Assessing the Energy-Efficiency Gap

Global energy consumption is on a path to grow 30-50 percent over the next 25 years, bringing with it, in many countries, increased local air pollution, greenhouse gas (GHG) emissions, and oil consumption, as well as higher energy prices.  Energy-efficient technologies offer considerable promise for reducing the costs and environmental damages associated with energy use, but these technologies appear not to be used by consumers and businesses to the degree that would apparently be justified, even on the basis of their own (private) financial net benefits.

For some thirty years, there have been discussions and debates about this phenomenon among researchers and others in academia, government, non-profits, and private industry, typically couched in terms of potential explanations of the so-called “energy efficiency gap” or “energy paradox.”

Thinking About the Energy-Efficiency Gap

I wrote about this some two years ago at this blog ().  I  noted then that Professor Richard Newell of Duke University and I had just launched an initiative – sponsored by the Alfred P. Sloan Foundation — to synthesize past work on potential explanations of the energy paradox and identify key gaps in knowledge. We subsequently conducted a comprehensive review and assessment of social-science research on the adoption of energy-efficient technologies.

We worked with leading social scientists — including scholars from economics, psychology, and other disciplines, at a workshop held at Harvard — to examine the various possible explanations of the energy paradox and thereby to help identify the frontiers of knowledge on the diffusion of energy-efficient technologies.  As materials became available, we posted them at the project’s Harvard website and the project’s Duke website.

Releasing a New Monograph

I’m pleased to inform readers of this blog that we have now released a major monograph, Assessing the Energy Efficiency Gap, co-authored with Todd Gerarden, a Harvard Ph.D. student in Public Policy and a Pre-Doctoral Fellow of the Harvard Environmental Economics Program (HEEP).  The monograph draws in part from the research workshop held at Harvard (in October 2013), in which most of the U.S.-based scholars (primarily, but not exclusively, economists) then conducting research on the energy-efficiency gap participated. HEEP co-sponsored a second such research workshop with the Centre for European Economic Research (ZEW) in Mannheim, Germany in March 2014, where European economists explored the same topic. Closely-related research was presented by panelists at the annual conference of the Allied Social Science Association in January 2015.

In the new monograph, Gerarden, Newell, and I examine both the “energy paradox,” the apparent reality that some energy-efficiency technologies that would pay off for adopters are nevertheless not adopted, and the broader phenomenon we characterize as the “energy-efficiency gap,” the apparent reality that some energy-efficiency technologies that would be socially efficient are not adopted. The contrast is between private and social optimality, which ultimately has important implications for the role of various policies, as well as their expected net benefits.

Four Key Questions

We begin by decomposing cost-minimizing energy-efficiency decisions into their fundamental elements, which allows us to identify four major questions, the answers to which are germane to sorting out the causes (and reality or lack thereof) of the paradox and gap.

First, we ask whether the energy efficiency and associated pricing of products on the market are economically efficient. To answer this question, we examine the variety of energy-efficient products on the market, their energy-efficiency levels, and their pricing. Although the theory is clear, empirical evidence is—in general—quite limited. More data that could facilitate potential future empirical research are becoming available, although firm-level data are much less plentiful than data on consumers. We do not see this area as meriting high priority for future research, however, with the exception of research that evaluates the effectiveness and efficiency of existing energy-efficiency information policies and examines options for improving these policies.

Second, we ask whether energy operating costs are inefficiently priced and/or understood. Even if consumers make privately optimal decisions, energy-saving technology may diffuse more slowly than the socially optimal rate, because of negative externalities. So, even if the energy paradox is not present, the energy-efficiency gap may be. As in the first realm, the theoretical arguments are strong. Empirical evidence is considerable, and in many cases data are likely to be available for additional research. Existing policies appear not to be sufficient from an economic perspective, suggesting that further research is warranted. Indeed, we ascribe high priority to the pursuit of research in this realm.

Third, we ask whether product choices are cost-minimizing in present-value terms, or whether various market failures and/or behavioral phenomena inhibit such cost-minimization. We find that the empirical evidence ranges from strong (split incentives/agency issues and inattention/salience phenomena) to moderate (heuristic decision-making/bounded rationality, systematic risk, and option value) to weak (learning-by-using, loss aversion, myopia, and capital market failures). Importantly, here, as elsewhere in our review, the bulk of previous work has focused on the residential sector and much less attention has been given to the commercial and industrial sectors. Some areas merit priority for future research, such as empirical analysis of split incentives/agency issues in areas where efficiency standards are not present, and much more work can be done in the behavioral realm.

Fourth, we ask whether other unobserved costs may inhibit energy-efficient decisions. We find that the empirical evidence is generally sound, and that data needed for more research are available. We assign a relatively high priority to future research, particularly to aid understanding of consumer demand for product attributes that are correlated with energy efficiency, thereby informing policy and product development decisions.

Three Categories of Potential Explanations of the Gap

Finally, we ask what these findings have to say about the three categories of explanations (reviewed in detail in my 2013 essay at this blog) for the apparent underinvestment in energy-efficient technologies relative to the predictions of some engineering and economic models: (1) market failures, (2) behavioral effects, and (3) modeling flaws.  In brief, potential market-failure explanations include information problems, energy market failures, capital market failures, and innovation market failures. Potential behavioral explanations include inattentiveness and salience, myopia and short sightedness, bounded rationality and heuristic decision-making, prospect theory and reference-point phenomena, and systematically biased beliefs. Finally, potential modeling flaws include unobserved or understated costs of adoption; ignored product attributes; heterogeneity in benefits and costs of adoption across potential adopters; use of incorrect discount rates; and uncertainty, irreversibility, and option value.

It turns out that all three categories of explanations are theoretically sound and that limited empirical evidence exists for every category as well, although the empirical research is by no means consistently strong across all of the specific explanations.  The validity of each of these explanations—and the degree to which each contributes to the energy-efficiency gap—are relevant for crafting sensible policies, so Gerarden, Newell, and I hope that our new monograph can help inform both future research and policy.  Given the many energy-efficiency policies and programs that are already in place, high priority should be given to research that evaluates the effectiveness, cost-effectiveness, and overall economic efficiency of existing energy-efficiency policies, as well as options for their improvement.


Thinking About the Energy-Efficiency Gap

Adoption of energy-efficient technologies could reap both private and social rewards, in the form of economic, environmental, and other social benefits from reduced energy consumption. Social benefits include improvements in air quality, reduced greenhouse-gas emissions, and increased energy security. In response, governments around the world have adopted policies to increase energy efficiency.  Still, there is a broadly held view that various barriers to the adoption of energy-efficient technologies have prevented the realization of a substantial portion of these benefits.

For some thirty years, there have been discussions and debates among researchers and others in academia, government, non-profits, and private industry regarding the so-called “energy efficiency gap” (or “energy paradox”) — the apparent reality that many energy-efficiency technologies are not adopted even when it makes sense for consumers and businesses to do so, based on their private costs and benefits. That is, decision makers appear to “under-invest” in energy-efficient technologies, relative to the predictions of some engineering and economic models.

What causes this gap?  The answer to that question could presumably help inform the development of better public policy in this realm.

Possible Explanations for the Energy-Efficiency Gap

Potential explanations for the energy efficiency gap tend to fall into three broad categories: (1) market failures, such as lack of information or misplaced incentives; (2) behavioral effects, such as inattentiveness to future energy savings when purchasing energy-consuming products; and (3) modeling flaws, such as assumptions that understate the costs or overstate the benefits of energy efficiency.  In this essay, I simply want to outline the types of hypothetical explanations of the gap that have been posited within these three broad categories.

Market-Failure Explanations

First, various Innovation Market Failures have been posited, including:  research and development (R&D) and learning-by-doing spillovers; inefficient product quality and differentiation due to market power; and inefficient introduction of new products due to consumer taste spillovers (for example, consumers becoming comfortable with a new technology).

Second, another set of potential market-failure explanations for the gap may be characterized as Information Problems.  These include:  lack of information on the part of consumers (learning-by-using or so-called experience goods; energy prices; energy consumption of products; and available substitutes); asymmetric information (the “lemons problem”); and split incentives and principal-agent issues (such as the frequently-discussed renter/owner dichotomy).

Third, there are Capital Market Failures and Liquidity Constraints, which may be a particularly significant issue in developing-country contexts.

Fourth, there are Energy Market Failures, including various externalities (environmental, energy security, congestion, and accident risk), as well as average-cost pricing of electricity.

Behavioral Explanations

The rise of behavioral economics has brought to the fore another well-defined set of potential explanations of the energy efficiency gap.  A variety of alternative taxonomies could be employed to separate these explanations, but one such taxonomy would categorize the explanations as:

Model and Measurement Explanations

The third category of possible explanations of the energy efficiency gap consists essentially of a set of reasons why observed levels of diffusion of energy-efficiency technologies may actually be privately optimal.

First, there is the possibility of unobserved or understated adoption costs, including unaccounted for product characteristics.

Second, there may be overstated benefits of adoption, due to inferior project execution relative to assumptions, and/or poor policy design.

Third, an incorrect discount rate may be employed in an analysis, when the correct consumer and firm discount rates should vary with:

  • opportunity cost of and access to capital
  • income
  • buying versus retrofitting equipment
  • systematic risk
  • option value (see below)

Fourth, there is frequently heterogeneity across end users in the benefits and costs of employing energy-efficiency technologies, so that what is privately optimal on average will not be privately optimal for all.  This can refer either to static (cross-sectional) heterogeneity or to dynamic (intertemporal) heterogeneity, that is, technology improvements over time, which raises two possibilities:  the reality of some potential adopters being short of the frontier, and the presence of option value to waiting.

Fifth and finally, there is the possibility of uncertainty (real, not informational, as above), irreversibility, and option value.  This could be due to uncertainty regarding future energy prices, or can be linked with option value that arises for delaying investments that have only minimal if any salvage value.

Public Policy and Next Steps

Determining the validity of each of these possible explanations — and the degree to which each contributes to the energy efficiency gap — are crucial steps in crafting the most appropriate public policy responses.

To inform future research and policy, Professor Richard Newell of Duke University and I have launched an initiative – sponsored by the Alfred P. Sloan Foundation — to synthesize past work on these potential explanations of the energy paradox and identify key gaps in knowledge.  We are conducting a comprehensive review and assessment of published and ongoing social-science research on the adoption of energy-efficient technologies, including scholarly literature, industry case studies, reports from national and sub-national governments, and, to the extent possible, consulting reports evaluating specific programs.

We are working with leading social scientists — including scholars from economics, psychology, and other disciplines — to examine the various possible explanations of the energy paradox and thereby to help identify the frontiers of knowledge on the diffusion of energy-efficient technologies.  We hope the products of this initiative will help decision makers in industry and government better understand the energy efficiency gap, and will thereby contribute to decisions that maximize the potential economic, environmental, and other social benefits associated with optimal adoption of energy-efficient technologies.  As materials become available, we will post them at the project’s Harvard website and the project’s Duke website, and I will alert readers of this blog.  In the meantime, please stay tuned.


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.