothing meaningful is likely to happen if the country’s economic problems are not addressed.

Q: What will be the potential challenges/roadblocks in the way of implementing those top priorities?

A: The key challenge the administration faces in its second term as it attempts to achieve some balance among these three competing objectives is the reality of a very high degree of political polarization in the two houses of Congress.

The numbers are dramatic.  For example, when the Clean Air Act Amendments of 1990 that established the landmark SO2 allowance trading system were being considered in the U.S. Congress, political support was not divided on partisan lines. Indeed, environmental and energy debates from the 1970s through much of the 1990s typically broke along geographic lines, rather than partisan lines, with key parameters being degree of urbanization and reliance on specific fuel types, such as coal versus natural gas. The Clean Air Act Amendments of 1990 passed the U.S. Senate by a vote of 89-11 with 87 percent of Republican members and 91 percent of Democrats voting yea, and the legislation passed the House of Representatives by a vote of 401-21 with 87 percent of Republicans and 96 percent of Democrats voting in support.

But, 20 years later when climate change legislation was receiving serious consideration in Washington, environmental politics had changed dramatically, with Congressional support for environmental legislation coming mainly to reflect partisan divisions. In 2009, the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454), often known as the Waxman-Markey bill, that included an economy-wide cap-and-trade system to cut carbon dioxide (CO2) emissions. The Waxman-Markey bill passed by a narrow margin of 219-212, with support from 83 percent of Democrats, but only 4 percent of Republicans. (In July 2010, the U.S. Senate abandoned its attempt to pass companion legislation.) Political polarization in the Congress (and the country) has implications far beyond energy and environmental policy, but it is particularly striking in this realm.

Q: In the Obama administration’s second term, are there openings/possibilities for compromises in those areas?

A: It is conceivable – but in my view, unlikely – that there may be an opening for implicit (not explicit) “climate policy” through a carbon tax. At a minimum, we should ask whether the defeat of cap-and-trade in the U.S. Congress, the virtual unwillingness over the past 18 months of the Obama White House to utter the phrase “cap-and-trade” in public, and the defeat of Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO2 emissions reductions in the United States.

First of all, there surely is such an opening in the policy wonk world. Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax. And a much-publicized meeting in July, 2012, at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy. Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world. But what about in the real political world? The good news is that a carbon tax is not “cap-and-trade.” That presumably helps with the political messaging! But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax! Also, note that President Obama’s silence extends beyond disdain for cap-and-trade per se. Rather, it covers all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington. Note that the only election outcome that could have lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would have been: the Democrats took back control of the House of Representatives, the Democrats achieved a 60+ vote margin in the Senate, and the President was reelected. Only the last of these happened. It’s not enough.

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with the Obama White House to work constructively to address the short-term and long-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “ifs”) it turns out to be easier politically to eschew increases in taxes on labor and investment and turn to taxes on consumption, then there could be a political opening for new energy taxes, even a carbon tax.

Such a carbon tax – if intended to help alleviate budget deficits – could not be the economist’s favorite, a revenue-neutral tax swap of cutting distortionary taxes in exchange for implementing a carbon tax. Rather, as a revenue-raising mechanism – like the Obama administration’s February 2009 budget for a 100%-auction of allowances in a cap-and-trade scheme – it would be a new tax, pure and simple. Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – will not be optimistic.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax. The key question is whether the phrases “climate policy” and “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure.  The key group to bring on board will presumably be conservative Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.

What remains most likely to happen is what I’ve been saying for several years, namely that despite the apparent inaction by the Federal government, the official U.S. international commitment — a 17 percent reduction of CO2 emissions below 2005 levels by the year 2020 – is nevertheless likely to be achieved!  The reason is the combination of CO2 regulations which are now in place because of the Supreme Court decision [freeing the EPA to treat CO2 like other pollutants under the Clean Air Act], together with five other regulations or rules on SOX [sulfur compounds], NOX [nitrogen compounds], coal fly ash, particulates, and cooling water withdrawals. All of these will have profound effects on retirement of existing coal-fired electrical generation capacity, investment in new coal, and dispatch of such electricity.

Combined with that is Assembly Bill 32 (AB 32) in the state of California, which includes a CO2 cap-and-trade system that is more ambitious in percentage terms than Waxman-Markey was in the U.S. Congress, and which became binding on January 1, 2013.  Add to that the recent economic recession, which reduced emissions. And more important than any of those are the effects of developing new, unconventional sources of natural gas in the United States on the supply, price, and price trajectory of natural gas, and the consequent dramatic movement that has occurred from coal to natural gas for generating electricity.  In other words, there will be actions having significant implications for climate, but most will not be called “climate policy,” and all will be within the regulatory and executive order domain, not new legislation.

Q: Are there lessons that a second Obama administration can draw upon from the first administration, or from history, when constructing its energy & environmental policy over the next four years?

A: It will take a great deal of dedicated effort and profound luck to find political openings that can bridge the wide partisan divide that exists on climate change policy and other environmental issues. Think about the following. Nearly all our major environmental laws were passed in the wake of highly publicized environmental events or “disasters,” including the spontaneous combustion of the Cuyahoga River in Cleveland, Ohio, in 1969, and the discovery of toxic substances at Love Canal in Niagara Falls, New York, in the mid-1970s. But note that the day after the Cuyahoga River caught on fire, no article in The Cleveland Plain Dealer commented that the cause was uncertain, that rivers periodically catch on fire from natural causes. On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries. A direct consequence of the observed “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different. Unlike the environmental threats addressed successfully in past U.S. legislation, climate change is essentially unobservable to the general population. We observe the weather, not the climate.  Notwithstanding last year’s experience with Super Storm Sandy, it remains true that until there is an obvious, sudden, and perhaps cataclysmic event – such as a loss of part of the Antarctic ice sheet leading to a dramatic sea-level rise – it is unlikely that public opinion in the United States will provide the tremendous bottom-up demand that inspired previous congressional action on the environment over the past forty years.

That need not mean that there can be no truly meaningful, economy-wide climate policy (such as carbon-pricing) until disaster has struck.  But it does mean that bottom-up popular demand may not come in time, and that instead what will be required is inspired leadership at the highest level that can somehow bridge the debilitating partisan political divide.

Postscript:  Please note that the Kennedy School series on the second term of the Obama administration also includes an interview with my colleague, Professor Joseph Aldy, offering his own views on potential environmental policy developments in the next four years.

Cap-and-Trade, Carbon Taxes, and My Neighbor’s Lovely Lawn

The recent demise of serious political consideration of an economy-wide U.S. CO2 cap-and-trade system and the even more recent resurgence in interest among policy wonks in a U.S. carbon tax should prompt reflection on where we’ve been, where we are, and where we may be going.


Almost fifteen years ago, in an article that appeared in 1998 in the Journal of Economic Perspectives, “What Can We Learn from the Grand Policy Experiment?  Lessons from SO2 Allowance Trading,” I examined the implications of what was then the very new emissions trading program set up by the Clean Air Act Amendments of 1990 to cut acid rain by half over the succeeding decade.  In that article, I attempted to offer some guidance regarding the conditions under which cap-and-trade (then known as “tradable permits”) was likely to work well, or not so well.  Here’s a brief summary of what I wrote at the time:

(1)  SO2 trading was a case where the cost of abating pollution differed widely among sources, and where a market-based system was therefore likely to have greater gains, relative to conventional, command-and-control regulations (Newell and Stavins 2003). It was clear early on that SO2 abatement cost heterogeneity was great, because of differences in ages of plants and their proximity to sources of low-sulfur coal. But where abatement costs are more uniform across sources, the political costs of enacting an allowance trading approach are less likely to be justifiable.

(2)  The greater the degree to which pollutants mix in the receiving airshed or watershed, the more attractive a cap-and-trade (or emission tax) system will be, relative to a conventional uniform standard. This is because taxes or cap-and-trade can – in principle – lead to localized “hot spots” with relatively high levels of ambient pollution. Some states (in particular, New York) tried unsuccessfully to erect barriers to trades they thought might increase deposition within their borders.  This is a significant distributional issue.  It can also be an efficiency issue if damages are nonlinearly related to pollutant concentrations.

(3)  The efficiency of a cap-and-trade system will depend on the pattern of costs and benefits. If uncertainty about marginal abatement costs is significant, and if marginal abatement costs are quite flat and marginal benefits of abatement fall relatively quickly, then a quantity instrument, such as cap-and-trade, will be more efficient than a price instrument, such as an emission tax (Weitzman 1974).  With a stock pollutant (such as CO2), this argument favors a price instrument (Newell and Pizer 2003).  However, when there is also uncertainty about marginal benefits, and marginal benefits are positively correlated with marginal costs (which, it turns out, is a relatively common occurrence for a variety of pollution problems), then there is an additional argument in favor of the relative efficiency of quantity instruments (Stavins 1996).

(4)  Cap-and-trade will work best when transaction costs are low (Stavins 1995), and the S02 experiment showed that if properly designed, private markets will tend to render transaction costs minimal.

5)  Considerations of political feasibility point to the wisdom of proposing trading instruments when they can be used to facilitate emissions reductions, as was done with SO2 allowances and lead rights trading, less so for the purpose of reallocating existing emissions abatement responsibility (Revesz and Stavins 2007).

(6)  National policy instruments that appear impeccable from the vantage point of Cambridge, Massachusetts, Berkeley, California, or Madison, Wisconsin, but consistently prove infeasible in Washington, D.C., can hardly be considered “optimal.”

Implications for CO2 Policy

In the same article, I noted that many of these issues could be illuminated by considering a concrete example:  the “current interest” in applying cap-and-trade to the task of cutting CO2 emissions to reduce the risk of global climate change.  Some of the points I made in this regard in my 1998 article were:

(a)  The number of sources of CO2 emissions are vastly greater than in the case of SO2 emissions as a precursor of acid rain, where the focus could be placed on a few hundred electric utility plants.  Feasibility considerations alone argue for market-based instruments (cap-and-trade or taxes) to achieve meaningful reductions of CO2 emissions.

(b)  The diversity of sources of CO2 in a modern economy and the consequent heterogeneity of emission reduction costs bolster the case for using cost-effective market-based instruments.

(c)  As the ultimate global-commons problem, CO2 is a truly uniformly-mixed pollutant.  With no concern for hot spots, market-based instruments present none of the problems that can arise in the case of localized environmental threats.

(d)  Any pollution-control program must face the possibility of emissions leakage from regulated to unregulated sources. This would be a severe problem for an international CO2 program, where emissions would tend to increase in nonparticipant countries. Furthermore, it raises concerns for the emission-reduction-credit (not cap-and-trade) system in the Kyoto Protocol known as the Clean Development Mechanism (CDM).  Such an offset system can lower aggregate costs by substituting low-cost for high-cost control, but may also have the unintended effect of increasing aggregate emissions beyond what they would otherwise have been, because there is an incentive for adverse selection: sources in developing countries that would reduce their emissions, opt in, and receive credit for actions they would have taken anyway.

(e)  Although any trading program could potentially serve as a model for the case of global climate change, I argued that the trading system that accomplished the U.S. phaseout of leaded gasoline in the 1980s merited particular attention. The currency of that system was not lead oxide emissions from motor vehicles, but the lead content of gasoline. So too, in the case of global climate, great savings in monitoring and enforcement costs could be had by adopting input trading linked with the carbon content of fossil fuels. This is reasonable in the climate case, since – unlike in the SO2 case – CO2 emissions are roughly proportional to the carbon content of fossil fuels and scrubbing alternatives are largely unavailable, at least at present.

(f)   Natural sequestration of CO2 from the atmosphere by expanding forested areas is available (even in the United States) at reasonable cost (Stavins 1999).  Hence, it could be valuable to combine any carbon trading (or carbon tax) program with a carbon sequestration program, although this will raise significant challenges in regard to monitoring and enforcement.

(g)  In regard to carbon permit allocation mechanisms, auctions would have the advantage that revenues could be used to finance reductions in distortionary taxes.  Free allocation could increase regulatory costs enough that the sign of the efficiency impact could conceivably be reversed from positive to negative net benefits (Parry, Williams, and Goulder 1999).  On the other hand, free allocation of carbon permits would meet with much less political resistance.

The Necessity of Market-Based Instruments:  Cap-and-Trade or Carbon Taxes

I concluded that developing a cap-and-trade system for climate change would bring forth an entirely new set of economic, political, and institutional challenges.  At the same time, I recognized that the diversity of sources of CO2 emissions and the magnitude of likely abatement costs made it equally clear that only a market-based instrument – some form of carbon rights trading or (probably revenue-neutral) carbon taxes – would be capable of achieving the domestic targets that might eventually be forthcoming.

In other words, my conclusion in 1998 strongly favored a market-based carbon policy, but was somewhat neutral between carbon taxes and cap-and-trade.  Indeed, at that time and for the subsequent eight years or so, I remained agnostic regarding what I viewed as the trade-offs between cap-and-trade and carbon taxes.  What happened to change that?  Three words:  The Hamilton Project.

The Making of an Advocate

For those of you who don’t know, the Hamilton Project is an initiative based at the Brookings Institution that – according to its web site – “offers a strategic vision and produces innovative policy proposals on how to create a growing economy that benefits more Americans.”

In 2007, the Project’s leadership asked me to write a paper proposing a U.S. CO2 cap-and-trade system.  I responded that I would prefer to write a paper proposing the use of a market-based CO2 policy, describing the two alternatives of cap-and-trade and carbon taxes.  I explained that I was by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years.  Indeed, I noted, both cap-and-trade and carbon taxes would be good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences.

The Hamilton Project leaders said no, they wanted me to make the best case I could for cap-and-trade, not a balanced investigation of the two policy instruments.  Someone else would be commissioned to write a proposal for a carbon tax.  (That turned out to be Professor Gilbert Metcalf of Tufts University – now on leave at the U.S. Department of the Treasury – who did a splendid job!)  Thus, I was made into an advocate for cap-and-trade.  It’s as simple as that.

Giving It My Best Shot

I argued in my Hamilton Project paper (which you can read here) that despite the tradeoffs between the two principal market-based instruments that could target CO2 emissions, the best (and most likely) approach for the short to medium term in the United States was a cap-and-trade system, based on three criteria:  environmental effectiveness, cost effectiveness, and distributional equity.  Although my position was not simple capitulation to politics, I argued that sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should be made in a real-world political context.

I said that the key merits of the cap-and-trade approach were, first, the program could provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels.  Second, it offered an easy means of compensating for the inevitably unequal burdens imposed by a climate policy.  Third, it provided a straightforward means to link with other countries’ climate policies.  Fourth, it avoided the political aversion in the United States to taxes.  Fifth, it was unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach had a history of successful adoption and implementation in this country over the past two decades.

I recognized that there were some real differences between taxes and cap-and-trade that needed to be recognized.  First, environmental effectiveness:  a tax does not guarantee achievement of an emissions target, but it does provide greater certainty regarding costs.  This is a fundamental tradeoff.  Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly cost-containment mechanisms.  On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and is why virtually no environmental NGOs have favored the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same.  But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table.  But political pressures on a cap-and-trade system lead to different allocations of the free allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.

I concluded that proponents of carbon taxes worried about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax would be sensitive to the same political pressures, and should be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

Of course, such positive political economy arguments look much less compelling in the wake of the defeat of cap-and-trade legislation in the U.S. Congress and its successful demonization by conservatives as “cap-and-tax.”

A Political Opening for Carbon Taxes?

Does the defeat of cap-and-trade in the U.S. Congress, the obvious unwillingness of the Obama White House to utter the phrase in public, and the outspoken opposition to cap-and-trade by Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO2 emissions reductions?

First of all, there surely is such an opening in the policy wonk world.  Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax.  And a much-publicized meeting in July at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy.  Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world.  But what about in the real political world?  The good news is that a carbon tax is not “cap-and-trade.”  That presumably helps with the political messaging!  But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax!   Also, note that Romney’s stated opposition and Obama’s silence extend beyond disdain for cap-and-trade per se.  Rather, they cover all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington, no matter what the outcome of the election.  Note that the only election outcome that could lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would be:  the Democrats take back control of the House of Representatives, and the Democrats achieve a 60+ vote margin in the Senate, and the President is reelected.  A quick check at Five Thirty Eight (Nate Silver’s superb election forecast website at the New York Times) and other polling web sites makes it abundantly clear that the probability of such Democratic control of the White House and Congress is so small that it’s hardly worth discussing.

What About Fiscal Policy Reform?

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with either a Romney or Obama White House to work together constructively to address not only the short-term fiscal cliff at the end of this calendar year, but also the longer-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “if’s”) it turns out to be easier politically to eschew increases in taxes on labor and investment and therefore turn to taxes on consumption, then there could be a political opening for new energy taxes, in particular, (drum roll ….) a carbon tax.

Such a carbon tax – if intended to help alleviate budget deficits – could not be the economist’s favorite, a revenue-neutral tax swap of cutting distortionary taxes in exchange for implementing a carbon tax.  Rather, as a revenue-raising mechanism – like the Obama administration’s February 2009 budget for a 100%-auction of allowances in a cap-and-trade scheme – it would be a new tax, pure and simple.  Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – are not optimistic.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax.  The key question is whether the phrases “climate policy” or “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure.  The key group to bring on board will presumably be conservative Tea Party Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.


Even if the much-ballyhooed political opening for carbon taxes is largely illusory, the opening for policy wonks is real.  And here is where action is happening, and should continue to happen.  At some point the politics will change, and it’s important to be ready.  This is why economic research on carbon taxes is very much needed, particularly in the context of broader fiscal challenges, and it is why I’m pleased to see it happening at Resources for the Future, Harvard University, and elsewhere.

Bottom Line

I would personally be delighted if a carbon tax were politically feasible in the United States, or were to become politically feasible in the future.  But I’m forced to conclude that much of the current enthusiasm about carbon taxes in the academic and broader policy-wonk community in the wake of the defeat of cap-and-trade is – for the time being, at least – largely a manifestation of the grass looking greener across the street.

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)?

The Promise and Problems of Pricing Carbon

Friday, October 21st was a significant day for climate change policy worldwide and for the use of market-based approaches to environmental protection, but it went largely unnoticed across the country and around the world, outside, that is, of the State of California.  On that day, the California Air Resources Board voted unanimously to adopt formally the nation’s most comprehensive cap-and-trade system, intended to provide financial incentives to firms to reduce the state’s greenhouse gas (GHG) emissions, notably carbon dioxide (CO2) emissions, to their 1990 level by the year 2020, as part of the implementation of California’s Assembly Bill 32, the Global Warming Solutions Act of 2006.  Compliance will begin in 2013, eventually covering 85% of the state’s emissions.

This policy for the world’s eighth-largest economy is more ambitious than the much heralded (and much derided) Federal policy proposal – H.R. 2454, the Waxman-Markey bill – that was passed by the U.S. House of Representatives in June of 2009, and then died in the U.S. Senate the following year.  With a likely multi-year hiatus on significant climate policy action in Washington now in place, California’s system – which will probably link with similar cap-and-trade systems being developed in Ontario, Quebec, and possibly British Columbia – will itself become the focal point of what may evolve to be the “North American Climate Initiative.”

The Time is Ripe for Reflection

California’s formal adoption of its CO2 cap-and-trade system is an important milestone on the multinational path to carbon pricing policies, and signals that the time is ripe to reflect on the promise and problems of pricing carbon, which is the title of a new paper that Joe Aldy and I have written for a special issue of the Journal of Environment and Development edited by Thomas Sterner and Maria Damon on “Experience with Environmental Taxation” (“The Promise and Problems of Pricing Carbon:  Theory and Experience,” October 27, 2011).  [For anyone who is not familiar with my co-author, let me state for the record that Joseph Aldy is an Assistant Professor of Public Policy at the Harvard Kennedy School, having come to Cambridge, Massachusetts, from Washington, D.C., where he served, most recently, during 2009 and 2010, as Special Assistant to the President for Energy and Environment.  Before that, he was a Fellow at Resources for the Future, the Washington think tank.]

Why Price Carbon?

In a modern economy, nearly all aspects of economic activity affect greenhouse gas – in particular, CO2 – emissions.  Hence, for a climate change policy to be effective, it must affect decisions regarding these diverse activities.  This can be done in one of three ways:  mandating that businesses and individuals change their behavior; subsidizing businesses and individuals; or pricing the greenhouse gas externality.

As economists and virtually all other policy analysts now recognize, by internalizing the externalities associated with CO2 emissions, carbon pricing can promote cost-effective abatement, deliver powerful innovation incentives, and – for that matter – ameliorate rather than exacerbate government fiscal problems.  [See the concise and compelling argument made by Yale Professor William Nordhaus in his essay, “Energy:  Friend or Enemy?” in The New York Review of Books, October 27, 2011.]

By pricing CO2 emissions (or, more likely, by pricing the carbon content of the three fossil fuels – coal, petroleum, and natural gas), governments wisely defer to private firms and individuals to find and exploit the lowest cost ways to reduce emissions and invest in the development of new technologies, processes, and ideas that could further mitigate emissions.

Can Market-Based Instruments Really Work?

Market-based instruments have been used with considerable success in other environmental domains, as well as for pricing CO2 emissions.  The U.S. sulfur dioxide (SO2) cap-and-trade program cut U.S. power plant SO2 emissions more than 50 percent after 1990, and resulted in compliance costs one half of what they would have been under conventional regulatory mandates.

The success of the SO2 allowance trading program motivated the design and implementation of the European Union’s Emission Trading Scheme (EU ETS), the world’s largest cap-and-trade program, focused on cutting CO2 emissions from power plants and large manufacturing facilities throughout Europe.  The U.S. lead phase-down of gasoline in the 1980s, by reducing the lead content per gallon of fuel, served as an early, effective example of a tradable performance standard.  These and other positive experiences provide motivation for considering market-based instruments as potential approaches to mitigating GHG emissions.

What Policy Instruments Can be Used for Carbon Pricing?

In our paper, Joe Aldy and I critically examine the five generic policy instruments that could conceivably be employed by regional, national, or even sub-national governments for carbon pricing:  carbon taxes, cap-and-trade, emission reduction credits, clean energy standards, and fossil fuel subsidy reduction.  Having written about these approaches many times in previous essays at this blog, today I will simply direct the reader to those previous posts or, better yet, to the paper we’ve written for the Journal of Environment and Development.

Although it is natural to think and talk about carbon pricing using the future tense, a few carbon pricing regimes are already in place.

Regional, National, and Sub-National Experiences with Carbon Pricing

Explicit carbon pricing policy regimes currently in place include the European Union’s Emissions Trading Scheme (EU ETS); the Regional Greenhouse Gas Initiative in the northeast United States; New Zealand’s cap-and-trade system; the Kyoto Protocol’s Clean Development Mechanism; a number of northern European carbon tax policies; British Columbia’s carbon tax; and Alberta’s tradable carbon performance standard (similar to a clean energy standard).  We describe and assess all of these in our paper.

Also, the Japanese Voluntary Emissions Trading System has operated since 2006 (Japan is considering a compulsory emissions trading system), and Norway operated its own emissions trading system for several years before joining the EU ETS in 2008.  Legislation to establish cap-and-trade systems is under debate in Australia (combined with a carbon tax for an initial three-year period) and in the Canadian provinces of Ontario and Quebec.  And, of course, California is now committed to launching its own GHG cap-and-trade system.

International Coordination Will Be Needed

Of course, climate change is truly a global commons problem:  the location of greenhouse gas emissions has no effect on the global distribution of damages.  Hence, free-riding problems plague unilateral and multilateral approaches, because mitigation costs are likely to exceed direct benefits for virtually all countries.  Cost-effective international policies – insuring that countries get the most environmental benefit out of their mitigation investments – will help promote participation in an international climate policy regime.

In principle, internationally-employed market-based instruments can achieve overall cost effectiveness.  Three basic routes stand out.  First, countries could agree to apply the same tax on carbon (harmonized domestic taxes) or adopt a uniform international tax.  Second, the international policy community could establish a system of international tradable permits, – effectively a nation-state level cap-and-trade program.  In its simplest form, this represents the Kyoto Protocol’s Annex B emission targets and the Article 17 trading mechanism.  Third and most likely, a more decentralized system of internationally-linked domestic cap-and-trade programs could ensure internationally cost-effective emission mitigation.  We examine the merits and the problems associated with each of these means of international coordination in the paper.

What Lies in the Future?

In reality, political responses in most countries to proposals for market-based approaches to climate policy have been and will continue to be largely a function of issues and factors that transcend the scope of environmental and climate policy.  Because a truly meaningful climate policy – whether market-based or conventional in design – will have significant impacts on economic activity in a wide variety of sectors and in every region of a country, proposals for these policies inevitably bring forth significant opposition, particularly during difficult economic times.

In the United States, political polarization – which began some four decades ago, and accelerated during the economic downturn – has decimated what had long been the key political constituency in the Congress for environmental action, namely, the middle, including both moderate Republicans and moderate Democrats.  Whereas Congressional debates about environmental and energy policy had long featured regional politics, they are now fully and simply partisan.  In this political maelstrom, the failure of cap-and-trade climate policy in the U.S. Senate in 2010 was essentially collateral damage in a much larger political war.

It is possible that better economic times will reduce the pace – if not the direction – of political polarization.  It is also possible that the ongoing challenge of large budgetary deficits in many countries will increase the political feasibility of new sources of revenue.  When and if this happens, consumption taxes (as opposed to traditional taxes on income and investment) could receive heightened attention, and primary among these might be energy taxes, which can be significant climate policy instruments, depending upon their design.

That said, it is probably too soon to predict what the future will hold for the use of market-based policy instruments for climate change.  Perhaps the two decades we have experienced of relatively high receptivity in the United States, Europe, and other parts of the world to cap-and-trade and offset mechanisms will turn out to be no more than a relatively brief departure from a long-term trend of reliance on conventional means of regulation.  It is also possible, however, that the recent tarnishing of cap-and-trade in U.S. political dialogue will itself turn out to be a temporary departure from a long-term trend of increasing reliance on market-based environmental policy instruments.  It is much too soon to say.

A Wave of the Future: International Linkage of National Climate Change Policies

The latest rage in Washington policy discussions these days (that’s relevant to climate change) is renewed interest in renewable electricity standards, this time in the form of so-called “clean energy standards.”  I’ve written about this policy approach recently at this blog (Renewable Energy Standards: Less Effective, More Costly, but Politically Preferred to Cap-and-Trade?, January 11, 2011), and will do so again in the near future, but for today I want to turn to an important issue – for the long term – on the related topic of the international dimensions of climate change policy.

The Current State of Affairs

Despite the death in the U.S. Senate last year of serious consideration of an economy-wide cap-and-trade system for carbon dioxide (CO2) emissions – and the apparent political hiatus of such consideration at least until after the November 2012 elections – a major cap-and-trade system for greenhouse gas (GHG) emissions is in place in the European Union; similar systems are in place or under development in New Zealand, California, and several Canadian provinces; systems are being considered at the national level in Australia, Canada, and Japan; and a global emission reduction credit scheme – the Clean Development Mechanism (CDM) – has an enthusiastic and important constituency of supporters in the form of the world’s developing countries.

So, despite the fact that there has been an undeniable loss of momentum due to recent political developments in Australia, Japan, and the United States, it remains true that cap-and-trade is still the most likely domestic policy approach for CO2 emissions reductions throughout the industrialized world, given the rather unattractive set of available alternative approaches.  This makes it important to think about the possibility of linking these national and regional cap-and-trade systems in the future.  Such linking occurs when the government that maintains one system allows regulated entities to use allowances or credits from other systems to meet compliance obligations.

Thinking About Linkage

In 2007, with support from the International Emissions Trading Association (IETA) and the Electric Power Research Institute (EPRI), Judson Jaffe and I analyzed the opportunities and challenges presented by linking tradable permit systems.  Jaffe was then at Analysis Group in Boston, and is now at the U.S. Department of the Treasury.  We presented our findings at the thirteenth Conference of the Parties of the U.N. Framework Convention on Climate Change in Bali, Indonesia, in December, 2007.  In 2010, Matthew Ranson (a Ph.D. student in Public Policy at Harvard), Jaffe, and I expanded on these ideas in an article that was published in Ecology Law Quarterly, “Linking Tradable Permit Systems:  A Key Element of Emerging International Climate Policy.” In today’s blog post, I summarize the highlights of this complex, yet important topic.

First, for anyone new to this territory, let me review the basic facts.  Tradable permit systems fall into two categories:  cap-and-trade and emission reduction credits.  Under cap-and-trade (CAT), the total emissions of regulated sources are capped and the sources are required to hold allowances equal to their emissions.  Under a credit system, entities that voluntarily undertake emission reduction projects are awarded credits that can be sold to participants in cap-and-trade systems.

The Merits of Linking

By broadening markets for allowances and credits, linking increases the liquidity and improves the functioning of markets.  Linking can reduce the costs of the linked systems by making it possible to shift emission reductions across systems.  Just as allowance trading within a system allows higher-cost emission reductions to be replaced by lower-cost reductions, trading across systems allows higher-cost reductions in one system to be replaced by lower-cost reductions in another system.

Other Implications

Along with the cost savings it can offer, linking has other implications that warrant serious consideration.  Under some circumstances, linked systems collectively will not achieve the same level of emission reductions as they would absent linking.  This can result either from a link’s impact on emissions under the linked systems, or from its impact on emissions leakage from those systems.  Linking also has distributional impacts across and within systems.  And linking can reduce the control that a country has over the impacts of its tradable permit system.  In particular, when a domestic CAT system is linked with another CAT system, decisions by the government overseeing the other system can influence the domestic system’s allowance price, distributional impacts, and emissions.

By the way, linkage can also occur among a heterogeneous set of domestic policy instruments, including carbon taxes and various types of regulation, although the linking is more challenging under such circumstances.  On this, see “Linking Policies When Tastes Differ: Global Climate Policy in a Heterogeneous World,” a discussion paper by Gilbert Metcalf, Department of Economics, Tufts University,  and David Weisbach, University of Chicago Law School, for the Harvard Project on Climate Agreements.

Concerns About Linking

Importantly, trading brought about by unrestricted links between CAT systems will lead to the automatic propagation of certain design elements, including:  offset provisions and linkages with other systems; banking and borrowing of allowances across time; and safety-valve provisions.  If these provisions, sometimes characterized as cost-containment measures, are present in one of the linked systems, they will automatically be made available to participants in the other system.

In the near-term, some links will be more attractive and easier to establish than others.  Given the design-element propagation implications of two-way links between cap-and-trade systems, to facilitate such links it may be necessary to harmonize some design elements.  And in some cases, it may be necessary to establish broader international agreements governing aspects of the design of linked cap-and-trade systems beyond mutual recognition of allowances.

An Emerging De Facto International Climate Policy Architecture?

Whereas some two-way links between cap-and-trade systems may thus take more time to establish, in the near-term one-way links between cap-and-trade and credit systems likely will be more attractive and easier to establish.  A one-way link with a credit system may offer a cap-and-trade system greater cost savings than a two-way link with another cap-and-trade system.  Also, such one-way links can only reduce allowance prices in the cap-and-trade system, giving a government greater control over its system than if it established a two-way link with another cap-and-trade system.  The additionality problem is an important concern associated with such links, but it can be managed – to some degree – through the criteria established for awarding or recognizing credits.

Most important, if emerging cap-and-trade systems link with a common credit system, such as the CDM, this will create indirect links among the cap-and-trade systems.  Through the indirect links that they create, such one-way linkages can achieve much of the near-term cost savings and risk diversification that direct two-way links among cap-and-trade systems would achieve.  And they can do this without requiring the same foundation that likely would be needed to establish direct two-way links, such as harmonization of cost-containment measures.  Such linkage may well emerge as part of the de facto post-Kyoto international climate policy architecture, and is fully consistent with the bottom-up, decentralized approach of the Cancun Agreements.


For much more detailed discussions, here are some publications available on the web that describe various aspects of linkage:

Jaffe, Judson, Matthew Ranson, and Robert Stavins.  “Linking Tradable Permit Systems:  A Key Element of Emerging International Climate Policy Architecture.” Ecology Law Quarterly 36(2010):789-808.

Jaffe, Judson, and Robert Stavins.  “Linkage of Tradable Permit Systems in International Climate Policy Architecture.” The Harvard Project on International Climate Agreements, Discussion Paper 08-07, Cambridge, Massachusetts, September, 2008.

Jaffe, Judson, and Robert Stavins. Linking a U.S. Cap-and-Trade System for Greenhouse Gas Emissions: Opportunities, Implications, and Challenges. Washington, D.C.: AEI-Brookings Joint Center for Regulatory Studies, January 2008.

Jaffe, Judson, and Robert Stavins.  Linking Tradable Permit Systems for Greenhouse Gas Emissions: Opportunities, Implications, and Challenges. Prepared for the International Emissions Trading Association, Geneva, Switzerland. November, 2007.

Also, this issue of linkage among tradable permit systems has come up previously in a number of my essays at this blog:

AB 32, RGGI, and Climate Change: The National Context of State Policies for a Global Commons Problem

The Real Options for U.S. Climate Policy

What Hath Copenhagen Wrought? A Preliminary Assessment of the Copenhagen Accord

Only Private Sector Can Meet Finance Demands of Developing Countries

Approaching Copenhagen with a Portfolio of Domestic Commitments

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

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.

Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy

For many years, there has been a great deal of discussion about carbon-pricing – whether carbon taxes or cap-and-trade – as an essential part of a meaningful national climate policy.  It has long been recognized that although carbon-pricing will be necessary, it will not be sufficient. Economists and other policy analysts have noted that policies intended to foster climate-friendly technology research and development (R&D) will also be necessary, but likewise will not be sufficient on their own.

Some recent studies and press accounts, which I reference below, have identified these two approaches to addressing CO2 emissions as substitutes, rather than complements.  That is fundamentally inconsistent with decades of research, and so my purpose in this essay is to set the record straight.

Carbon Pricing:  Necessary But Not Sufficient

First of all, why is there so much talk among policy analysts and policy makers – not simply among academics – about carbon‑pricing as the core of a meaningful strategy to reduce CO2 emissions?  Why, in fact, is this approach so overwhelmingly favored by the analytical community?  The answer is simple and surprisingly pragmatic.

First, there is no other feasible approach that can provide meaningful emissions reductions, such as the 80 percent reduction in national CO2 emissions by 2050 that was part of the legislation passed by the U.S. House of Representatives and proposed in the Senate and part of the Obama administration’s conditional pledge under the Copenhagen Accord.  Because of the ubiquity and diversity of energy use in a modern economy, conventional regulatory approaches –standards of various kinds – simply cannot do the job.  Only carbon pricing – either in the form of carbon taxes or cap-and-trade – can significantly tilt in a climate-friendly direction the millions of decentralized decisions that are made in our economy every day.

Second, carbon-pricing is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources.  Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost.

Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time.

For these reasons, carbon-pricing is a necessary component of a truly meaningful national climate policy.  [I’ve written about this in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”]  However, although it is a necessary policy component, carbon-pricing is not sufficient on its own. This is because there are other market failures that dilute the impacts of price signals on decision makers.

Technology R&D Policies:  Also Necessary, Also Not Sufficient

The most important of these “other market failures” is the public good nature of information.  Companies carrying out research and development (R&D) incur the full costs of their efforts, but they do not capture the full benefits.  This is because even with a perfectly-enforced system of intellectual property rights (such as patents), there are tremendous spillover benefits to other firms.  Decades of economic research – much of it by my former colleague and co-author, Professor Adam Jaffe, now Dean of Arts and Sciences at Brandeis University – has analyzed with empirical (econometric) analysis the remarkable degree to which inventions and innovations by one firm provide valuable information that leads to new inventions and innovations by other firms.

So, firms pay the costs of their R&D, but do not reap all the benefits.  The existence of this positive externality of firms’ R&D – or put differently, the public-good nature of the information generated by R&D – means that the private sector will carry out less than the “efficient” amount of R&D of new climate-friendly technologies in response to given carbon prices.  Hence, other public policies are needed to address this “R&D market failure.”

New path-breaking technologies will be needed to address climate change, and public support for private-sector or public-sector R&D will be crucial to meet this need.  But, at the same time, to address the climate-change market failure itself (that is, the externality associated with greenhouse gas emissions), carbon pricing will be necessary, for all of the reasons I gave above.  This is an application of an important and fundamental principle in economics:  two market failures require the use of two policy instruments.

Empirical analyses have repeatedly verified this crucial point – that combining carbon-pricing with R&D support is more cost-effective than adopting either approach alone.  Included in this set of studies are the following:  Carolyn Fischer (Resources for the Future) and Richard Newell (U.S. Energy Information Administration, on leave from Duke University), “Environmental and Technology Policies for Climate Mitigation”; Stephen Schneider (late of Stanford University) and Lawrence Goulder (Stanford University), “Achieving Low-Cost Emissions Targets”; and Daren Acemoglu (MIT), Philippe Aghion, Leonardo Bursztyn, and David Hemous (Harvard University), “The Environment and Directed Technical Change.”

Complements, Not Substitutes

An interesting, recent column, “Next Step on Policy for Climate,” by David Leonhardt in the New York Times (October 13, 2010, p. B1) might give some people the mistaken impression that technology policies are an adequate, even sensible substitute for carbon-pricing.  That was not the intended message of the column.  In fact, Leonhardt – perhaps the leading economic journalist writing today in the United States ­– indicates clearly in his column that he is skeptical of the notion of thinking of technology subsidies as an adequate substitute for carbon-pricing (in particular, cap-and-trade).  And in a follow-up post at the New York Times’ Economix, he makes clear that “these two policies are not mutually exclusive.”

Nevertheless, Leonhardt’s original column (which included a very nice profile of my colleague, Professor Michael Greenstone of MIT) focused attention on a recent report –  a report that could give the false impression that technology policies would be a sensible substitute for serious carbon-pricing.  The report in question – “Post-Partisan Power” – received significant coverage, primarily because of its sponsorship:  a combination of a prominent Republican-oriented Washington think tank, the American Enterprise Institute (AEI), and an equally prominent Democratic-oriented Washington think tank, the Brooking Institution (and a third partner, the Breakthrough Institute, a California-based environmental think tank).

The report may well garner some bi-partisan political support, because it promises a free lunch of painless, win-win solutions, a promise that will resonate with many elected officials.  Indeed, the report’s sub-title is “how a limited and direct approach to energy innovation can deliver clean, cheap energy, economic productivity, and national prosperity.”  What’s not to like? And the authors are presumably smart and politically shrewd.  I know that’s the case with the AEI author, Steven Hayward, who I debated last year in the pages of the Wall Street Journal.

To its credit, the report lays out a menu of policies intended to stimulate carbon-friendly technological change, ranging from $500 million of Federal government funding of K-12 curriculum development and teacher training to $25 billion annually of direct Federal funding of energy innovation.

For the reasons I explained above (the “R&D market failure” and the “carbon emissions externality”), both direct technology R&D policies and serious carbon-pricing are necessary, but neither is sufficient on its own.  Unfortunately, this new report ­­– and some of the press coverage surrounding it – makes the claim that such direct government funding of technology innovation is a sufficient and sensible substitute for meaningful carbon-pricing.  That claim is both unfortunate and wrong, as it is supported neither by sound reasoning nor empirical research, as I have described above.

Again, many of the individual technology policy recommendations offered by the AEI-Brookings-BI report are worthy of serious consideration (as a complement, not a substitute for an economy-wide carbon-pricing policy).  But the specifics – indeed, much of the meat – are missing.  “Reform the nation’s morass of energy subsidies” – yes, but exactly which subsidies (all of which have important political constituencies behind them) will be eliminated?  “Recognize the potential for nuclear power” – yes, and both the House and Senate carbon-pricing schemes would have provided tremendous incentives for nuclear power investment.

Overall, there should be concern about how all of this will be funded.  Where will the $25 billion per year come from?  The report appropriately states that this should not come from general revenues, and thus add to the Federal debt.  “Phasing out current subsidies for wind, solar, ethanol, and fossil fuels” could be meritorious on its own, but how much does this generate, and does it even pass a political laugh-test?  Interestingly, beyond this, despite considerable rhetoric about moving beyond debates about carbon-pricing, the report recommends that in order to avoid adding to the Federal debt, it would be necessary to impose new taxes, including increased royalties for oil and gas extraction, a tax on imported oil, a tax on electricity sales, and a “very small carbon price” (presumably from a modest carbon tax or unambitious cap-and-trade system).

The actual numbers would be helpful, and the political feasibility remains a serious question.  The political challenges that emerged in the effort to pass cap-and-trade climate legislation will not magically disappear if there’s an attempt to induce Congress to approve $25 billion in funding.  As Tom Friedman noted on October 12th in the New York Times, Congress has not come close to fully funding the outstanding requests for about $4 billion for ARPA-E (energy) research.

More broadly, despite the attraction of the AEI-Brookings-BI proposal as a potential complement to carbon-pricing (and I am serious that the proposal is of value in that context), one has to be very careful about comparing proposed new policies in idealized form (for example, precisely the right subsidies eliminated and precisely the right new subsidies introduced) with real policies with all their warts (for example, the cap-and-trade bill that was passed by the House last year).  Making such comparisons can lead to flawed analysis and misleading results.

This is not a new issue.  Robert Hahn and I wrote about this generic problem nearly 20 years ago in an article (“Economic Incentives for Environmental Protection:  Integrating Theory and Practice”) which appeared the American Economic Review Papers and Proceedings (May 1992).  At the time, our concern was that this mistake was being made not by the opponents but by the supporters of cap-and-trade and other (then essentially untested) market-based instruments.  We worried that “many analysts use highly stylized benchmarks for comparison that ignore likely political realities,” and suggested that an appropriate “comparison would be between actual command-and-control policies and either actual trading [cap-and-trade] programs … or a reasonably constrained theoretical … program.”

Likewise today, when carrying out comparisons of policy alternatives, it is fine to compare two theoretical, idealized alternatives, or to compare two real-world policies, but it is problematic and usually misleading to compare a theoretical, idealized policy of one type with a real-world example of another type of policy.

The Bottom Line

Carbon-pricing – whether carbon taxes or cap-and-trade – will be an essential part of any truly meaningful national climate policy.  Likewise, to address the “R&D market failure,” direct technology innovation policies will also be required.  Both are necessary.  Neither is sufficient.  These are complements, not substitutes.


Postscript: Four years ago, the U.S. Congressional Budget Office (CBO) — widely recognized for its non-partisan, first-rate research — produced a study on the same topic as the AEI-Brookings-BI report, but did so with rigor and without ideology.  The CBO report — Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide Emissions (September 2006) — was prepared by Dr. Terry Dinan, a long-time, respected CBO economist, and was peer reviewed by an impressive set of academic and other experts.  Sadly, the CBO paper received little press coverage, despite its high quality and its relevance.  For anyone interested in the topic of this post, particularly those who disagree with my theme, I hope you will read the CBO report.

Also, a reader of this blog post sent me a paper by David Hart and Kadri Kallas (from MIT’s Energy Innovation working paper series) that examines “Alignment and Misalignment of Technology Push and Regulatory Pull.” It’s worth reading in the context of combining carbon pricing and technology R&D policies.

AB 32, RGGI, and Climate Change: The National Context of State Policies for a Global Commons Problem

Why should anyone be interested in the national context of a state policy?  In the case of California’s Global Warming Solutions Act (AB 32), the answer flows directly from the very nature of the problem — global climate change, the ultimate global commons problem.  Greenhouse gases (GHGs) uniformly mix in the atmosphere.  Therefore, any jurisdiction taking action — whether a nation, a state, or a city — will incur the costs of its actions, but the benefits of its actions (reduced risk of climate change damages) will be distributed globally.  Hence, for virtually any jurisdiction, the benefits it reaps from its climate‑policy actions will be less than the cost it incurs.  This is despite the fact that the global benefits of action may well be greater — possibly much greater — than global costs.

This presents a classic free-rider problem, in which it is in the interest of each jurisdiction to wait for others to take action, and benefit from their actions (that is, free-ride).  This is the fundamental reason why the highest levels of effective government should be involved, that is, sovereign states (nations).  And this is why international, if not global, cooperation is essential. [See the extensive work in this area of the Harvard Project on International Climate Agreements.]

Despite this fundamental reality, there can still be a valuable role for sub-national climate policies.  Indeed, my purpose in this essay is to explore the potential for such state and regional policies — both in the presence of Federal climate policy and in the absence of such policy.  I begin by describing the national climate policy context, and then turn to sub-national policies, such as California’s AB 32 and the Regional Greenhouse Gas Initiative (RGGI) in the northeast.  My focus is on how these sub-national policies will interact with a Federal climate policy.  It turns out that some of the interactions will be problematic, others will be benign, and still others could be positive.  I also examine the role that could be played by sub-national policies in the absence of a meaningful Federal policy, with the conclusion that — like it or not — we may find that Sacramento comes to take the place of Washington as the center of national climate policy.

The (Long-Term) National Context:  Carbon-Pricing

I need not tell readers of this blog that virtually all economists and most other policy analysts favor a national carbon‑pricing policy (whether carbon tax or cap-and-trade) as the core of any meaningful climate policy action in the United States.  Why is this approach so overwhelmingly favored by the analytical community?

First, no other feasible approach can provide truly meaningful emissions reductions (such as an 80% cut in national CO2 emissions by mid-century).  Second, it is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources.  Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost.  Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time.  Fourth, although carbon pricing is not sufficient on its own (because of other market failures that reduce the impact of price signals — more about this below), it is a necessary component of a sensible climate policy, because of factors 1 through 3, above.  [I’ve written about carbon-pricing in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”]

But carbon-pricing is a hot-button political issue.  This is primarily because it makes the costs of the policy transparent, unlike conventional policy instruments, such as performance and technology standards, which tend to hide costs.  Carbon-pricing is easily associated with the dreaded T-word.  Indeed, in Washington, cap-and-trade has been successfully demonized as “cap-and-tax.” As a result, the political reality now appears to be that a national, economy-wide carbon-pricing policy is unlikely to be enacted before 2013.  Does this mean that there will be no Federal climate policy in the meantime?  No, not at all.

The (Short-Term) National Context:  Federal Regulations on the Way or Already in Place

Regulations of various kinds may soon be forthcoming — and in some cases, will definitely be forthcoming — as a result of the U.S. Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding” that emissions of carbon dioxide and other greenhouse gases endanger public health and welfare.  This triggered mobile source standards earlier this year, the promulgation of which identified carbon dioxide as a pollutant under the Clean Air Act, thereby initiating a process of using the Clean Air Act for stationary sources as well.

Those new standards are scheduled to begin on January 2, 2011, with or without the so‑called “tailoring rule” that would exempt smaller sources.  Among the possible types of regulation that could be forthcoming for stationary sources under the Clean Air Act are:  new source performance standards; performance standards for existing sources (Section 111(d)); and New Source Review with Best Available Control Technology standards under Section 165.

The merits that have been suggested of such regulatory action are that it would be effective in some sectors, and that the threat of such regulation will spur Congress to take action with a more sensible approach, namely, an economy-wide cap‑and‑trade system.  However, regulatory action on carbon dioxide under the Clean Air Act will accomplish relatively little and do so at relatively high cost, compared with carbon pricing.  Also, it is not clear that this threat will force the hand of Congress; it clearly has not yet done so.  Indeed, it is reasonable to ask whether this is a credible threat, or will instead turn out to be counter‑productive (when stories about the implementation of inflexible, high‑cost regulatory approaches lend ammunition to the staunchest opponents of climate policy).

It’s also possible that air pollution policies for non‑greenhouse gas pollutants, the emissions of some of which are highly correlated with CO2 emissions, may play an important role.  For example, three‑pollutant legislation focused on SOx, NOx, and mercury could have profound impacts on the construction and operation of coal‑fired electricity plants, without any direct CO2 requirements.  Without any new legislation, a set of rules which could have significant impacts on coal-fired power plants are now making their way through the regulatory process — including regulations affecting ambient ozone, SO2/NO2, particulates, ash, hazardous air pollutants (mercury), and effluent water.

There is also the possibility of new energy policies (not targeted exclusively at climate change) having significant impacts on CO2 emissions.  The possible components of such an approach that would be relevant in the context of climate change include:  a national renewable electricity standard; Federal financing for clean energy projects: energy efficiency measures (building, appliance, and industrial efficiency standards; home retrofit subsidies; and smart grid standards, subsidies, and dynamic pricing policies); and new Federal electricity‑transmission siting authority.

Even without action by the Congress or by the Administration, legal action on climate policy is likely to take place within the judicial realm.  Public nuisance litigation will no doubt continue, with a diverse set of lawsuits being filed across the country in pursuit of injunctive relief and/or damages.  Due to recent court decisions, the pace, the promise, and the problems of this approach remain uncertain.

Beyond the well‑defined area of public nuisance litigation, other interventions which are intended to block permits for new fossil energy investments, including both power plants and transmission lines will continue.  Some of these interventions will be of the conventional NIMBY character, but others will no doubt be more strategic.

But with political stalemate in Washington on carbon-pricing or national climate policy, attention is inevitably turning to regional, state, and even local policies intended to address climate change.

Sub-National Climate Policies

The Regional Greenhouse Gas Initiative (RGGI) in the Northeast has created a cap‑and‑trade system among electricity generators.  More striking, California’s Global Warming Solutions Act (Assembly Bill 32, or AB 32) will likely lead to the creation of a very ambitious set of climate initiatives, including a statewide cap‑and‑trade system (unless it’s stopped by ballot initiative — Proposition 23 — or a new Governor, depending on the outcome of the November 2010 elections).  The California system is likely to be linked with systems in other states and Canadian provinces under the Western Climate Initiative.  Currently, more than half of the 50 states are contemplating, developing, or implementing climate policies.

In the presence of a Federal policy, will such state efforts achieve their objectives?  Will the efforts be cost-effective?  The answer is that the interactions of state policies with Federal policy can be problematic, benign, or positive, depending upon their relative scope and stringency, and depending upon the specific policy instruments used.  This is the topic of a paper which Professor Lawrence Goulder (Stanford University) and I have written, “Interactions Between State and Federal Climate Change Policies” (National Bureau of Economic Research Working Paper 16123, June 2010).

Problematic Interactions

Let’s start with the case of a Federal policy which limits emission quantities (as with cap-and-trade) or uses nationwide averaging of performance (as with some proposals for a national renewable portfolio standard).  In this case, emission reductions accomplished by a “green state” with a more stringent policy than the Federal policy — for example, AB 32 combined with Waxman-Markey/H.R. 2454 — will reduce pressure on other states, thereby freeing, indeed encouraging (through lower allowance prices) emission increases in the other states.  The result would be 100% leakage, no gain in environmental protection from the green state’s added activity, and a national loss of cost-effectiveness.

Potential examples of this — depending upon the details of the regulations — include: first, AB 32 cap-and-trade combined with Federal cap-and-trade (H.R. 2454) or combined with some U.S. Clean Air Act performance standards; second, state limits on GHGs/mile combined with Federal CAFE standards; and third, state renewable fuels standards combined with a Federal RFS, or state renewable portfolio standards combined with a Federal RPS.  A partial solution would be for these Federal programs to allow states to opt out of the Federal policy if they had an equally or more stringent state policy.  Such a partial solution would not, however, be cost-effective.

Benign Interactions

One example of benign interactions of state and Federal climate policy is the case of the Regional Greenhouse Gas Initiative (RGGI) in the northeast.  In this case, the state policies are less stringent than an assumed Federal policy (such as H.R. 2454).  The result is that the state policies become non-binding and hence largely irrelevant.

A second example — that warms the hearts of economists, but appears to be politically irrelevant for the time being — is the case of a Federal policy that sets price, not quantity, i.e., a carbon tax, or a binding safety-valve or price collar in a cap-and-trade system.  In this case, more stringent actions in green states do not lead to offsetting emissions in other states induced by a changing carbon price.  It should be noted, however, that there will be different marginal abatement costs across states, and so aggregate reductions would not be achieved cost-effectively.

Positive Interactions

Three scenarios suggest the possibility of positive interactions of state and Federal climate policies.  First, states can — in principle — address market failures not addressed by a Federal carbon-pricing policy.  A prime example is the principal‑agent problem of insufficient energy‑efficiency investments in renter‑occupied properties, even in the face of high energy prices.  This is a problem that is best addressed at the state or even local level, such as through building codes and zoning.

Second, state and regional authorities frequently argue that states can serve as valuable “laboratories” for policy design, and thereby provide useful information for the development of Federal policy.  However, it is reasonable to ask whether state authorities will allow their “laboratory” to be closed after the experiment has been completed, the information delivered, and a Federal policy put in place.  Pronouncements from some state leaders should cause concern in this regard.

Third, states can create pressure for more stringent Federal policies.  A timely example is provided by California’s Pavley I motor-vehicle fuel-efficiency standards and the subsequent change in Federal CAFE requirements.  There is historical validation of this effect, with California repeatedly having increased the stringency of its local air pollution standards, followed by parallel Federal action under the Clean Air Act.  This linkage is desirable if the previous Federal policy is insufficiently stringent, but whether that is the case is an empirical question.

Thus, in the presence of Federal climate policy, interactions with sub-national policies can be problematic, benign, or positive, depending upon the relative scope and stringency of the sub-national and national policies, as well as the particular policy instruments employed at both levels. [For a more rigorous derivation of the findings above, as well as an examination of a larger set of examples, please see my paper with Stanford Professor Lawrence Goulder, referenced above.]

But comprehensive Federal carbon-pricing policy appears to be delayed until 2013, at the earliest.  And it is possible that pending Federal regulatory action under the Clean Air Act will be curtailed or significantly delayed either by the new Congress or by litigation.  Therefore, it is important to consider the role of state and regional climate policies in the absence of Federal action.

Sub-National Climate Policies in the Absence of Federal Action

In brief, in the absence of meaningful Federal action, sub‑national climate policies could well become the core of national action.  Problems will no doubt arise, including legal obstacles such as possible Federal preemption or litigation associated with the so‑called Dormant Commerce Clause.

Also, even a large portfolio of state and regional policies will not be comprehensive of the entire nation, that is, not truly national in scope (for a quick approximation of likely coverage, check out a recent map of blue states and red states).

And even if the state and regional policies were nationally comprehensive, there would be different policies of different stringency in different parts of the country, and so carbon shadow‑prices would by no means be equivalent, meaning that the overall policy objectives would be achieved at excessive social cost.

Is there a solution (if only a partial one)?  Yes.  If the primary policy instrument employed in the state and regional policies is cap-and-trade, then the respective carbon markets can be linked.  Such linkage occurs through bilateral recognition of allowances, which results in reduced costs, reduced price volatility, reduced leakage, and reduced market power.  Good news all around.

Such bottom‑up linkage of state and regional cap‑and‑trade systems could be an important part or perhaps even the core of future of U.S. climate policy, at least until there is meaningful action at the Federal level.  In the meantime, it is at least conceivable — and perhaps likely — that linkage of state‑level cap‑and‑trade systems will become the (interim) de facto national climate policy architecture.

In this way, Sacramento would take the place of Washington as the center of national climate policy deliberations and action.  No doubt, this possibility will please some, and frighten others.


P.S.  For those of you interested in the topic of this blog post, you may also find of particular interest a conference organized by the University of California, taking place in Sacramento on October 4th, “California’s Climate Change Policy:  The Economic and Environmental Impacts of AB 32.”  You can learn more about it by clicking on this link.

In Defense of Markets

Cap-and-trade has been demonized by conservatives as part of an effective strategy to stop climate legislation from moving forward in the U.S. Congress.  As I wrote in my previous blog post (“Beware of Scorched-Earth Strategies in Climate Debates,” July 27, 2010), this unfortunate tarnishing of market-based instruments for environmental protection will come back to haunt conservatives and liberals alike when it becomes politically difficult to use the power of the marketplace to reduce business costs in the pursuit of a wide variety of environmental objectives.

Cap-and-trade has been vilified as a national energy tax, an elaborate Ponzi scheme, and a giveaway to corporate polluters.  The fact that none of these attacks are factually correct has not seemed to reduce their political effectiveness.  This is one element of the poisonous atmosphere which has come to dominate so much of national political discourse, at least in this election year.

When Senate leaders decided they could not assemble the sixty votes necessary to cut-off debate on meaningful climate legislation, they pulled nationwide, economy-wide cap-and-trade off the table, quite possibly until after a new Congress is seated in January of 2013.  But when serious attention is again given to meaningful national climate policy, as it surely will be, consideration will inevitably include carbon-pricing, whether in the form of carbon taxes or cap-and-trade, because these approaches have tremendous advantages over the alternatives (“The Real Options for U.S. Climate Policy,” June 23rd, 2010).

Therefore, it is important to set the record straight, and respond to at least some of the attacks that have been made on cap-and-trade specifically and carbon-pricing broadly.  That is the fundamental purpose of an Issue Brief Dr. Janet Peace and I have written.  Our report, “In Brief:  Meaningful and Cost Effective Climate Policy:  The Case for Cap and Trade,” was published by the Pew Center on Global Climate Change in June, 2010.  In today’s blog post, I will highlight just a few of our findings.

Questions and Concerns

While the justification for putting a price on carbon emissions seems straightforward to most policy analysts, some of the public and even some policy makers have questioned whether creating a market for greenhouse gas (GHG) reductions would be a cure worse than the disease itself:

  • Why employ market-based approaches to GHG emission reductions, when markets are subject to manipulation?
  • Would a market-based approach to reducing greenhouse gas emissions be a corporate handout?
  • Can markets be trusted to reduce emissions?
  • Will a market-based approach, such as cap-and-trade, be too costly?
  • Are other approaches likely to be more effective and less complicated?

In our Pew Center report, Janet Peace and I respond to all of these questions, but in today’s blog post I will highlight our response just to the first question.  For the full and complete story, I urge readers to see the original report, which can be downloaded freely from the Pew Center’s web site.

Why create a market for GHG emissions, when markets – in general – are subject to manipulation and have failed terribly?

With the U.S. economy experiencing its worst recession since the Great Depression, amidst corporate scandals, pyramid schemes, and a series of government bailouts, some members of the public as well as elected officials have come to question the ability of markets to perform their basic functions.  Despite the past successes of market mechanisms to address environmental problems such as acid rain, leaded gasoline, and stratospheric ozone depletion, this growing distrust of markets has led some to question whether market-based approaches are appropriate instruments to help tackle the exceptionally challenging problem of global climate change.

The storyline goes roughly like this:  establishing a “carbon market” for greenhouse gas emissions opens the door for financial intermediaries – banks and brokers – to be involved.  Since we know that they cannot be trusted, and only care about making profits (and not about reducing emissions), how could any approach that involves them be part of an effective solution?

In reality, of course, our recent economic turmoil does not mean that “markets” in any general sense do not work; only that markets require appropriate oversight.  Our economy fundamentally is a market-based system, but oversight – including, where appropriate, effective rules and regulations – can be essential to ensure transparency and prevent manipulation.

With appropriate rules and oversight, markets have been shown to work exceptionally well to address environmental problems.  They provide key flexibility to regulated entities to adopt least-cost approaches to emission reductions, while providing powerful incentives for technological innovation and diffusion, which serve to reduce costs over time.  Real world experiences with using market-based instruments for environmental protection include CFC trading under the Montreal Protocol (to protect the ozone layer); SO2 allowance trading under the U.S. Clean Air Act Amendments of 1990 (to curb acid rain); NOx trading (to control regional smog in the eastern U.S.); and eliminating lead from gasoline in the 1980s.

Studies that have evaluated the performance of these market-based approaches to environmental protection have found that they have achieved their environmental objectives and have done so at lower cost than conventional, command-and-control approaches.  Estimates of cost savings range from 7 percent to 96 percent, with more than half of studies showing that market-based programs cut the cost of regulation by well over 50% compared with command-and-control options.  For example, the SO2 allowance trading program resulted in 33 percent cost savings — on the order of $1 billion annually, while reducing power-sector emissions from 15.7 million tons in 1990 to 7.6 million tons million tons in 2008.  The phase-down of leaded gasoline in the 1980s, which employed trading of environmental credits, was also successful in meeting its environmental targets, while yielding cost savings of about $250 million per year.

The evidence is incontrovertible – market-based approach to environmental protection can work, effectively achieving environmental targets and keeping costs to a minimum.  These approaches are not deregulation, but reformed and improved regulation.  And like all markets, these environmental markets need rules and oversight.

A Real and Pressing Problem

The fundamental reason why we face the threat of global climate change is that there is no price or cost for emitting greenhouse gases.  In the absence of a price, the damages associated with a changing climate are not considered by companies or individuals when they make their energy choices.  A cap-and-trade policy creates this price by establishing a limit on the amount of greenhouse gas emissions and allowing firms covered by the program the flexibility to trade allowances.  The environmental integrity of the program is ensured by the “cap” on emissions, and the costs of the program are kept as low as possible through the creation of a market (where firms can buy and sell allowances).

Concern about financial markets and fraudulent investment scams has created an atmosphere of distrust regarding the functioning and effectiveness of markets.  By extension, questions have been raised about the wisdom of creating a market with a cap-and-trade program for controlling greenhouse gases.  In truth, appropriate oversight and regulation of carbon markets will be required.  The problem has been the abuse of markets, not something fundamental about markets themselves.

Climate change is a real and pressing problem.  Strong government actions are required, as well as enlightened political leadership at the national and international levels. Creation of a market for greenhouse gas emissions can work, but is contingent on government action to establish this policy.  When the Congress decides to return to this issue ­– as it inevitably will – cap-and-trade policy specifically and carbon-pricing generally must be considered seriously and debated honestly, otherwise it will be fundamentally impossible to provide the right incentives to put the United States on a climate-friendly path of robust and sustainable economic growth.


P.S.  For those of you interested in the important climate policy developments that are occurring in the state of California, you may find of interest a conference organized by the University of California, taking place in Sacramento on October 4th, “California’s Climate Change Policy:  The Economic and Environmental Impacts of AB 32.”  You can learn more about it by clicking on this link.

Beware of Scorched-Earth Strategies in Climate Debates

With the apparent collapse last week of U.S. Senate consideration of a meaningful climate policy, it is important to reflect on what could be a very serious long-term casualty of these acrimonious climate policy debates, namely the demonizing of cap-and-trade and the related tarnishing of market-based approaches to environmental protection.

In an op-ed which appeared on July 27th in The Boston Globe (click here for link to the original op-ed), Richard Schmalensee and I commented on this unfortunate outcome of U.S. political debates and described the irony that the attack on cap-and-trade – and carbon-pricing, more broadly – has been led by conservatives, who should take pride as the creators of these cost-effective policy innovations in three Republican administrations.

Rather than summarize (or expand on) our op-ed, I simply re-produce it below as it was published by The Boston Globe, with some hyperlinks added for interested readers.

By the way, for anyone who is not familiar with Dick Schmalensee, let me 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 Council of Economic Advisers in the George H. W. Bush administration from 1989 to 1991.


The Power of Cap-and-Trade

by Richard Schmalensee and Robert Stavins

The Boston Globe, July 27, 2010

LAST WEEK, the Senate abandoned its latest attempt to pass climate legislation that would limit carbon dioxide emissions, putting off any action until the fall at the soonest. In the process, conservative Republicans dubbed the cap-and-trade systemcap-and-tax.’’ Regardless of what they think about climate change, however, they should resist demonizing market-based approaches to environmental protection and reverting to pre-1980s thinking that saddled business and consumers with needless costs.

In fact, market-based policies should be embraced, not condemned by Republicans (as well as Democrats). After all, these policies were innovations developed by conservatives in the Reagan, George H. W. Bush, and George W. Bush administrations (and once strongly condemned by liberals).

In the 1980s, President Ronald Reagan’s Environmental Protection Agency successfully put in place a cap-and-trade system to phase out leaded gasoline. The result was a more rapid elimination of leaded gasoline from the marketplace than anyone had anticipated, and at a savings of some $250 million per year, compared with a conventional no-trade, command-and-control approach.

In June 1989, President George H. W. Bush proposed the use of a cap-and-trade system to cut by half sulfur dioxide emissions from coal-fired power plants and consequent acid rain. An initially resistant Democratic Congress overwhelmingly endorsed the proposal. The landmark Clean Air Act amendments of 1990 passed the Senate 89 to 10 and the House 401 to 25. That cap-and-trade system has cut sulfur dioxide emissions by 50 percent, and has saved electricity companies — and hence shareholders and ratepayers — some $1 billion per year compared with a conventional, non-market approach.

In 2005, George W. Bush’s EPA issued the Clean Air Interstate Rule, aimed at achieving the largest reduction in air pollution in more than a decade, including reducing sulfur dioxide emissions by a further 70 percent from their 2003 levels. Cap-and-trade was again the policy instrument of choice in order to keep costs down and achieve the rapid reductions at minimum economic pain. (The rule was later invalidated by the courts, and is now being reformulated.)

To reject this legacy and embrace the failed 1970s policies of one-size-fits-all regulatory mandates would signify unilateral surrender of principled support for markets. If some conservatives oppose energy or climate policies because of disagreement about the threat of climate change or the costs of those policies, so be it. But in the process of debating risks and costs, there should be no tarnishing of market-based policy instruments. Such a scorched-earth approach will come back to haunt when future environmental policies will not be able to use the power of the marketplace to reduce business costs.

Virtually all economists agree on a market-based approach to reduce carbon dioxide emissions. Some favor carbon taxes combined with revenue-neutral cuts in distortionary taxes, whereas others support cap-and-trade mechanisms — or “cap-and-dividend,’’ with revenues from auctioned allowances refunded directly to citizens.

Conventional approaches advanced as “painless alternatives’’ — a plethora of standards, special-interest technology subsidies, and tax breaks — won’t do the job, and will be unnecessarily expensive. While we are struggling to revitalize the economy, we simply cannot afford to turn our backs on markets and impose unnecessary costs on businesses and consumers.

A price on carbon is the least costly way to provide meaningful incentives for technology innovation and diffusion, reduce emissions from fossil fuels, and drive energy efficiency. In the long run, it can reduce our use of oil and drive our transportation system toward alternative energy sources.

Market-based approaches to environmental protection – including cap-and-trade – should be lauded, not condemned, by political leaders, no matter what their party affiliation. Demonizing cap-and-trade in the short term will turn out to be a mistake with serious long-term consequences for the economy, for business, and for consumers.

The Real Options for U.S. Climate Policy

The time has not yet come to throw in the towel regarding the possible enactment in 2010 of meaningful economy-wide climate change policy (such as that found in the Waxman-Markey legislation passed by the U.S. House of Representatives in June, 2009, or the more recent Kerry-Lieberman proposal in the Senate).  Meaningful action of some kind is still possible, or at least conceivable.  But with debates regarding national climate change policy becoming more acrimonious in Washington as midterm elections approach, it is important to ask, what are the real options for climate policy in the United States – not only in 2010, but in 2011 and beyond.  That’s the purpose of this essay.

Federal Policy Options

Let’s begin my considering Federal policy options under two distinct categories:  pricing instruments and other approaches.  Carbon-pricing instruments could take the form of caps on the quantity of emissions (cap-and-trade, cap-and-dividend, or baseline-and-credit), or approaches that directly put carbon prices in place (carbon taxes or subsidies).  Beyond pricing instruments, the other approaches include regulation under the Clean Air Act, energy policies not targeted exclusively at climate change, public nuisance litigation, and NIMBY and other public interventions to block permits for new fossil-fuel related investments.  I will discuss each of these in turn.

Quantity-Based Carbon Pricing

I’ve frequently written about cap-and-trade in the past (See, for example:  Here We Go Again: A Closer Look at the Kerry-Lieberman Cap-and-Trade Proposal; Eyes on the Prize:  Federal Climate Policy Should Preempt State and Regional Initiatives; Any Hope for Meaningful U.S. Climate Policy? You be the Judge; Confusion in the Senate Regarding Allowance Allocation?; Cap-and-Trade versus the Alternatives for U.S. Climate Policy; Can Countries Cut Carbon Emissions Without Hurting Economic Growth?; Cap-and-Trade: A Fly in the Ointment? Not Really; National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead; Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal; The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey; The Making of a Conventional Wisdom), and so I will be very brief on this instrument in this essay.

A Quick Reminder about Cap-and-Trade

In brief, there are four principal merits of the cap-and-trade approach to achieving significant reductions of carbon dioxide (CO2) emissions.  First, this approach achieves overall targets at minimum aggregate cost, that is, it is cost-effective, both in the short term by allocating responsibility among sources, and in the long term, by providing price signals that will drive technological innovation and diffusion of carbon-friendly technologies.  Second, the allowance allocation under a cap-and-trade system can be used to build a constituency of political support across sectors and geographic areas without driving up the cost of the program or reducing its environmental performance.  Third, we have significant experience in the United States with the use of this approach, including during the 1980s to phase out leaded gasoline from the marketplace, and since the 1990s to cut acid rain by 50 percent.  Fourth, and of great importance, a domestic cap-and-trade system can be linked directly and cost-effectively with cap-and-trade systems and emission-reduction-credit systems in other parts of the world to keep costs down domestically.

Three principal concerns have been voiced about cap-and-trade systems in U.S. debates.  First, while a cap-and-trade system constrains the quantity of emissions, the costs of control are left uncertain (although such cost uncertainty can be limited — if not eliminated — through the use of safety valves, price collars, or related mechanisms).  Second, in the wake of concerns regarding the roll that financial markets played in the global recession, there have been many fears about the possibilities of market manipulation in a cap-and-trade system.  A third concern – in a political context – is that this cost-effective approach to environmental protection, pioneered by the Republican administration of President George H. W. Bush, has – ironically — been demonized by conservatives in current debates.

That said, a variety of pending design issues will need to be addressed in the development of any cap-and-trade system, including:  ambition, scope (suddenly important because of a renewed focus in Washington on the possibility of a utility-only cap), point of regulation in the economy, allowance allocation, the role of offsets, cost-containment mechanisms, international competition protection, and regulatory oversight.  (I’ve written about all of these design issues in previous essays at this blog and elsewhere.)

A Design-Change for Cap-and-Trade?

Does the current political climate call for a design change — or at least a name change — for cap-and-trade?   Both stepwise and sectoral approaches are being considered.  A stepwise approach of beginning with one or a few sectors of the economy and subsequently expanding gradually to an economy-wide program was embodied in both the Waxman-Markey legislation and in the Kerry-Lieberman proposal.  Under a sectoral approach, cap-and-trade would be used for some sectors, but other approaches would be used for other parts of the economy.  To some degree, the Kerry-Lieberman proposal embodies this approach.  The current focus in Washington is on the possibility of using cap-and-trade for the electricity sector only.

Although the politics may argue for a stepwise or sectoral approach, it should be recognized that neither is likely to be cost-effective, because it is highly unlikely that marginal abatement costs will be equated across all sectors of the economy without the use of a single (implicit) price on carbon.

So the potential approach now receiving much attention in Washington of employing a cap-and-trade system in the electricity sector only would — in all likelihood — achieve less in terms of overall emissions reductions, and would not be cost-effective (due to the exclusion of other sectors).  However, it is at least conceivable that will prove to be the best among politically-feasible paths to a better future policy.  That is, of course, a political — not an economic — question.

A Populist Approach?

Populism has emerged as a major theme in recent electoral politics in the United States, both from the left and from the right.  What might be characterized as a populist approach would be a cap-and-trade system with 100% of the allowances auctioned and the auction revenue returned directly “to the people.”  Although this is a standard variant of cap-and-trade design, contemporary politics — with its demonization of the phrase “cap-and-trade” — might well argue for a name change:  how about “cap-and-dividend?”

This approach is embodied in the CLEAR Act of Senators Maria Cantwell (D-Washington) and Susan Collins (R-Maine).  The merits of this approach include its simplicity, appearance of fairness, and related appeal to the populist mood.  Concerns, however, include the proposal’s relatively modest environmental achievements (according to an analysis by the World Resources Institute), its overall cost due to restrictions on trading, and its apparent political infeasibility, given its lack of visible support in the Congress.

Other Trading Mechanisms

In addition to cap-and-trade, the other major type of tradable permit system is an emission-reduction-credit system, or baseline-and-credit system.  Because such approaches lack caps, they raise some well-known concerns, in particular the necessity of comparing actual emissions with what emissions would have been in the absence of the policy.  In such a system, the latter is fundamentally unobserved and unobservable.  This is the problem of “additionality,” which comes up in spades in the case of the Clean Development Mechanism (CDM), but also in the context of most other offset programs.

A related trading mechanism is found in the Clean Energy Standards approach, embodied in Senator Richard Lugar’s (R-Indiana) legislative proposal.  This mechanism is similar to a Renewable Portfolio Standard (RPS), but allows for a broader set of qualified sources;  not only renewables, but also nuclear power, fossil fuel power with carbon capture and storage (CCS), and – in principle — efficient natural gas.  If the clean energy credits are denominated in units of carbon free megawatt hours and are tradable, then the merits of this approach include the flexibility that is provided through trading.  The concerns include the lack of an emissions cap, and the difficulty of expanding this approach to other sectors or linking it with a cap-and-trade system.  However, if the clean energy credits are denominated in emissions per megawatt hour, then the program can more easily be converted to or linked with a cap-and-trade system.

Direct Carbon Pricing

A carbon tax system would be similar in design to an upstream cap-and-trade approach.  There is some real interest in this approach, mainly from academics, and there is also what I would characterize as “strategic interest,” principally from those who recognize that once the focus is on carbon taxes rather than other instruments, political debates will inevitably result in less ambitious targets or, in fact, no policy at all.

Carbon Taxes in Brief

Having said this, the merits of a carbon tax approach compared with cap-and-trade include the fact that cost uncertainty is eliminated with the tax approach (although, of course, there is quantity uncertainty, that is, no emissions cap).  And, I mentioned earlier, the cost uncertainty inherent in a cap-and-trade system can be reduced, if not eliminated, with cost-containment mechanisms such as a price collar.

Another merit of the carbon tax approach is that it would generate substantial revenues (as would a cap-and-trade system in which the allowances are auctioned).  These revenues can be used – in principle – for a variety of worthwhile public purposes, including reducing distortionary taxes, which would serve to lower the overall social cost of the policy.  Third, the tax approach is (at least perceived to be) much simpler than the allowance market that would be generated by a cap-and-trade scheme.

Major concerns regarding carbon taxes are fourfold.  First, despite their social cost-effectiveness, pollution taxes can be more costly to the regulated sector than even a non-cost-effective command-and-control instrument.  Second, unlike cap-and-trade, the tax approach lacks a benign mechanism for building political constituency, and is likely to lead to requests for tax exemptions, and hence a less ambitious policy and possibly a more costly one.  Third, although it is not impossible to link such as system internationally (for purposes of cost containment), it is more challenging to do so than with the quantity based cap-and-trade alternative.  A fourth and final concern is the apparent political infeasibility of this approach, at least currently in the United States.

In this regard, it is important to note that what has frequently been interpreted as hostility to cap-and-trade in the U.S. Senate is actually – on closer inspection — broader hostility to the very notion of carbon pricing (or any climate change policy).  Surely, the political reception to a carbon tax would be even less enthusiastic than the reception that has greeted recent cap-and-trade proposals.

Subsidies:  The Good, the Bad, and the Ugly

If it’s so politically difficult to tax “bad behavior,” how about subsidizing “good behavior?”  The mirror image of a tax is indeed a subsidy, and two potential price-based approaches to achieving greenhouse gas emission reductions are the use of climate-friendly subsidies and the elimination of problematic subsidies that exacerbate the climate problem.

In thinking about climate-friendly subsidies, we should first keep in mind that the Obama economic stimulus package enacted by the Congress includes significant subsidies (and tax credits) for renewables and efficiency upgrades — to the tune of about $80 billion.  A major problem has been that the administration (in particular, the Department of Energy) has been finding it difficult to spend the money fast enough.  Also, some would consider subsidies for biofuels, such as ethanol, as falling within this category of climate-friendly subsidies, but clearly that is a matter of considerable controversy.

Principal among the problematic subsidies – and hence major candidates for reduction or elimination – are subsidies for the development and use of fossil fuels.  According to the Environmental Law Institute, U.S. fossil-fuel subsidies and tax breaks currently amount to $8-$10 billon per year.  At the global level, the International Energy Agency has estimated that such fossil-fuel subsidies now amount to $550 billion annually!  President Obama proposed at the G20 meeting in Pittsburgh in November, 2009, that such subsidies be phased out around the world, and there seemed at the time to be broad-based support for this proposal.  However, it should not be surprising that less than a year later, it now appears that the commitment may be watered down somewhat at the G20 meeting in Toronto this June.

The merit of trying to use climate-friendly subsidies is based on the fact that subsidies affect relative prices, much like taxes do, but are much more politically attractive, since politicians prefer to give out benefits rather than costs to their constituents.  And eliminating problematic subsidies can be economically efficient.

But a major concern of using climate-friendly subsidies is that the funds go not only to marginal units that otherwise would not be taking specific actions, but also to infra-marginal units that are pleased to accept the funds, but whose behavior is unaffected by them.  This means that this approach is relatively costly to the government (and to society at large) for what is accomplished.  And a concern of removing fossil fuel subsidies – particularly in the current political climate of worries about oil imports – is that this can work against so-called “energy security” (some have therefore suggested the addition of an “oil import fee”).

Climate Change Regulation under the Clean Air Act

Regulations of various kinds may soon be forthcoming – and in some cases, will definitely be forthcoming – as a result of the U.S. Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding” that emissions of carbon dioxide and other greenhouse gases endanger public health and welfare.  This triggered mobile source standards earlier this year, the promulgation of which identified carbon dioxide as a pollutant under the Clean Air Act, thereby initiating a process of using the Clean Air Act for stationary sources as well.

Those new standards are scheduled to begin on January 1, 2011, with or without the so-called “tailoring rule” that would exempt smaller sources.  Among the possible types of regulation that could be forthcoming for stationary sources under the Clean Air Act include:  new source performance standards; performance standards for existing sources (Section 111(d)); and New Source Review with Best Available Control Technology standards under Section 165.

The merits that have been suggested of such regulatory action are that it would be effective in some sectors, and that the threat of such regulation will spur Congress to take action with a more sensible approach, namely, an economy wide cap-and-trade system.

However, regulatory action on carbon dioxide under the Clean Air Act will accomplish relatively little and do so at relatively high cost, compared with carbon pricing.  Also, it is not clear that this threat will force the hand of Congress.  Indeed it is reasonable to ask whether this is a credible threat, or will instead turn out to be counter-productive (when stories about the implementation of inflexible, high-cost regulatory approaches lend ammunition to the staunchest opponents of climate policy).

Furthermore, there is the question of possible preemption.  Although Senator Lisa Murkowski’s (R-Alaska) resolution was defeated in the Senate, Senator Jay Rockefeller’s (D-West Virginia) proposal of a two-year delay of Clean Air Act regulatory action is still pending; and depending upon the outcome of the November elections, there may be a series of further Congressional actions to tie the hands of EPA in this regard.

Regulation of Conventional Pollutants under the Clean Air Act

It’s also possible that air pollution policies for non-greenhouse gas pollutants, the emissions of some of which are highly correlated with CO2 emissions, may play an important role.  For example, the three-pollutant legislation co-sponsored by Senator Thomas Carper (D-Delaware) and Senator Lamar Alexander (R-Tennessee), focused on SOx, NOx, and mercury, could have profound impacts on the construction and operation of coal-fired electricity plants, without any direct CO2 requirements.  Beyond this, there are also possibilities of policies for the non-CO2 greenhouse gases.

Important, Unanswered Questions

An important pending question regarding EPA’s use of the Clean Air Act is whether EPA may legally create CO2 cap-and-trade or offset markets under existing Clean Air Act authority.  The answer appears to be “probably yes.”  There is positive precedent from EPA’s emissions trading program of the 1970s, and it’s a leaded gasoline phase-down of the 1980s, although recent court decisions regarding the Bush administration’s Clean Air Interstate Rule may cause concern in this regard.

The more important question, however, may turn out to be whether EPA can politically create significant CO2 markets in the face of Congressional opposition.  The answer to this is considerably less clear.

Energy Policies Not Targeted Exclusively at Climate Change

The “positive politics” generated by the Gulf oil spill, combined with the “negative politics” of addressing climate change explicitly, may well increase the likelihood of so-called “energy-only” legislation being enacted this year.  Senator Jeff Bingaman’s (D-New Mexico) bill from the Environment and Natural Resources Committee and perhaps Senator Richard Lugar’s bill will feature centrally in any bipartisan initiative.

The possible components of such an approach which would be relevant in the context of climate change include:  a national renewable electricity standard; Federal financing for clean energy projects: energy efficiency measures (building, appliance, and industrial efficiency standards; home retrofit subsidies; and smart grid standards, subsidies, and dynamic pricing policies); and new Federal electricity-transmission siting authority.

Other Legal Mechanisms

Even without action by the Congress or by the Administration, legal action on climate policy is likely to take place within the judicial realmPublic nuisance litigation will no doubt continue, with a diverse set of lawsuits being filed across the country in pursuit of injunctive relief and/or damages.  Due to recent court decisions, the pace, the promise, and the problems of this approach remain uncertain.

Beyond the well-defined area of public nuisance litigation, other interventions which are intended to block permits for new fossil energy investments, including both power plants and transmission lines will continue.  Some of these interventions will be of the conventional NIMBY character, but others will no doubt be more strategic.

Does the Road to National Climate Policy Need to Go through Washington?

With political stalemate in Washington, attention may increasingly turn to regional, state, and even local policies intended to address climate change.  The Regional Greenhouse Gas Initiative (RGGI) in the Northeast has created a cap-and-trade system among electricity generators.  More striking, California’s Global Warming Solutions Act (Assembly Bill 32, or AB 32) will likely lead to the creation of a very ambitious set of climate initiatives, including a statewide cap-and-trade system (unless it’s stopped by ballot initiative or a new Governor, depending on the outcome of the November 2010 elections).  The California system is likely to be linked with systems in other states and Canadian provinces under the Western Climate Initiative.

These sub-national policies will interact in a variety of ways – some good, some bad — with Federal policy when and if Federal policy is enacted.  As Professor Lawrence Goulder (Stanford University) and I have written in a new paper for the National Bureau of Economic Research (NBER), some of these interactions could be problematic, such as the interaction between a Federal cap-and-trade system and a more ambitious cap-and-trade system in California under AB 32, while other interactions would be benign, such as RGGI becoming somewhat irrelevant in the face of a Federal cap-and-trade system that was both more stringent and broader in scope.

An important question is whether there can be sensible sub-national policies even in the presence of an economy-wide Federal carbon-pricing regime?  The answer is surely yes, partly because other market failures will continue to exist that are not addressed by carbon pricing.  A prime example is the principal-agent problem of insufficient energy-efficiency investments in renter-occupied properties, even in the face of high energy prices.  This is a problem that is best addressed at the state or even local level, such as through building codes and zoning.

In the meantime, in the absence of meaningful Federal action, sub-national climate policies could well become the core of national action.  Problems will no doubt arise, including legal obstacles such as possible Federal preemption or litigation associated with the so-called Dormant Commerce Clause.  Also, even a large portfolio of state and regional policies will not be comprehensive of the entire nation, that is, not truly national in scope.  And even if they are nationally comprehensive, with different policies of different stringency in different parts of the country, carbon shadow-prices will by no means be equivalent, and so overall policy objectives will be achieved at excessive social cost.

Is there a solution, if only a partial one?  Yes, state and regional carbon markets can be linked.  Such linkage occurs as a result of bilateral recognition of allowances, which results in reduced costs, price volatility, leakage, and market power.  Such bottom-up linkage of state and regional cap-and-trade systems may be an important part or perhaps the core of future of U.S. climate policy, at least until there is meaningful action at the Federal level.  In the meantime, it is at least conceivable that linkage of state-level cap-and-trade systems across the United States will become the de facto post-2012 national climate policy architecture.

The Path Ahead

Conventional politics clearly disfavors market-based (pricing) environmental policy approaches that render costs obvious or at least somewhat transparent, despite the fact that the costs of these same policies are actually less than those of alternative approaches.  Instead, conventional politics favors approaches to environmental protection that render costs less obvious (or better yet invisible), such as renewable portfolio standards, and — for that matter — all sorts of command-and-control performance and technology standards.

But carbon pricing will be necessary to address the diverse economy-wide sources of CO2 emissions effectively and at sensible cost, whether the carbon pricing comes about through an economy-wide Federal cap-and-trade system or through a Federal carbon tax.  It is inconceivable that truly meaningful reductions in CO2 emissions could be achieved through purely regulatory approaches, and it remains true that whatever would be achieved, would be accomplished at excessively high cost.

So, although it is true – as I have sought to explain in this essay – that there are a diverse set of options for future climate policy in the United States, the best available alternative to an economy-wide cap-and-trade system enacted in 2010 may be an economy-wide cap-and-trade system enacted in 2011.  But ultimately, the question of what is the best alternative this year to an economy-wide cap-and-trade system is a political, not an economic question.

Who Killed Cap-and-Trade?

In a recent article in the New York Times, John Broder asks “Why did cap-and-trade die?” and responds that “it was done in by the weak economy, the Wall Street meltdown, determined industry opposition and its own complexity.”  Mr. Broder’s analysis is concise and insightful, and I recommend it to readers.  But I think there’s one factor that is more important than all those mentioned above in causing cap-and-trade to have changed from politically correct to politically anathema in just nine months.  Before turning to that, however, I would like to question the premise of my own essay.

Is Cap-and-Trade Really Dead?

Although cap-and-trade has fallen dramatically in political favor in Washington as the U.S. answer to climate change, this approach to reducing carbon dioxide (CO2) emissions is by no means “dead.”

The evolving Kerry-Graham-Lieberman legislation has a cap-and-trade system at its heart for the electricity-generation sector, with other sectors to be phased in later (and it employs another market-based approach, a series of fuel taxes for the transportation sector linked to the market price for allowances).  Of course, due to the evolving political climate, the three Senators will probably not call their system “cap-and-trade,” but will give it some other creative label.

The competitor proposal from Senators Cantwell and Collinsthe CLEAR Act — has been labeled by those Senators as a “cap-and-dividend” approach, but it is nothing more nor less than a cap-and-trade system with a particular allocation mechanism (100% auction) and a particular use of revenues (75% directly rebated to households) — and, it should be mentioned, some unfortunate and unnecessary restrictions on allowance trading.

And we should not forget that cap-and-trade continues to emerge as the preferred policy instrument to address climate change emissions throughout the industrialized world — in Europe, Australia, New Zealand, and Japan (as I wrote about in a recent post).

But back to the main story — the dramatic change in the political reception given in Washington to this cost-effective approach to environmental protection.

A Rapid Descent From Politically Correct to Politically Anathema

Among factors causing this change were:  the economic recession; the financial crisis (linked, in part, with real and perceived abuses in financial markets) which thereby caused great suspicion about markets in general and in particular about trading in intangible assets such as emission allowances; and the complex nature of the Waxman-Markey legislation (which is mainly not about cap-and-trade, but various regulatory approaches).

But the most important factor — by far — which led to the change from politically correct to politically anathema was the simple fact that cap-and-trade was the approach that was receiving the most serious consideration, indeed the approach that had been passed by one of the houses of Congress.  This brought not only great scrutiny of the approach, but — more important — it meant that all of the hostility to action on climate change, mainly but not exclusively from Republicans and coal-state Democrats, was targeted at the policy du jour — cap-and-trade.

The same fate would have befallen any front-running climate policy.

Does anyone really believe that if a carbon tax had been the major policy being considered in the House and Senate that it would have received a more favorable rating from climate-action skeptics on the right?  If there’s any doubt about that, take note that Republicans in the Congress were unified and successful in demonizing cap-and-trade as “cap-and-tax.”

Likewise, if a multi-faceted regulatory approach (that would have been vastly more costly for what would be achieved) had been the policy under consideration, would it have garnered greater political support?  Of course not.  If there is doubt about that, just observe the solid Republican Congressional hostility (and some announced Democratic opposition) to the CO2 regulatory pathway that EPA has announced under its endangerment finding in response to the U.S. Supreme Court decision in Massachusetts vs. EPA.

(There’s a minor caveat, namely, that environmental policy approaches that hide their costs frequently are politically favored over policies that make their costs visible, even if the former policy is actually more costly.  A prime example is the broad political support for Corporate Average Fuel Economy (CAFE) standards, relative to the more effective and less costly option of gasoline taxes.  Of course, cap-and-trade can be said to obscure its costs relative to a carbon tax, but that hardly made much difference once opponents succeeded in labeling it “cap-and-tax.”)

In general, any climate policy approach — if it was meaningful in its objectives and had any chance of being enacted — would have become the prime target of political skepticism and scorn.  This has been the fate of cap-and-trade over the past nine months.

Why is Political Support for Climate Policy Action So Low in the United States?

If much of the political hostility directed at cap-and-trade proposals in Washington has largely been due to hostility towards climate policy in general, this raises a further question, namely, why has there been so little political support in Washington for climate policy in general.  Several reasons can be identified.

For one thing, U.S. public support on this issue has decreased significantly, as has been validated by a number of reliable polls, including from the Gallup Organization.  Indeed, in January of this year, a Pew Research Center poll found that “dealing with global warming” was ranked 21st among 21 possible priorities for the President and Congress.  (It should be noted some polls are not consistent with these.)  This drop in public support is itself at least partly due to the state of the national economy, as public enthusiasm about environmental action has — for many decades — been found to be inversely correlated with various measures of national economic well-being.

Although the lagging economy (and consequent unemployment) is likely the major factor explaining the fall in public support for climate policy action, other contributing factors have been the so-called Climategate episode of leaked e-mails from the University of East Anglia and the damaged credibility of the Intergovernmental Panel on Climate Change (IPCC) due to several errors in recent reports.

Furthermore, the nature of the climate change problem itself helps to explain the relative apathy among the U.S. public.  Nearly all of our major environmental laws have been passed in the wake of highly-publicized environmental events or “disasters,” ranging from Love Canal to the Cuyahoga River.

But the day after Cleveland’s Cuyahoga River caught on fire in 1969, no article in The Cleveland Plain Dealer commented that “the cause was uncertain, because rivers periodically catch on fire from natural causes.”  On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries.  A direct consequence of the “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different.  Unlike the environmental threats addressed successfully in past legislation, climate change is essentially unobservable.  You and I observe the weather, not the climate (note the dramatic difference of opinion about the reality of climate change between climatologists and television weathercasters).  Until there is an obvious and sudden event — such as a loss of part of the Antarctic ice sheet leading to a disastrous sea-level rise — it’s unlikely that public opinion in the United States will provide the bottom-up demand for action that has inspired previous Congressional action on the environment over the past forty years.

Finally, it should be acknowledged that the fiercely partisan political climate in Washington has completed the gradual erosion of the bi-partisan coalitions that had enacted key environmental laws over four decades.  Add to this the commitment by the opposition party to deny the President any (more) political victories in this year of mid-term Congressional elections, and the possibility of progressive climate policy action appears unlikely in the short term.

An Open-Ended Question

There are probably other factors that help explain the fall in public and political support for climate policy action, as well as the changed politics of cap-and-trade.  I suspect that readers will tell me about these.

Any Hope for Meaningful U.S. Climate Policy? You be the Judge.

The current conventional wisdom ­– broadly echoed by the news media and the blogosphere – is that comprehensive, economy-wide CO2 cap-and-trade legislation is dead in the current U.S. Congress, and perhaps for the next several years.

Watch out for conventional wisdoms!  They inevitably appear to be the collective judgment of numerous well-informed observers and sources, but frequently they are little more than the massive repetition of a few sample points of opinion across the echo-chamber of the professional news media and the blogosphere.

Keep in mind that the conventional wisdom as recently as June of 2009 had it that – with the Waxman-Markey bill having been passed triumphantly by the House of RepresentativesSenate action would follow; the only question raised by many commentators was whether the final legislation could be sent to the President for his signature by the time of the Copenhagen climate talks in December.  My, how the conventional wisdom has changed!

But over the past nine months, the politics have not fundamentally changed.  In June of 2009, passage of meaningful climate legislation in the Senate was already unlikely, because of the terrible economic recession in which the country found itself, and – of even greater political salience ­– lingering high rates of unemployment.  And with the lack of Republican support for the stimulus bill, the relatively small (partisan) margin by which the House passed Waxman-Markey, the then-upcoming challenges of health care and financial regulatory reform dominating the legislative calendar, and concerns voiced about climate legislation by moderate Senate Democrats, success in the Senate was always a long-shot.

What is the Likely Legislative Outcome?

In addition to ongoing consideration of an economy-wide cap-and-trade system, another possibility now receiving attention is a utility-only cap-and-trade system, which some members of the Congress inexplicably find more attractive than an economy-wide approach.  The result of such a system would be much less accomplished (forget about the President’s “conditional commitment” under the Copenhagen Accord), and at much greater cost.  This would be equivalent to taking the Northeast’s Regional Greenhouse Gas Initiative (RGGI) as a model for national action.  Not a good idea.

Even more likely is that the Congress would develop a so-called energy-only bill, which would – to a large degree – consist of killing the one part of Waxman-Markey worth saving (the comprehensive CO2 cap-and-trade system), and moving forward with the worst parts of that legislation – the smorgasbord of regulatory initiatives.  As I’ve written previously, those additional elements of the legislation are highly problematic.  When implemented under the cap-and-trade umbrella, many of those conventional standards and subsidies would have no net greenhouse-gas-reducing benefits, would limit flexibility, and would thereby have the unintended consequence of driving up compliance costs. That’s the soft under‑belly of the House legislation.

Without the cap-and-trade umbrella, that same set of standards and subsidies will accomplish very little, and do so at exceedingly high cost.  Take just one example that seems to be popular among politicians – “renewable portfolio standards” (RPS), requirements that all states or all electricity utilities derive some fixed share of their power, say 20%, from renewable sources.  Note, for example, that such an approach does not distinguish between coal and natural gas, despite the dramatically different impacts these fuels have on CO2 emissions (and a host of other environmental outcomes).  Furthermore, although an RPS may displace some new coal-fired generation with other types of generation, there is little, if any, effect on the operation of existing coal-fired power plants.

If those other, regulatory parts of the climate legislation are so ineffective and so costly, why are they so popular with politicians?  The reason is simple.  The costs are hidden.  The government simply mandates that electric utilities or manufacturers take particular actions, employing the best technology available.  Where’s the cost?  Unlike a cap-and-trade system, there’s no analysis and debate about the cost of allowances (and the marginal abatement costs they represent); and unlike a carbon tax, there’s no analysis and no focus on the dollar amount of the tax and the aggregate cost.  That is the unfortunate but fundamental political economy behind much of U.S. environmental policy since the first Earth Day in 1970.

What about Court-Ordered Regulation?

Whether “best-available-control technology standards” are crafted by the Congress or put in place by the Environmental Protection Agency (EPA) under the court-ordered mandate stemming from the Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding,” such an approach will be relatively ineffective and terribly costly for what is accomplished.  The EPA route would essentially apply the mechanisms of the Clean Air Act, intended for localized, “criteria air pollutants,” to CO2, resulting in ineffective and costly regulations.

The White House (and most member of Congress) recognize that this is an inappropriate way to address climate change, but they seem determined to go forward, claiming that this threat will force the hand of Congress to do something more sensible instead.  Unfortunately, this is akin to my telling you that if you don’t do what I want, I will shoot myself in the foot – not a very credible or intelligent threat.  What I am referring to is that costly Clean Air Act regulation of CO2 will play into the hands of right-wing opponents of climate action, creating a poster-child of excessive regulatory intervention that will bring about a backlash against sensible climate policies.  EPA claims that there will be no such excessive regulatory actions, because it will exempt small sources through a so-called “tailoring rule.”  But legal scholars have noted that the tailoring rule stands on questionable legal grounds and could be invalidated by the courts.  In this regard, note that the first lawsuits to stop EPA from exempting small sources are coming from groups on the right, not the left.

Perhaps Senator Murkowski’s proposed joint resolution (H.J. Res. 66), introduced on January 21, 2010, disapproving (stopping) EPA’s regulatory action under the endangerment finding could save the Administration.  The conventional wisdom is that Senator Murkowski’s resolution has no political future, but with a bi-partisan list of 40 co-sponsors, that’s a total of 41 votes (more than the current total of 40 “Yes” and “Probably Yes” votes in the Senate for serious climate legislation, according to Environment and Energy Daily).  And remember that the disapproval resolution requires only 51, not 60 votes in the Senate, under the rules of the enabling statute, the Congressional Review Act of 1996 (signed by President Clinton, and part of the Republican “Contract with America”).  Of course, House action, not to mention signature by President Obama, would also be required for the resolution to take effect.  But a positive vote in the Senate will send a strong political message.

So Is There No Hope for Good Climate Policy?

Here is where it gets interesting, because as much as the current political environment in Washington may seem increasingly unreceptive to an economy-wide cap-and-trade system or some other meaningful and sensible climate policy, there is one promising approach that could actually benefit from the national political climate.

In these pages, I have expressed support for cap-and-trade mechanisms to address climate change, including the system embodied in the Waxman-Markey legislation that emerged from the House in June of last year.  Although that approach is scientifically sound, economically sensible, and may still turn out to be politically acceptable, there’s a modified version of cap-and-trade that could be much more attractive in this era of rampant expressions of populism, coming both from the right (“no new taxes”) and the left (“bash the corporations”).  Neither of those views, of course, is consistent with sound economic thinking on the environment, but it’s nevertheless possible to recognize their national appeal and build upon them.

This could be done with a simple upstream cap-and-trade system in which all of the needed allowances are sold (auctioned) – not given freely – to fossil-fuel producers and importers, and a very large share – say 75% – of the revenue is rebated directly to American households through monthly checks in a progressive scheme through which all individuals receive identical payments.

Such an approach could appeal to the populist sentiments that are increasingly dominating political discourse and judgments in this mid-term election year.  Such a system – which would have direct and visible positive financial consequences (i.e., rebate checks larger than energy price increases) for 80% of American households – might not only not be difficult for politicians to support, but it might actually be difficult for politicians to oppose!

Importantly, even though this is a specific type of cap-and-trade design (which has been known, studied, and proposed for decades), for better political optics, it should be called something else.  How about “cap-and-dividend?”

A CLEAR Answer?

What I’ve described bears a close resemblance to the “Carbon Limits and Energy for America’s Renewal (CLEAR) Act,” sponsored by Senators Maria Cantwell (D-Washington) and Susan Collins (R-Maine).  So, the politics of their proposal looks appealing, and the substance of it looks promising – a simple upstream cap-and-trade system (called something else), with 100% of the allowances auctioned (with a “price collar” on allowance prices to reduce cost uncertainty), 75% of the revenue refunded to all legal U.S. residents, each month, on an equal per capita basis as non-taxable income, the other 25% of the revenue dedicated to specified purposes, including “transition assistance,” and some built-in measures of protection for particularly energy-intensive, trade-sensitive sectors (not unlike Waxman-Markey).

That’s the good news.  The bad news, however, is that the proposal needs to be changed before it can promise to be not only politically attractive, but economically and environmentally sensible.  In particular, as it is currently structured, only producers and importers of fossil fuels can buy the carbon allowances.  In an up-stream system – an approach I have endorsed for years – it is producers and importers that are subject to compliance, that is, must eventually hold the allowances.  That’s fine.  But there is no sound reason to exclude other entities from participating in the auction markets; and doing so will greatly reduce market liquidity.

Furthermore, the Senators’ proposal says that holders of carbon allowances are actually prohibited from creating, selling, purchasing, or trading carbon derivatives, thereby tremendously reducing the efficiency of the market and needlessly driving up costs.  While no doubt borne out of a well-intentioned desire to protect consumers (remembering the recent impacts of mortgage-backed securities on financial markets), the Senators’ approach is akin to responding to a tragic airplane crash by concluding that the best way to protect consumers from air disasters in the future is simply to ban flying.

Less important structurally, but most important environmentally, an analysis by the World Resources Institute (which I have not validated) indicates that the caps – as currently set – would not bring about emissions reductions by 2020 that would even come close to the President’s announced goal of 17% reductions (equivalent to the Waxman-Markey targets), as submitted by the United States under the Copenhagen Accord.

But these and other problems with the CLEAR proposal can – in principle – be addressed while maintaining its basic structure and political attraction.

An Economic Perspective

It is interesting to note that many – perhaps most – economists have long favored the variant of cap-and-trade whereby allowances are auctioned and the auction revenue is used to cut distortionary taxes (on capital and/or labor), thereby reducing the net social cost of the policy.  Cap-and-Dividend moves in another direction.  This system (which was introduced several years ago in the “Sky Trust” proposal) has some merits compared with the economist’s favorite approach of tax cuts, namely that the Cap-and-Dividend scheme addresses some of the distributional issues that would be raised by using the auction revenue to fund tax cuts (which could favor higher income households).  On the other hand, it eliminates the efficiency (cost-effectiveness) gains associated with the tax-cut approach.  In fact, Stanford’s Larry Goulder has estimated that the tax-and-dividend approach would cost 40% more than an approach of combining an auction of allowances with ideal income tax rate cuts.  (By “ideal,” I mean focusing on tax cuts that would lead to the lowest net cost.)

In general, there are sound reasons to seek to compensate consumers for the energy price increases that will be brought about by a cap-and-trade system, or any meaningful climate change policy. But it is important not to insulate consumers from those price increases, as diluting the price signal reduces the effectiveness and drives up the cost of the overall policy.  Thus, “compensation” as in Cap-and-Dividend is fine, but “insulation” is not.

The most politically salient question with the Waxman-Markey approach of freely allocating a significant portion of the allowances to the private sector is how to distribute (that is, who gets) those allowances which are freely allocated.  In this regard, contrary to much of the hand-wringing in the press, the deal-making that took place in the House and may still take place in the Senate for shares of free allowances is an example of the useful and important mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled without reducing the policy’s effectiveness or driving up its cost.

The ultimate political question seems to be whether there is greater (geographic and sectoral) political support for the Waxman-Markey (H.R. 2454) approach of substantial free allocations and targeted use of auction revenue, or if there is greater (populist) political support for the full auction combined with lump-sum rebate which characterizes the “cap-and-dividend” approach.  Alas, the textbook economics preference — full auction combined with cuts of distortionary taxes — appears to be a political, if not academic, orphan.

Approaching Copenhagen with a Portfolio of Domestic Commitments

As we approach the beginning of the Fifteenth Conference of the Parties of the United Nations Framework Convention on Climate Change (UNFCCC) in Copenhagen in December, international negotiations are focused on developing a climate policy framework for the post-2012 period, when the Kyoto Protocol’s first commitment period will have ended.  In addition to negotiations under the UNFCCC, other intergovernmental outlets, including the G8(+5) and the Major Economies Forum, are trying to reach common ground among the world’s major emitters of greenhouse gases.  To date, these efforts have not produced a politically, economically, and environmentally viable structure for a future climate agreement.

In the Harvard Project on International Climate Agreements (a global effort which now includes 35 research initiatives in Australia, China, Europe, India, Japan, and the United States), we continue to investigate promising post-2012 international policy architectures, as part of our on-going effort to help the countries of the world identify the key design elements of a post-2012 architecture that is scientifically sound, economically rational, and politically pragmatic.

One approach we have recently examined is a “portfolio of domestic commitments,” an approach which could be effective, but more flexible and politically palatable than other international arrangements.  Under such a scheme, nations would agree to honor commitments to greenhouse gas emission reductions laid out in their own domestic laws and regulations.  A portfolio of commitments might emerge from a global meeting such as the UNFCCC Conference of the Parties, or a smaller number of major economies could negotiate an agreement among themselves, and then invite other countries to join.

Despite the obvious differences between such a system and the conventional “targets and time tables” approach embodied in the Kyoto Protocol, negotiators should not dismiss this new approach out of hand.  There are several ways to construct a portfolio of domestic commitments, and negotiators have numerous levers available to tailor an agreement to meet their political, economic, and environmental goals.  In a recent Harvard Project Viewpoint, I outlined some basic features of a portfolio approach, highlighted a few major issues and concerns, and discussed the potential feasibility of this approach.

The Portfolio of Domestic Commitments Approach

The core of a portfolio of domestic commitments is agreement among a set of member countries to conform to the climate change mitigation requirements specified by their respective domestic laws, regulations, and official planning documents (the last being domestically binding in centrally planned economies).  The portfolio approach gives member countries free rein to dictate the precise form their domestic commitments will take, whether those be greenhouse gas cap-and-trade systems, carbon taxes, intensity targets, performance or technology standards, or other instruments.  A portfolio agreement should be highly credible, given that it is grounded in domestic commitments, binding in and enforceable by law previously made by the very governments signing on to the international agreement.

Domestic commitments might take the form of specified greenhouse gas emission targets or the form of particular actions that could be taken to reduce emissions, both envisioned in the Bali Action Plan as “nationally-appropriate mitigation actions” (NAMAs).  A target-based approach has the advantage of being transparent and relatively simple to aggregate across countries to reach a global target.  On the other hand, action-oriented goals can be more concrete and may be easier for many governments to implement in the short term.  There is no reason why both targets and actions could not be pursued simultaneously.  Coexistence of multiple approaches is not uncommon in environmental policy.

Ongoing commitments for several years into the future are necessary to stabilize and eventually reduce atmospheric greenhouse gas concentrations to combat climate change.  Under a portfolio approach, these domestic commitments could be represented in a table of national schedules attached to an agreement.  Australia has proposed a model agreement that includes such schedules. The schedules would signal a continuing commitment to the international community, and their inclusion in an international agreement would provide a disincentive for member nations to deviate from them in the future.

Countries would not be limited to acting unilaterally to meet their domestic commitments.  They could choose to submit joint goals or targets — for example, on a regional level — or link with other countries through a multinational carbon trading regime to reduce costs.  (Such linkage is the subject of another Harvard Project paper — by Judson Jaffe and myself.)  The portfolio approach would not be a bar to international cooperation.

A primary consideration for a portfolio agreement is the well-established principle of “common but differentiated responsibilities.”  This principle acknowledges that responsibility is shared for solving the climate change challenge, but suggests that historical differences in contribution to the problem and economic and technical disparities be reflected in varying national commitments.  A portfolio of domestic commitments may be particularly well-suited to implement this principle because it allows for countries to make commitments along a continuum of stringency, rather than dividing nations into two groups as did the Kyoto Protocol.  The placement of each country upon the continuum would depend on an array of political, economic, and environmental concerns.  (On this, see recent Harvard Project papers by Jeffrey Frankel and Valentina Bosetti, and by Sheila Olmstead and myself.)

Key Issues for Negotiators

Negotiators will inevitably need to tackle a number of key issues in crafting a portfolio agreement, three of which we highlight here.  The first is the extent to which domestic commitments could be relaxed in later years to reflect changed circumstances.  The second is the formal status such an agreement would have under international law.  Third is the necessity to monitor conformance to domestic commitments.

Rigidity of Commitments

One approach would be for a portfolio agreement to log domestic commitments and allow countries to relax those commitments in response to changes in political or economic climate or advances in the understanding of the threat of climate change.  In essence, such an agreement would function as a depository for current domestic legislation, serving the dual roles of information-gathering and diplomatic recognition of shared commitment to the climate problem.  It is difficult to imagine countries registering objections to such an agreement, given that they would not be binding themselves to future commitments.

For precisely this reason, however, climate negotiators may wish to stay the hand of future governments by barring relaxation or abandonment of preexisting climate commitments.  In other words, the agreement could set minimum commitments on a country-specific basis.  Amendments would be allowed only if they maintained or strengthened domestic commitments to climate change mitigation.  Such a precommitment strategy is not generally included in domestic legislation or plans, and it is likely to require careful wording and additional domestic legislation to become effective in some countries.

There is surely the possibility of domestic commitments being ignored by future leaders, but note that this concern is not unique to the portfolio approach.  All climate policy architectures — indeed, all international agreements — face this problem, and the question is whether the precommitment challenge is greater under this approach than it would be under others.  One possible compromise position would be to allow revision of domestic commitments, but only at specified intervals, in order to account for dramatic shifts in economic or environmental situations and expectations.

Type of Legal Instrument

Another key issue is the official legal status of a portfolio of domestic commitments.  There are a number of possible structures for such an agreement, each with different implications under international law.  A treaty is the most formal option and would be the most binding on participating nations.  Treaty law is relatively well-developed, as compared with the law governing other international instruments, and the law of treaties provides a framework for enforcement and dispute resolution.  But treaties are difficult to craft and face the perils of national ratification.

Outside of a treaty, there are various other instruments of international law that could be used in the portfolio approach.  For example, in the United States, congressional-executive and sole-executive agreements can be entered into by the President and do not require the approval of two-thirds of the Senate, as do treaties.  (See, for example, Nigel Purvis’s work on executive agreements.)   Other “soft law” instruments, such as explicitly nonbinding agreements, political declarations, and U.N. declarations, are fallback options which merit consideration for implementing a portfolio approach.  Ultimately, negotiators will choose the best instrument, based on how open countries are to the agreement and what obligations the agreement imposes.

Monitoring and MRV

Throughout the industrialized countries — and increasingly in the emerging economies — domestic environmental regulations include internal mechanisms for monitoring and enforcement.  A portfolio agreement could rely on countries to be prompted by international pressure to enforce their commitments, or an agreement could take a more active role.  The agreement could, for example, put in place an international monitoring body, license domestic entities in each country to monitor national commitments, or suggest model codes for enforcement.  International assistance may be necessary to aid countries lagging in technical or administrative capacity to monitor greenhouse gas emissions and enforce domestic policies.  More broadly, the agreement would need to define—to the extent possible—uniform measurement, reporting, and verification (MRV) procedures and assure that all countries could implement these procedures.

Feasibility of a Portfolio of Domestic Commitments

A portfolio of domestic commitments has several advantages as the foundation of a future international climate policy architecture.  The agreement could be flexible enough to allow countries to implement the mitigation instruments of their choice and link those instruments with domestic instruments in other nations if they so chose.  It could also allow for countries to accede at various times, thus giving them adequate time to prepare to participate.  (See David Victor’s Harvard Project paper on climate accession deals.)   This approach could also be an ideal vehicle for implementing the principle of common but differentiated responsibilities, since member countries would not need to be lumped together into rigid tiers of commitment (as they are under the dichotomous Annex I approach of the Kyoto Protocol).

Perhaps most crucial is the political feasibility of the portfolio approach.  In recent months, several major economies have expressed willingness to consider a climate policy architecture along these lines, including Australia, India, and the United States.  For this reason alone, the portfolio approach merits serious consideration, despite the significant hurdles to negotiating an effective portfolio agreement.

The concerns regarding this approach to a future global climate policy architecture are significant, but so are its potential advantages.  In general, there are real challenges to developing any post-2012 international climate policy architecture that is scientifically sound, economically rational, and politically pragmatic.  The challenges facing this approach are no greater – and may be less – than those facing other means of addressing the threat of global climate change.

Can Countries Cut Carbon Emissions Without Hurting Economic Growth?

In the September 21st issue of the Wall Street Journal, the editors pose the following question: can countries cut carbon emissions without hurting economic growth? In his introductory essay, Michael Totty frames the issues as follows:

“There’s little doubt: Cutting greenhouse gases will be costly. But that leads to two big questions. First, how costly? And second, can nations afford it? As policy makers around the world take action to avoid a predicted climate catastrophe, the debate is turning to the costs of reducing carbon-dioxide emissions. Energy-efficiency measures are often pricey, and alternative energy sources are more expensive than the fossil fuels they replace. A steep price on carbon emissions will ripple through the economy. Does that mean a serious effort to tackle global warming is incompatible with economic growth? Or can we make significant cuts in greenhouse-gas emissions without causing serious damage to the economy?

We put the question to a pair of experts. Robert Stavins, a professor of business and government at Harvard University and director of Harvard’s environmental economics program, says the answer to the second question is yes: Making the necessary cuts need cause little more than a blip in world-wide growth if smart policies are used.

Steven Hayward, a fellow at the American Enterprise Institute for Public Policy Research, says no: Energy use — and the carbon dioxide it emits — is so central to the world’s economy that major cuts can’t be made without significant damage.

Of course, the answers can depend in large part on how “significant cuts” and “serious damage” are defined. Many scientists, the European Parliament and the Waxman-Markey climate legislation approved by the U.S. House of Representatives have set a goal of cutting carbon emissions about 80% by 2050, so that was picked as constituting significant cuts.

As the accompanying essays show, such a definition leaves plenty of room for disagreement.”

I encourage you to read the entire Journal Report on Environment in the Wall Street Journal (there’s an excellent Q&A on carbon offsets by Bob Curran) and to check out my affirmative response, “Yes: The Transition Can be Gradual — and Affordable,” as well as Steven Hayward’s well-articulated negative response, “No: Alternatives are Simply Too Expensive.”

Understandably, the editors wanted to highlight differences between us in order to develop a concise and clear debate. I find it interesting, however, that in an audio interview/debate at the Wall Street Journal web site (Podcast: Crafting a Global Policy), which was by nature more free-wheeling and less limited by space constraints, there is a remarkable amount of agreement between Mr. Hayward and me on a number of key issues.

For now, in today’s post — liberated from space constraints — I want to expand a bit on my WSJ essay, in which I responded, yes, the transition can be gradual and affordable.

Can the nations of the world meaningfully address the threat of global climate change without inflicting unjustifiable damage to their economies? The answer that has emerged with increasing clarity is a resounding “yes.”

Although “The Day After Tomorrow,” the 2004 disaster epic about the greenhouse effect’s apocalyptic consequences, had less scientific basis than “The Wizard of Oz,” scientific reality is disturbing enough. Man-made emissions of greenhouse gases — including carbon dioxide (CO2) from the combustion of fossil fuels — are very likely to change the earth’s climate in ways that most people will regret. World energy trends are unsustainable — environmentally, economically, and socially.

The global recession has slowed emissions growth, but the world is on a path to more than double global atmospheric greenhouse gas (GHG) concentrations to 1,000 parts per million (ppm) in CO2-equivalent terms by the end of the century, resulting in an average global temperature increase of 6 degrees Centigrade. But increased temperatures — which might well be welcome in some places — are only part of the story.

The most important consequences of climate change will be changes in precipitation (causing, for example, 75 to 250 million people in Africa to be exposed to increased water stress due to climate change by 2020, with rain-fed agriculture yields falling by as much as 50%), disappearance of glaciers throughout the world (and decreased snowpack in areas ranging from the western United States to Asia), droughts in mid to low latitudes (with severe effects in Australia), decreased productivity of cereal crops (at lower latitudes, especially in tropical regions), increased sea level, loss of islands and 30% of global coastal wetlands, increased flooding (in all parts of the world, but greatest in Asia), greater storm frequency and intensity (both typhoons and hurricanes), risk of massive species extinction (20 to 30% of all species, including massive coral mortality), and significant spread of infectious disease. On the other hand, climate change will also bring some health benefits to temperate areas, such as fewer deaths from cold exposure. But such benefits will be greatly outweighed by negative health effects of rising temperatures (cardo-respiratory, diarrhoeal, and infectious diseases, and increased morbidity and mortality from heat waves, floods, and droughts), especially in developing countries.

These impacts will have severe economic, social, and political consequences for countries worldwide, ranging from malnutrition and mass migration (hundreds of millions of people displaced) to national security threats. Bottom-line, comprehensive estimates of economic impacts of unrestrained climate change vary, with most falling in the range of 2 to 5% of world GDP per year by the middle of the century. The best estimates of marginal damages of emissions (again, by mid-century) are in the range of $100 to $175 per ton of CO2 (in today’s dollars).

The world is already experiencing the adverse effects of increasing concentrations of GHGs in the atmosphere, with concentrations already about 60% above pre-industrial levels, greatly exceeding the natural range over the past 600,000 years. Just one example: the Greenland ice sheet has been losing mass at a rate of 179 billion tons per year since 2003.

To have a coin toss’s 50-50 chance of keeping temperature increases below 2 degrees Centigrade — the level at which the worst consequences of climate change can be avoided — it will be necessary to stabilize atmospheric concentrations at 450 ppm. (Even this would result in significant sea-level rise, species loss, and increased frequency of extreme weather, according to the U.N. Intergovernmental Panel on Climate Change.) Consistent with the 450 ppm goal is a long-range target of cutting U.S. emissions 80% below 2005 levels by 2050, which happens to be the target of legislation passed earlier this year by the U.S. House of Representatives, H.R. 2454, the so-called Waxman-Markey bill.

Now, to the heart of the WSJ question: will a serious effort to tackle global warming is incompatible with economic growth? My response was and is that the nations of the world do not have to wreck their economies to avert the crisis. If appropriate and intelligent policies are employed, the job can be done at reasonable and acceptable cost.

Critics argue that the Waxman-Markey legislation — to cut U.S. emissions 80% below 2005 levels by 2050 — will mean big, disruptive changes to our infrastructure and untold economic damage. But they make a couple of basic errors. For one thing, they seem to think we’d have to replace the entire infrastructure quickly, paying trillions of dollars to shift to cleaner power. They also seem to assume that we have to choose between much more expensive energy and no energy at all.

The move to greener power doesn’t have to be completed immediately, and it doesn’t have to be painful. The right transition plan will increase consumers’ bills gradually and modestly, and allow companies to make gradual, well-timed moves.

How would this work? One way is via a combination of national and multinational cap-and-trade systems. Companies around the world would be issued rights by their governments to produce carbon, which they could buy and sell on an open market. If they wanted to produce more carbon, they could buy another company’s rights. If they produced less carbon than they needed, they could sell their extra rights. What’s more, companies could earn more rights by creating appropriate “offsets” that mitigated their carbon use, such as planting forests. Nations could add carbon taxes to the mix.

The effect would be to send price signals through the market — making use of less carbon-intensive fuels more cost-competitive, providing incentives for energy efficiency and stimulating climate-friendly technological change, such as methods of capturing and storing carbon, as well as safe nuclear power.


Julian Puckett

Robert Stavins

More Efficient

True, in the short term changing the energy mix will come at some cost, but this will hardly stop economic growth. As economies have grown and matured, they have become more adept at squeezing more economic activity out of each unit of energy they generate and consume. Consider this: From 1990 to 2007, while world emissions rose 38%, world economic growth soared 75% — emissions per unit of economic activity fell by more than 20%.

Critics argue we can’t possibly increase efficiency enough to hit the 80% goal. In a very limited sense, that’s true. Efficiency improvements alone, like the ones that propelled us forward in the past, won’t get us where we need to go by 2050. But this plan doesn’t rely solely on boosting efficiency. It brings together a host of other changes, such as moving toward greener power sources. What’s more, making gradual changes means we don’t have to scrap still-productive power plants, but rather begin to move new investment in the right direction.

As for how much this will cost, the best economic analyses — including studies from the U.S. Congressional Budget Office and the U.S. Energy Information Administration — say such a policy in the U.S. could cost considerably less than 1% of gross domestic product per year in the long term, or up to $175 per household in 2020. (As the Obama administration is fond of saying, that’s about the cost of one postage stamp per household per day.)

In the end, we would be delaying 2050’s expected economic output by no more than a few months. And bear in mind that previous environmental actions, such as attacking smog-forming air pollution and cutting acid rain, have consistently turned out to be much cheaper than predicted.

The best economic experts have validated the wisdom of adopting climate policies: from Yale’s William Nordhaus, who has supported moderate carbon taxes to cut emissions as an “insurance policy” against the most serious consequences of climate change, to MIT’s Richard Schmalensee and Columbia’s Glenn Hubbard, who have endorsed the climate policy recommendations of the bipartisan National Commission on Energy Policy, to Harvard’s Martin Weitzman, who has argued for much more aggressive policies because of the risk of particularly catastrophic outcomes. And a diverse set of CEOs, including the heads of some of the largest U.S. corporations, acting as part of the U.S. Climate Action Partnership, have called on the government “to quickly enact strong national legislation to require significant reductions of greenhouse gas emissions.”

Critics are wary of raising energy prices, arguing that no nations have grown wealthy with expensive power. But historically, it is the scarcity and cost of energy that have prompted technological changes as well as the use of new forms of power. What’s more, critics challenge the price estimates the experts have set out. They say that the predictions depend on extensive — and unrealistic — cooperation among nations. In particular, they say, developing nations won’t sign onto plans for curbing emissions, for fear of losing their economic momentum.

Indeed, we do need a sensible international arrangement in place to achieve low costs, and the economic pain will be much greater if we don’t set up an international carbon market. But it can be done. Many nations have already initiated such emissions-control policies. And the world can be brought together in a meaningful, long-term arrangement that is scientifically sound, economically rational and politically pragmatic.

Road to Cooperation

Because the benefits of any single nation taking action to address global climate change are spread worldwide, unlike the costs, it may never be in the self-interest of a single country to take unilateral action. This is the nature of a global commons problem. For this reason, international cooperation is required; this is the point of climate negotiations among some 190 countries, which will continue in Copenhagen this December. It is also the motivation for the U.S. administration’s Major Economies Forum, which brings together the 17 largest economies, accounting for 80% of GHG emissions.

Europe has already put significant climate policy in place, and Australia, New Zealand, and Japan are moving to have their policies in place within a year. But without evidence of serious action by the U.S., there will be no meaningful future international agreement, and certainly not one that includes the key, rapidly-growing developing countries — Brazil, China, India, Indonesia, Mexico, South Africa, and South Korea. U.S. policy developments can and should move in parallel with international negotiations.

Understandably, developing countries have a very different perspective than the currently industrialized world regarding climate policy. After all, the vast majority of the accumulated stock of man-made greenhouse gases in the atmosphere is due to economic activity in the richer countries over the past century and more. But the share of global emissions attributable to developing countries is significant and growing rapidly. China surpassed the United States as the world’s largest CO2 emitter in 2006. And developing countries are likely to account for more than half of global emissions by the year 2020, if not before. China, Korea, and others are beginning to take action.

Most important, all of the key countries of the world can be brought together in a meaningful and pragmatic arrangement. Such a post-Kyoto international agreement can expand the scope of action to include key developing countries, but with targets linked via an appropriate formula with economic growth, so that emissions can be reduced around the world, while emissions (and job) leakage from the industrialized to the developing world is avoided, and economic growth continues in all parts of the world.

Reducing Costs

The longer we put off serious action, the more aggressive our future efforts will need to be, as greenhouse gases and carbon-spewing capital assets continue to accumulate. Plants built today will determine emissions for a generation. In the steel sector — where plant lifetimes typically exceed 25 years — more than half of all plants in the world are now less than 10 years old. The picture is similar in the cement industry, as well as more broadly throughout the economy. For every year of delay before moving to a sustainable emissions path, the global cost of taking necessary actions increases by hundreds of billions of dollars.

Critics argue that we can afford to wait because the world of tomorrow will be wealthier and better able to absorb the costs. But acting sooner, such as by adopting the emission caps proposed in the U.S. House legislation, will lower the ultimate costs of achieving the target, because there will be more time allowed for gradual transition — which is what keeps costs down. Perhaps most important, the costs of failing to take action — the damages of climate change — would be substantially greater.

Getting serious about climate change won’t be free, and it won’t be easy. But if state-of-the-science predictions about the consequences of continued delay are correct, the time has come for sensible and meaningful action.

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.

The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey

The headline of this post is not meant to be ironic.   Despite all the hand-wringing in the press and the blogosphere about a political “give-away” of allowances for the cap-and-trade system in the Waxman-Markey bill voted out of committee last week, the politics of cap-and-trade systems are truly quite wonderful, which is why these systems have been used, and used successfully.

The Waxman-Markey allocation of allowances has its problems, which I will get to, but before noting those problems it is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems:  the allocation of allowances – whether the allowances are auctioned or given out freely, and how they are freely allocated – has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs.  (Well, there are some relatively minor, but significant caveats – those “problems” I mentioned — about which more below.)  By the way, 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.

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms’ production and emission reduction decisions.  Firms face the same emissions cost regardless of the allocation method.  When using an allowance, whether it was received for free or purchased, a firm loses the opportunity to sell that allowance, and thereby recognizes this “opportunity cost” in deciding whether to use the allowance.  Consequently, the allocation choice will not influence a cap’s overall costs.

Manifest political pressures lead to different initial allocations of allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.  This means that ordinary political pressures need not get in the way of developing and implementing a scientifically sound, economically rational, and politically pragmatic policy.  Contrast this with what would happen when political pressures are brought to bear on a carbon tax proposal, for example.  Here the result will most likely be exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs (as some low-cost emission reduction opportunities are left off the table).  Furthermore, the hypothetical carbon tax example is the norm, not the exception.  Across the board, political pressures often reduce the effectiveness and increase the cost of well-intentioned public policies.  Cap-and-trade provides natural protection from this.  Distributional battles over the allowance allocation in a cap-and-trade system do not raise the overall cost of the program nor affect its environmental impacts.

In fact, the political process of states, districts, sectors, firms, and interest groups fighting for their share of the pie (free allowance allocations) serves as the mechanism whereby a political constituency in support of the system is developed, but without detrimental effects to the system’s environmental or economic performance.  That’s the good news, and it should never be forgotten.

But, depending upon the specific allocation mechanisms employed, there are several ways that the choice to freely distribute allowances can affect a system’s cost.  Here’s where the “caveats” and “problems” come in.

First, auction revenue may be used in ways that reduce the costs of the existing tax system or fund other socially beneficial policies.  Free allocations to the private sector forego such opportunities.  Below I will estimate the actual share of allowance value that accrues to the private sector.

Second, some proposals to freely allocate allowances to electric utilities may affect electricity prices, and thereby affect the extent to which reduced electricity demand contributes to limiting emissions cost-effectively.  Waxman-Markey allocates allowances to local distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets.  So, electricity prices would likely be affected by these allocations under existing state regulatory regimes.  The Waxman-Markey legislation seeks to address this problem by specifying that the economic value of the allowances given to electricity and natural gas local distribution companies should be passed on to consumers through lump-sum rebates, not through a reduction in electricity rates, thereby compensating consumers for increases in electricity prices, but without reducing incentives for energy conservation.

Third, and of most concern in the context of the Waxman-Markey legislation, “output-based updating allocations” provide perverse incentives and drive up costs of achieving a cap.  This merits some explanation.  If allowances are freely allocated, the allocation should be on the basis of some historical measures, such as output or emissions in a (previous) base year, not on the basis of measures which firms can affect, such as output or emissions in the current year.  Updating allocations, which involve periodically adjusting allocations over time to reflect changes in firms’ operations, contrast with this.

An output-based updating allocation ties the quantity of allowances that a firm receives to its output (production).  Such an allocation is essentially a production subsidy.  This distorts firms’ pricing and production decisions in ways that can introduce unintended consequences and may significantly increase the cost of meeting an emissions target.  Updating therefore has the potential to create perverse, undesirable incentives.

In Waxman-Markey, updating allocations are used for specific sectors with high CO2 emissions intensity and unusual sensitivity to international competition, in an effort to preserve international competitiveness and reduce emissions leakage.  It’s an open question whether this approach is superior to an import allowance requirement, whereby imports of a small set of specific commodities must carry with them CO2 allowances.  The problem with import allowance requirements is that they can damage international trade relations.  The only real solution to the competitiveness issue 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.)

Also, output-based allocations are used in Waxman-Markey for merchant coal generators, thereby discouraging reductions in coal-fired electricity generation, another significant and costly distortion.

Now, let’s go back to the hand-wringing in the press and blogosphere about the so-called massive political “give-away” of allowances.  Perhaps unintentionally, there has been some misleading press coverage, suggesting that up to 75% or 80% of the allowances are given away to private industry as a windfall over the life of the program, 2012-2050 (in contrast with the 100% auction originally favored by President Obama).

Given the nature of the allowance allocation in the Waxman-Markey legislation, the best way to assess its implications is not as “free allocation” versus “auction,” but rather in terms of who is the ultimate beneficiary of each element of the allocation and auction, that is, how the value of the allowances is allocated.  On closer inspection, it turns out that many of the elements of the apparently free allocation accrue to consumers and public purposes, not private industry.

First of all, let’s looks at the elements which will accrue to consumers and public purposes.  Next to each allocation element is the respective share of allowances over the period 2012-2050 (measured as share of the cap, after the removal – sale — of allowances to private industry from a “strategic reserve,” which functions as a cost-containment measure.):

a.  Electricity and natural gas local distribution companies (22.2%), minus share (6%) that benefits industry as consumers of electricity (note:  there is a consequent 3% reduction in the allocation to energy-intensive trade-exposed industries, below, which is then dedicated to broad-based consumer rebates, below), 22.2 – 6 = 16.2%

b.  Home heating oil/propane, 0.9%

c.  Protection for low- and moderate-income households, 15.0%

d.  Worker assistance and job training, 0.8%

e.  States for renewable energy, efficiency, and building codes, 5.8%

f.   Clean energy innovation centers, 1.0%

g.  International deforestation, clean technology, and adaptation, 8.7%

h.  Domestic adaptation, 5.0%

The following elements will accrue to private industry, again with average (2012-2050) shares of allowances:

i.   Merchant coal generators, 3.0%

j.   Energy-intensive, trade-exposed industries (minus reduction in allocation due to EITE benefits from LDC allocation above) 8.0% – 3% = 5%

k.  Carbon-capture and storage incentives, 4.1%

l.   Clean vehicle technology standards, 1.0%

m. Oil refiners, 1.0%

n.  Net benefits to industry as consumers of lower-priced electricity from allocation to LDCs, 6.0%

The split over the entire period from 2012 to 2050 is 53.4% for consumers and public purposes, and 20.1% for private industry.  This 20% is drastically different from the suggestions that 70%, 80%, or more of the allowances will be given freely to private industry in a “massive corporate give-away.”

All categories – (a) through (n), above – sum to 73.5% of the total quantity of allowances over the period 2012-2050.  The remaining allowances — 26.5% over 2012 to 2050 — are scheduled in Waxman-Markey to be used almost entirely for consumer rebates, with the share of available allowances for this purpose rising from approximately 10% in 2025 to more than 50% by 2050.  Thus, the totals become 79.9% for consumers and public purposes versus 20.1% for private industry, or approximately 80% versus 20% — the opposite of the “80% free allowance corporate give-away” featured in many press and blogosphere accounts.  Moreover, because some of the allocations to private industry are – for better or for worse – conditional on recipients undertaking specific costly investments, such as investments in carbon capture and storage, part of the 20% free allocation to private industry should not be viewed as a windfall.

Speaking of the conditional allocations, I should also note that some observers (who are skeptical about government programs) may reasonably question some of the dedicated public purposes of the allowance distribution, but such questioning is equivalent to questioning dedicated uses of auction revenues.  The fundamental reality remains:  the appropriate characterization of the Waxman-Markey allocation is that 80% of the value of allowances go to consumers and public purposes, and 20% to private industry.

Finally, it should be noted that this 80-20 split is roughly consistent with empirical economic analyses of the share that would be required – on average — to fully compensate (but no more) private industry for equity losses due to the policy’s implementation.  In a series of analyses that considered the share of allowances that would be required in perpetuity for full compensation, Bovenberg and Goulder (2003) found that 13 percent would be sufficient for compensation of the fossil fuel extraction sectors, and Smith, Ross, and Montgomery (2002) found that 21 percent would be needed to compensate primary energy producers and electricity generators.

In my work for the Hamilton Project in 2007, I recommended beginning with a 50-50 auction-free-allocation split, moving to 100% auction over 25 years, because that time-path of numerical division between the share of allowances that is freely allocated to regulated firms and the share that is auctioned is equivalent (in terms of present discounted value) to perpetual allocations of 15 percent, 19 percent, and 22 percent, at real interest rates of 3, 4, and 5 percent, respectively.  My recommended allocation was designed to be consistent with the principal of targeting free allocations to burdened sectors in proportion to their relative burdens, while being politically pragmatic with more generous allocations in the early years of the program.

So, the Waxman-Markey 80/20 allowance split turns out to be consistent  — on average, i.e. economy-wide — with independent economic analysis of the share that would be required to fully compensate (but no more) the private sector for equity losses due to the imposition of the cap, and consistent with my Hamilton Project recommendation of a 50/50 split phased out to 100% auction over 25 years.

Going forward, many observers and participants in the policy process may continue to question the wisdom of some elements of the Waxman-Markey allowance allocation.  There’s nothing wrong with that.

But let’s be clear that, first, for the most part, the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost.

Second, questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.

Third, we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled.  On the contrary, 80% of the value of allowances accrue to consumers and public purposes, and some 20% accrue to covered, private industry.  This split is roughly consistent with the recommendations of independent economic research.

Fourth and finally, it should not be forgotten that the much-lamented deal-making that took place in the House committee last week for shares of the allowances for various purposes was a good example of the useful, important, and fundamentally benign mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled (without reducing the policy’s effectiveness or driving up its cost).

Although there has surely been some insightful press coverage and intelligent public debate (including in the blogosphere) about the pros and cons of cap-and-trade, the Waxman-Markey legislation, and many of its design elements, it is remarkable (and unfortunate) how misleading so much of the coverage has been of the issues and the numbers surrounding the proposed allowance allocation.

The New Auto Fuel-Efficiency Standards — Going Beyond the Headlines

On My 19th, 2009, President Obama announced new Federal fuel-efficiency standards for motor-vehicles that would make the current standards — known as Corporate Average Fuel Economy — or CAFE — standards significantly more stringent. These CAFE standards measure compliance as the average of a company’s entire fleet of cars, and so are more flexible and less costly than model-by-model standards, better matching consumer preferences and lowering production costs.

Other good news is that the administration’s proposal will yield a single standard nationwide, rather than two fuel efficiency standards, one for California and the 13 other states that chose to follow its more stringent Pavley standards, and another standard for the rest of the country under the existing CAFE program.  The result would have been that the states adopting the more stringent California standard would have brought about little incremental benefit for the environment beyond the national CAFE program, because auto manufacturers and importers would have largely undone the effects of the more stringent state-level fuel-efficiency requirements by selling more of the less fuel-efficient models in their fleets in the non-Pavley states.  This has been validated in an interesting research paper by Lawrence Goulder (Stanford University), Mark Jacobsen (University of California, San Diego), and Arthur van Benthem (Stanford University).  Thus, dual standards would have increased costs, but with little or no additional benefit to the environment.

These new Federal standards proposed by the Obama administration can therefore be one small step along the path to meaningful reductions in greenhouse gas emissions that cause climate change. That’s the good news. But it’s also true that the new standards are inferior to other possible approaches.

First of all, CAFE affects only the cars we buy, not how much we drive them, and so CAFE standards are less cost-effective than gasoline prices at reducing gasoline consumption, because gas prices (whether reflecting market conditions or government taxes) affect both which cars we buy and our choices about driving.

Some people may think that CAFE standards — unlike gas taxes — are costless for consumers. But according to the administration, the increases in CAFE standards (including both scheduled increases already on the books and the new Obama proposal) will add — on average — $1,300 to the cost of producing a new car.

Because CAFE standards increase the price of new cars, the standards have the unintentional effect of keeping older — dirtier and less fuel-efficient — cars on the road longer.  This counterproductive effect is typical of any vintage-differentiated-regulation, a topic which I have addressed in a previous post.  There is abundant empirical research on this issue.

Also, by decreasing the cost per mile of driving, CAFE standards — like any energy-efficiency technology standard — exhibit a “rebound effect,” namely, people have an incentive to drive more, not less, thereby lessening the anticipated reduction in gasoline usage.  This has also been documented empirically.

The bottom line is that gasoline prices are a much more effective – and more cost-effective – means of cutting gasoline demand, both in the short term and the long term. But if increasing gasoline prices through gas taxes is politically impossible – which certainly appears to be the case in the current political climate – why raise all of these objections? Am I allowing the (infeasible) perfect to be the enemy of the good? Not at all, as I will explain.

There is, in fact, another policy instrument available that has the same desirable impacts as gas taxes on gasoline prices (and, more importantly, on all other fossil fuel prices, as well), but inspires dramatically less political opposition.  And this instrument is not only politically feasible, but is right now achieving remarkable, broad-based political support in Washington. I’m talking about the economy-wide CO2 cap-and-trade system in Congressmen Waxman and Markey’s legislation in the House of Representatives. Their cap-and-trade system will serve to increase the price of gasoline, cut demand, and reduce emissions.  But, in addition, its impacts will go far beyond automobiles and trucks, and beyond the transportation sector, as well.

To seriously and cost-effectively address climate change, it is essential to put in place a single carbon price that affects all fossil fuels and all uses throughout the economy — not only in the transportation sector, but also electric power, and the manufacturing, commercial, and residential sectors. This is precisely what cap-and-trade does.  A meaningful, upstream, economy-wide cap-and-trade system will serve to increase the price of gasoline, as well as other fuels, electricity, and all goods and services in proportion to their carbon-intensity in production, and it does this (as would a carbon tax) in the right proportions for each fuel, energy source, and product, so that the overall cap is achieved at the least possible cost.  The real bottom line is that cap-and-trade is the cheapest, best, and only politically feasible approach that can achieve the significant reductions in CO2 emissions that will be necessary to meet President Obama’s ambitious climate goals.

Back to the Obama administration’s CAFE proposal, a separate and distinct question is what will the effects be on the U.S. automobile industry?  Will this be “good for the auto industry,” as the White House press release claimed?  Doesn’t the presence of so many leading auto executives on the podium with the President clearly indicate that this regulatory change is good for the U.S. auto industry?

First, it is surely the case that a single national standard is better for the auto industry – and society more broadly – than the dual system that would have been brought about by the 14 Pavley states going forward with more stringent standards.  There’s nothing new about the U.S. auto industry wanting a single national standard.  Indeed, for this reason, the industry supported the enactment of Federal clean air legislation in the 1970s.  We all prefer bad news to worse news, but that does not mean we welcome the bad news or that’s it good for us.

It’s also true that the U.S. auto industry has vastly less political clout now than it has had in decades, plus a much smaller share of the U.S. automobile market.  The industry is in severe economic decline, indeed on the verge of bankruptcy, and it is depending now on massive government handouts.  In this climate, it is hardly surprising that the U.S. auto industry is being exceptionally cooperative with the Federal government.

But is this policy in the long-term interest of the U.S. auto industry; is this “good for the U.S. auto industry?”  The answer to that question is unknown.  Keep in mind that for decades the U.S. auto manufacturers have just barely complied with CAFE standards each year, while Japanese manufacturers and importers have exceeded the standards.  So, at first blush, it would appear that it may be easier — less costly — for Japanese companies than U.S. companies to meet the heightened fuel-efficiency standards.  I’m not saying that the new standards will put the U.S. companies out of business, but simply that we don’t know at this point what the long-term impacts will be.  In my view, one should be skeptical about claims to the contrary.  As I’ve suggested in previous posts, the best reason to carry out environmental policies is that they are expected to be good for the environment.

A Tale of Two Taxes

Whether they are called “revenue enhancements” or “user charges,” fear of the political consequences of taxes restricts debate on energy and environmental policy options in Washington. In a March 7th post on “Green Jobs,” in which I argued that it is not always best to try to address two challenges with a single policy instrument, I also noted that in some cases such dual-purpose policy instruments can be a good idea, and I gave gasoline taxes as an example.

Although a serious recession is clearly not the time to expect political receptivity to such a proposal, the time will come — we all hope very soon — when the economy turns around, employment rises, and a sustained period of economic growth ensues. When that happens, serious consideration should be given to increases in the Federal tax on gasoline.

A gas tax increase — coupled with an offsetting reduction in other taxes, such as the Social Security tax on wages — could make most American households better off, while reducing oil imports, local pollution, urban congestion, road accidents, and global climate change. This revenue-neutral tax reform would exemplify the market-based approaches to environmental protection and resource management I examined in previous posts.

Such a change need not constitute a new tax, but a reform of existing ones. It is well known ­– both from economic theory and numerous empirical studies ­– that taxes tend to reduce the extent to which people undertake the taxed activity. In the United States, most tax revenues are raised by levies on labor and investment; the resulting reduction in these fundamentally desirable activities is viewed as an unfortunate but unavoidable side-effect of the need to raise revenue for government operations. Would it not make more sense to raise the revenue we need by taxing undesirable activities, instead of desirable ones?

Combustion of gasoline in motor vehicles produces local air pollution as well as carbon dioxide that contributes to global climate change, increases imports of oil, and exacerbates urban highway congestion. Can anyone really claim that — given a choice between discouraging work and discouraging gasoline consumption — it is better to discourage work?

According to the U.S. Department of Energy, a 50 cent gas tax increase could eventually reduce gasoline consumption by 10 to 15%, reduce oil imports by perhaps 500 thousand barrels per day, and generate about $40 billion per year in revenue.

Furthermore, this approach would be far more effective than on-going proposals to increase the Corporate Average Fuel Economy (CAFE) standards, which affect only new vehicles and lead to serious safety problems by encouraging auto makers to produce lighter vehicles. Also, remember that a major effect of CAFE standards has been to accelerate the shift from cars to SUVs and light trucks (so that overall fuel efficiency of new vehicles sold is no better than it was a decade ago, despite the great strides that have taken place in fuel efficiency technologies). As my Harvard colleague Martin Feldstein pointed out in The Wall Street Journal in 2006, the conventional approach “does nothing to encourage individuals to drive less, to use their cars more efficiently, or to shift sooner to new and more fuel efficient [and cleaner] vehicles.” A more enlightened approach ­— a market-based approach — would reward consumers who economize on gasoline use. And that is what a revenue-neutral gas tax is all about.

The revenue from the gas tax could be transferred to the Social Security Trust Fund and credited to current workers. If $40 billion per year from new gas tax revenues were transferred to Social Security, the payroll tax — the employee contribution to Social Security — could be cut by perhaps a third: a worker with annual wages of $30,000 would take home an additional $750 per year! The extra income would more than offset the cost of the gas tax, unless the worker drove over 35,000 miles per year in a car getting 25 miles or less per gallon. Rebating the gas tax in this way addresses the greatest concern about higher gas taxes — that they can hit hardest those workers who drive to their jobs. Further, a tax of this magnitude could be phased in gradually, perhaps no more than 10 cents per year over 5 years, allowing individuals and firms to adjust their consuming and producing behavior.

Proposals for gasoline tax increases in recent sessions of Congress would have dedicated the revenue to public spending (for transportation and other programs). A key difference is that the proposal I have outlined here is for a revenue-neutral change in which the gas tax revenue would be returned to Americans through reduced payroll taxes. To adopt some of the language I developed in my previous posts, such a change can be both efficient and equitable, and — for those reasons — perhaps even politically feasible.

Of course, such a scheme is not a panacea for U.S. energy and environmental problems. But it would make a significant contribution if enacted. On the other hand, political fear of the T-word in Washington may mean that it is never discussed seriously in public, let alone adopted. Most fear of taxes is due to politicians’ anxieties about asking their constituents to pay more. But an increase in the Federal gas tax, rebated through reduced payroll taxes would not cost most Americans any more and would have significant long-term benefits for the country. Still, fear of the T-word looms large; maybe it should be called an “All-American Ecologically Sound, Fully Recyclable, Anti-Terror, Energy-Independence Assessment.”