What are the Benefits and Costs of EPA’s Proposed CO2 Regulation?

­On June 2nd, the Obama Administration’s Environmental Protection Agency (EPA) released its long-awaited proposed regulation to reduce carbon dioxide (CO2) emissions from existing sources in the electricity-generating sector.  The regulatory (rule) proposal calls for cutting CO2 emissions from the power sector by 30 percent below 2005 levels by 2030.  This is potentially significant, because electricity generation is responsible for about 38 percent of U.S. CO2 emissions (about 32 percent of U.S. greenhouse gas (GHG) emissions).

On June 18th, EPA published the proposed rule in the Federal Register, initiating a 120-day public comment period.  In my previous essay at this blog, I wrote about the fundamentals and the politics of this proposed rule (EPA’s Proposed Greenhouse Gas Regulation: Why are Conservatives Attacking its Market-Based Options?).  Today I take a look at the economics.

Cost-Effective, Perhaps – but Efficient?

The proposed rule grants freedom to implementing states to achieve their specified emissions-reduction targets in virtually any way they choose, including the use of market-based instruments (the White House has referenced cap-and-trade in this context, although somewhat obliquely as “market-based programs,” and state-level carbon taxes might also be acceptable – if any states were to include them in their plans to implement the regualtion).  Also, the proposal allows for multistate proposals and for states and regions to establish linkages among their state and multi-state market-based instruments.  Some questions remain regarding the temporal flexibility (banking and borrowing) that the proposed rule will allow, but it’s reasonable to conclude at this point that although EPA may not be guaranteeing cost-effectiveness, it is allowing for it, indeed facilitating it.  As Dallas Burtraw of Resources for the Future has said, the proposed rule ought to be judged to be potentially cost-effective.

Cost-effectiveness (achieving a given target at the lowest possible aggregate cost) is one thing, but economists – and possibly some other policy wonks – may wonder if the proposal is likely to be efficient (maximizing the difference between benefits and costs).  This is a much higher mountain to climb, and a particularly challenging one for a regional, national, or sub-national climate-change policy, given the global commons nature of the problem.

The Challenge of this Global Commons Problem

GHGs mix globally in the atmosphere, and so damages are spread around the world and are unaffected by the location of emissions.  This means that any jurisdiction taking action – a region, a country, a state, or a city – will incur the direct costs of its actions, but the direct benefits (averted climate change) will be distributed globally.  Hence, the direct climate benefits a jurisdiction reaps from its actions will inevitably be less than the costs it incurs, despite the fact that global climate benefits may be greater – possibly much greater – than global costs.

(An Aside:  This presents the classic free-rider problem of this ultimate global commons problem:  It is in the interest of no country to take action, but each can reap the benefits of any countries that do take action.  This is why international, if not global, cooperation is essential.  See the extensive work of the Harvard Project on Climate Agreements.)

On June 2nd, EPA released its 376-page Regulatory Impact Analysis (RIA) of the proposed “Clean Power Plan” rule, the same day it released the 645-page proposed rule itselfAn RIA is essentially a benefit-cost analysis, required for significant new Federal rules by a series of Executive Orders going back to the presidency of Jimmy Carter, and reaffirmed by every President since, including most recently President Obama.

Given the fundamental economic arithmetic of a global commons problem, it would be surprising – to say the least – if EPA were to find that the expected benefits of the proposed rule would exceed its expected costs, but this is precisely what EPA has found.  Indeed, its central estimate is of positive net benefits (benefits minus costs) of $67 billion annually in the year 2030 (employing a mid-range 3% discount rate).  How can this be?

Two Answers to the Conundrum

First, EPA does not limit its estimate of climate benefits to those received by the United States (or its citizens), but uses an estimate of global climate benefits.

Second, in addition to quantifying the benefits of climate change impacts associated with CO2 emissions reductions, EPA quantifies and includes (the much larger) benefits of human-health impacts associated with reductions in other (correlated) air pollutants.

Of course, even if benefits exceed costs at the given level of stringency of the proposed rule, it does not mean that the rule is economically efficient, because it could be the case that benefits would exceed costs by an even greater amount with a more stringent or with a less stringent rule.  However, if benefits are not greater than costs (negative net benefits), then the rule cannot possibly be efficient, so I will stick with the all-too-common Washington practice and simply ask whether the analysis indicates a winner or a loser at the proposed rule’s given level of stringency.  In other words, the question becomes, “Is the proposed rule welfare-enhancing (even if it is not welfare-maximizing)?”

Now, let’s take a look at the numbers from these two key aspects of EPA’s economic analysis and the issues surrounding the calculations.

U.S. versus Global Damages

There are surely ethical arguments (and possibly legal arguments) for employing a global damage estimate, as opposed to a U.S. damage estimate, in a benefit-cost analysis of a U.S. climate policy, but until recently all Regulatory Impact Analyses over several decades had focused exclusively on U.S. impacts.

In a recent working paper, “Determining the Proper Scope of Climate Change Benefits,” Ted Gayer, Vice President and Director of Economic Studies at the Brookings Institution, and Kip Viscusi, University Distinguished Professor of Law, Economics, and Management at Vanderbilt University, review the history of RIAs, including their virtually exclusive focus on national impacts (defined by geography or U.S. citizenship) in benefit and cost estimates of regulations.

In the context of a conventional RIA, it does seem strange – at least at first blush – to use a global measure of benefits of a U.S. regulation.  If this practice were applied in a consistent manner – that is, uniformly in all RIAs – it would result in some quite bizarre findings.  For example, a Federal labor policy that increases U.S. employment while cutting employment in competitor economies might be judged to have zero benefits!

Another example, this one courtesy of Tim Taylor via Ted Gayer:  Under global accounting, if a domestic climate policy had the unintended consequence of causing emissions and economic leakage (through relocation of some manufacturing to other countries), that would not be considered a cost of the regulation (and with diminishing marginal utility of income, it might be counted as a benefit)!

On the other hand, a counter-argument to this line of thinking is that the usual narrow U.S.-only geographic scope of an RIA is simply not appropriate for a global commons problem.  Otherwise, we would simply restate in economic terms the free-rider consequences of a global commons challenge.  In other words, a domestic-only RIA of a climate policy could have the effect of “institutionalizing free riding,” to quote my Harvard Kennedy School colleague, Professor Joseph Aldy.  Of course, if global benefits are to be included in a regulatory assessment, it can be argued that global costs (such as leakage) should also be considered.

I leave it to legal scholars and lawyers to debate the law, and I defer to the philosophers among us to debate the ethics, but let’s at least ask what the consequences would be for EPA’s analysis if a U.S climate benefits number were used, rather than a global number.  For this purpose, we can start with EPA’s estimates (from Table ES-7 on page ES-19 and Table ES-10 on page ES-23 of its Regulatory Impact Analysis of the proposed rule) for 2030 benefits and costs, using a mid-range 3% real discount rate.  The estimated (global) climate benefits of the rule are $31 billion.

In order to think about what the domestic climate benefits might be, we can turn to the Obama administration’s original calculation of the Social Cost of Carbon in 2010, where the Interagency Working Group estimated a central global value for 2010 of $19 per ton of CO2, and noted (and explained in more detail in a subsequent scholarly paper by several members of the Working Group) that U.S. benefits from reducing GHG emissions would be, on average, about 7 to 10 percent of global benefits across the scenarios analyzed with the one model that permitted such geographic disaggregation.

(The Interagency Working Group also suggested that if climate damages are simply proportional to GDP, then the U.S. share would be about 23%.  However, given the IPCC’s prediction of highly unequal geographic distribution of climate change effects worldwide, combined with the exceptionally heterogeneous nature of climate sensitivity among the world’s economies, which vary from those with trivial reliance on agriculture to those dominated by their agricultural sectors, I find the argument behind this second approach unconvincing.)

Taking the midpoint of the Obama Working Group’s 7-10% range, U.S. damages (benefits) may be estimated to be 8.5% of global damages, which would reduce the $31 billion reported in the new RIA to about $2.6 billion, which is considerably less than the RIA’s estimated total annual compliance costs of $8.8 billion (assuming that the states facilitate cost-effective actions).  This validates the intuition, explained above, that for virtually any jurisdiction, the direct climate benefits it reaps from its actions will be less than the costs it incurs (again, despite the fact that global climate benefits may be much greater than global costs).

There are plenty of caveats on both sides of this simple analysis.  One of the most important is that if the proposed U.S. policy were to increase the probability of other countries taking climate policy actions (which I believe is probably the case), then the impacts on U.S. territory of such foreign policy actions would merit inclusion even in a traditional U.S.-only benefit-cost analysis.  More broadly, although it has been traditional to use a U.S.-only benefits measure in RIAs, the current guidelines for carrying out these analyses from the Office of Information and Regulatory Affairs of the U.S. Office of Management and Budget (Circular A-4) requires that geographic U.S. benefit and cost estimates be provided, but also allows for the optional inclusion of global estimates.

Pending resolution (or more likely, discussion and debate) from lawyers and philosophers regarding the legal and ethical issue of employing domestic benefits versus global benefits in a climate regulation RIA, it is essential to recognize that there is an even more important factor that explains how EPA came up with estimates of significant positive net benefits (benefits exceeding costs) for the proposed rule (and would have even if a domestic climate benefits number had been employed), namely, the inclusion of (domestic) health impacts of other air pollutants, the emissions of which are correlated with those of CO2.

Correlated Pollutants and Co-Benefits

The Obama Administration’s proposed regulation to reduce CO2 emissions from the electric power sector is intended to achieve its objectives through a combination of less electricity generated (compared with a business-as-usual trajectory), greater dispatch of electricity from less CO2-intensive sources (natural gas, nuclear, and renewable sources, instead of coal), and more investment in low CO2-intensive sources.  Hence, it is anticipated that less coal will be burned than in the absence of the regulation (and more use of natural gas, nuclear, and renewable sources of electricity).  This means not only less CO2 being emitted into the atmosphere, but also decreased emissions of correlated local air pollutants that have direct impacts on human health, including sulfur dioxide (SO2), nitrogen oxides (NOx), particulate matter (PM), and mercury (Hg).

It is well known that higher concentrations of these pollutants in the ambient air we breathe – particularly smaller particles of particulate matter (PM2.5) – have very significant human health impacts in terms of increased risk of both morbidity and mortality.  The numbers dwarf the climate impacts themselves.  Whereas the U.S. climate change impacts of CO2 reductions due to the proposed rule in 2030 are probably less than $3 billion per year (see above), the health impacts (co-benefits) of reduced concentrations of correlated (non-CO2) air pollutants are estimated by EPA to be some $45 billion/year (central estimate)!  (By the way, I assume that the co-benefits estimated by EPA are based upon a comparison with a business-as-usual baseline that includes the effects of all existing EPA and state regulations for these same local air pollutants.  If not, the RIA will need to be revised.)

The Bottom Line

The combined U.S.-only estimates of annual climate impacts of CO2 ($3 billion) and health impacts of correlated pollutants ($45 billion) greatly exceed the estimated regulatory compliance costs of $9 billion/year, for positive net benefits amounting to $39 billion/year in 2030.  This is the key argument related to the possible economic efficiency of the proposed rule from the perspective of U.S. welfare.  If EPA’s global estimate of climate benefits ($31 billion/year) is employed instead, then, of course, the rule looks even better, with total annual benefits of $76 billion, leading to EPA’s bottom-line estimate of positive net benefits of $67 billion per year.  See the summary table below.

The Obama Administration’s proposed regulation of existing power-sector sources of CO2 has the potential to be cost-effective, and if you accept these numbers, it can also be welfare-enhancing, if not welfare-maximizing.

That said, I assume that proponents of the Obama Administration’s proposed rule will take this assessment of EPA’s Regulatory Impact Analysis as evidence of the sensibility of the rule, and opponents of the Administration’s proposed actions will claim that my assessment of the RIA provides evidence of the foolishness of EPA’s proposal.  So it is in our pluralistic system (not to mention, in the context of the political polarization that has gripped Washington on this and so many other issues).


Benefits and Costs of EPA’s Proposed Clean Power Plan Rule in 2030

(Mid-Point Estimates, Billions of Dollars)

Climate Change Impacts

Health Impacts (Co-Benefits) of Correlated Pollutants plus …



Domestic Climate Impacts

Global Climate Impacts

  Climate Change

$ 3

$ 31



  Health Co-Benefits



Total Benefits

$ 3

$ 31



Total Compliance Costs

$ 9

$ 9

$ 9

$ 9

Net Benefits (Benefits – Costs)

– $ 6

$ 22

$ 39

$ 67


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.

Two Notable Events Prompt Examination of an Important Property of Cap-and-Trade

In December of 2010, a group of economists and legal scholars gathered at the University of Chicago to celebrate two notable events. One was the fiftieth anniversary of the publication of Ronald Coase’s “The Problem of Social Cost” (Coase 1960).  The other was Professor Coase’s 100th birthday.  The conference resulted in a special issue of The Journal of Law and Economics, which has just been published (although it is dated November 2011).

My frequent co-author, Robert Hahn (of the University of Oxford), and I were privileged to participate in the conference (a video of our presentation is available here).  We recognized that the fiftieth anniversary of the publication of Coase’s landmark study provided an opportunity for us to examine one of that study’s key implications, which is of great importance not only for economics but for public policy as well, in particular, for environmental policy.

The Coase Theorem and the Independence Property

In our just-published article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” Hahn and I took as our starting point a well-known result from Coase’s work, namely, that bilateral negotiation between the generator and the recipient of an externality will lead to the same efficient outcome regardless of the initial assignment of property rights, in the absence of transaction costs, income effects, and third party impacts. This result, or a variation of it, has come to be known as the Coase Theorem.

We focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We call this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.

The Practical Political Importance of the Independence Property

We were interested in the independence property because of its great political importance.  The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs.  Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.

In Theory, Does the Property Always Hold?

Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice.  In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

In Reality, Has the Property Held?

Of course, the fact that these factors can lead to the violation of the independence property does not mean that in practice they do so in quantitatively significant ways.  Therefore, Hahn and I also carried out an empirical assessment of the independence property in past and current cap-and-trade systems: lead trading; chlorofluorocarbons (CFCs) under the Montreal Protocol; the sulfur dioxide (SO2) allowance trading program; the Regional Clean Air Incentives Market (RECLAIM) in Southern California; eastern nitrogen oxides (NOX) markets; the European Union Emission Trading Scheme (EU ETS); and Article 17 of the Kyoto Protocol.

I encourage you to read our article, but, a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).

Politicians Have Had it Right

That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.

This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost.  So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted.  It is of real political importance and remarkable social value.