The Future of U.S. Carbon-Pricing Policy

In 2007, I was asked by the leaders of the Brookings Institution’s Hamilton Project to write a paper describing a national emissions trading system to reduce U.S. carbon dioxide (CO2) emissions to help address the threat of global climate change.  I responded that I would prefer to write broadly about carbon-pricing instruments, including what I considered to be the symmetric instruments of a carbon tax and a carbon trading program.  But the Hamilton Project leaders said no, they would find someone else to write about carbon taxes (which turned out to be Gib Metcalf), and they wanted me to “make the strongest case possible for” what is today called a cap-and-trade system.  I did my best, and in the process I came to be identified – and to some degree may have become – an advocate for CO2 cap-and-trade.  For better or for worse, during the Obama administration transition, the design recommendations in my Hamilton Project paper became one of the starting points for efforts to structure the administration’s proposed CO2 cap-and-trade system that became part of the failed Waxman-Markey legislation, H.R. 2454, the American Clean Energy and Security Act of 2009.

More than a decade later, I have written a new paper in which I seek to approach this question as I wished to in the first place, treating both instruments in a balanced manner, examining their merits and challenges, without necessarily favoring one or the other.  On May 16, 2019, I presented this new paper at the National Bureau of Economic Research’s first annual Environmental and Energy Policy and the Economy Conference, held at the National Press Club in Washington, D.C.  My topic was, “The Future of U.S. Carbon-Pricing Policy.”  (It will be forthcoming in Environmental and Energy Policy and the Economy, volume 1, edited by Matthew Kotchen, James Stock, and Catherine Wolfram, published by the University of Chicago Press.)  In today’s blog essay, I provide a very brief summary of the paper, based upon the presentation I made at the NBER conference.  I hope you will find this of sufficient interest to download and read the complete paper.

Premises, Questions, and Conclusions

I began this research with two major premises:  first, that economists and most other policy analysts agree that carbon-pricing will likely be a necessary (although not sufficient) part of any meaningful, long term U.S. climate change policy, because of:  (1) feasibility – the necessity of affecting millions, indeed hundreds of millions, of decentralized decisions; (2) cost-effectiveness, given the tremendous heterogeneity of marginal abatement costs; and (3) the importance of providing incentives for carbon-friendly technological change.  My second premise was that there is much less agreement among economists (and other policy analysts) regarding the choice of specific carbon-pricing policy instrument – carbon tax or cap-and-trade.

This prompts two questions:  (1) how do the two major approaches to carbon pricing compare on relevant dimensions, including but not limited to efficiency, cost-effectiveness, and distributional equity?  (2) Which approach is more likely to be adopted in the future in the United States?

Having carried out an exhaustive examination, two major conclusions stand out (among others).  First, that the specific designs of carbon taxes and cap-and-trade are more consequential than the choice between the two instruments.  And second, that political feasibility affects the normative merits of the two instruments, and vice versa.

Similarities & Symmetries

Of fourteen separate issues I examine, some appear at first to be key differences (in theory), but many of these differences fade on closer inspection, and depend on specifics of design.

First of all, carbon taxes and commensurate cap-and-trade turn out to be perfectly equivalent in regard to:   (a) incentives for emission reduction (both can be upstream on the carbon content of fossil fuels); (b) aggregate abatement costs (both can be cost-effective, both provide the same incentives for technological change, and both can utilize offsets to further lower aggregate abatement costs); and (c) effects on competitiveness (both can lessen these impacts via appropriate border adjustment mechanisms).

Next, the two instruments are nearly equivalent in regard to possibilities for raising revenue (cap-and-trade can utilize auctions, but given the structure of Congressional committees, revenue recycling may be easier with taxes).

And these instruments are similar in regard to:  (a) costs to regulated firms (cap-and-trade systems can freely allocate allowances, and taxes can provide inframarginal exemptions below a specified level of emissions); and (b) distributional impacts (the two instruments can be designed to be roughly equivalent in this regard).

Differences & Distinctions

Beginning with the least significant differences, there are relatively minor distinctions in terms of transaction costs (decreasing marginal transaction costs in cap-and-trade systems – such as with volume discounts on brokers’ fees – can violate the independence property, whereby the equilibrium allocation of allowances and hence aggregate costs are ordinarily independent of the initial allocation).

There are more meaningful, but still subtle differences with regard to:  (a) performance in the presence of uncertainty (for this, I urge you to read at least this section of the complete paper, because new research suggests that the implications of the classic Weitzman rule in the presence of a stock externality are moderated – if not reversed – due to the persistent effects of technology shocks, which foster positive correlation between marginal benefits and marginal costs); and (b) linkage with other jurisdictions (it is easier with cap-and-trade systems, but tax systems can also be linked).

That said, there are significant differences between the instruments in terms of:  (a) carbon-price volatility (a problem only with cap-and-trade systems, but a problem that can be mitigated with price collars and banking of allowances); (b) interactions with complementary policies (a significant issue with cap-and-trade systems, which is much less severe with carbon taxes, because the “waterbed effect” is eliminated); (c) market manipulation (there is a need for regulatory oversight in cap-and-trade systems, but tax evasion is a parallel issue in tax systems, although presumably less severe in the U.S. context); and (d) complexity and administrative requirements (cap-and-trade is certainly more complex and has greater administrative requirements, but one might ask whether a simple tax will remain “simple” as it works its way through the Congress).

Hybrid Policy Instruments and a Policy Continuum

Many of the remaining differences can diminish further with implementation.  Indeed, hybrid policies which mix features of tax and cap-and-trade blur distinctions.  For example, auctioning of allowances and the use of price collars bring cap-and-trade closer to a tax system; and quantity formula employed to adjust a tax, and the use of tax revenues to mitigate emissions bring a tax closer to cap-and-trade.  The result is that the dichotomous choice between a carbon tax and cap-and-trade can become a choice of design elements along a policy continuum, and the design of these instruments can be more consequential than the choice between the two.

Which is More Likely to be Adopted – Taxes or Trading?  Positive Political Theory

Framing this question in terms of the metaphor of a political market, it is helpful to think about political demand and political supply of policy instruments.  In terms of the demand from interest groups, first, regulated industry may oppose an ordinary tax approach, as it typically leads to greater costs than the simplest cap-and-trade (or than a performance standard, for that matter), because private industry is paying not only for compliance costs, but also for the tax on residual emissions.  Second, regulated industry may favor cap-and-trade, because it conveys scarcity rents to firms, and can provide entry barriers for potential new entrants, which can make the rents sustainable.

Environmental advocacy groups favor cap-and-trade, due to the emissions certainty it provides, but also because presumably they have a preference for policies that help obscure costs, and cap-and-trade does a better job of sweeping discussion of costs under the rug than does a tax.  However, in the era since cap-and-trade was demonized as “cap-and-tax,” this difference may be much less than it was!

Turning to the supply side (within the legislature), the revenue from either a tax or auctioning of allowances can be attractive to government.  And because of the independence property of cap-and-trade, legislators can allocate allowances to build political support without increasing the costs or reducing the effectiveness of the policy.  Of course, this important political advantage becomes an economic disadvantage if it invites particularly harmful rent-seeking behavior.  Finally, environmental policy makers tend to think in terms of pollution quantities, not prices.

Experience with Carbon Pricing:  Emissions Coverage & Price in Implemented Initiatives

            There are some fifty carbon-pricing systems in operation worldwide, with equal numbers of carbon taxes and carbon cap-and-trade systems.  A quick comparison of these policies reveals two striking realities.  First, the highest carbon prices (the height of the bars in the figure below) are for carbon taxes (in norther Europe).  Second, the scope of coverage (the width of each bar in the figure) of cap-and-trade systems greatly exceeds that of carbon taxes.  Putting the two features (severity and scope) together, a reasonable measure of the relative importance of the policies is given by multiplying the carbon price (tax level or market price of allowances) by the tons of coverage, that is, the respective areas in the figure.  On this basis, it appears that political revealed preference has been weighted toward cap-and-trade (at least up until now).

Carbon Price & Emissions Coverage of Implemented Carbon-Pricing Initiatives

Which Has Worked Better – Experiences with Trading and Taxes

Based upon more than thirty years of experience with cap-and-trade systems, including but not limited to CO2 programs, lessons regarding the design and efficacy of these systems can be drawn.  In brief, there is empirical evidence for the following:  cap-and-trade has proven to be environmentally effective and economically cost-effective; downstream, sectoral programs have been common, but economy-wide upstream systems are feasible; transaction costs have been low to trivial; a robust market requires a cap below business-as-usual; banking has been exceptionally important, representing a large share of the gains from trade; price collars are very beneficial; free allocation of allowances fosters political support, with a likely transition to greater auctioning over time; competitiveness impacts can be mitigated with an output-based updating allocation; “complementary policies” are common, but in some cases can have perverse consequences, including no additional emissions reduction, an increase in aggregate costs, and suppressed allowance prices.

Turning to experiences with carbon taxes, two applications stand out.  First, there are the northern European carbon tax systems, initiated in the 1990s in Norway, Sweden, Denmark, and Finland.  Typically these were elements of broader energy and excise tax reform initiatives, and some are at the highest levels of any carbon-pricing regimes worldwide.  However, fiscal cushioning has been common for industries expressing concerns.  That said, these taxes have raised significant revenues to finance spending or to lower other tax rates, but unfortunately, there is little empirical evidence of their emissions impacts.

More striking is British Columbia’s carbon tax, initiated in 2008, which comes closest to that recommended by economists.  Currently, it is an upstream tax of $27/ton of CO2, but with important exemptions in place for key industries.  Importantly, 100% of tax revenue was originally refunded through general tax rate cuts, but over time, there has been more focus on tax cuts for specific sectors and locations.  Although there is some debate in the literature, it appears to have been effective in reducing emissions.

Empirical Evidence for Positive Assessment

Given that the normative differences between the two instruments are minimal, a key question becomes which instrument is more politically feasible, and which is more likely — in practice — to be well designed.  Based on experiences with cap-and-trade and carbon taxes, the relative masses in the figure above suggest that political revealed preference has favored the former.  Furthermore, after years of deliberation, China has chosen trading for its national program (although it appears to be a set of sectoral tradable performance standards, not a true, mass-based cap-and-trade system).  In addition, the new “Transportation and Climate Initiative” in the northeast United States was first proposed in terms of fuel taxes but is gravitating toward cap-and-trade.  Also, New Jersey is preparing to rejoin the Regional Greenhouse Gas Initiative, and Oregon is poised to enact an economy-wide CO2 cap-and-trade system this year.  On the other hand, Washington State has twice defeated a carbon tax.

But past may not be prologue.  The demonization of the Waxman-Markey trading system as “cap-and-tax” may have reduced the political advantage of cap-and-trade (that it can hide the costs).  And there is clearly increasing interest in a national carbon tax in the policy world, including several bills in Congress and the prominent Climate Leadership Council proposal.  On the other hand, the “Green New Deal” is silent about carbon-pricing of any kind.

It is worthwhile focusing on the political economy of the British Columbia carbon tax.  Its successful enactment has been attributed to “the confluence of political conditions ripe for carbon taxation”:  untapped hydroelectric potential; a strongly environmentalist electorate (as in the case of California’s move to cap-and-trade with Assembly Bill 32); a right-center government with trust from the business community (as with the George H.W. Bush administration’s SO2 allowance trading system in the Clean Air Act amendments of 1990); and a premier with institutional capacity to pursue personal policy preferences.  There has been increasing public support over time, due to the perception of emissions reductions without severe economic impacts, but political pressures have caused the evolution of the system from using revenues exclusively to cut distortionary taxes to greater use of tax cuts to favor specific sectors and regions.

Clearly, political pressures can drive up social costs with either type of carbon-pricing instrument.  On the one hand, politics may disfavor the auctioning of allowances in cap-and-trade systems, while, on the other hand, politics may disfavor cost-effective cuts of distortionary taxes in tax systems.

Does Either Carbon-Pricing Instrument Dominate in Normative or Positive Terms?

When carbon taxes and cap-and-trade are designed to be truly comparable, their characteristics and outcomes are similar, and in some cases fully equivalent (normatively), in terms of their:  emission reductions, abatement costs, revenue raising, costs to regulated firms, distributional impacts, and competitiveness effects.  But on some other dimensions, there can be real differences in performance.  The tax approach is favored by administrative requirements, interactions with complementary policies, and effects on carbon-price volatility; whereas cap-and-trade is favored by linkage with policies in other jurisdictions, and possibly by anticipated performance in the presence of uncertainty.  In the positive political economy domain, the evidence is also decidedly mixed.  Hence, there is not a strong case for the blanket superiority of either instrument.  Differences in design simply dominate differences between the instruments themselves.

Can Carbon-Pricing be Made More Politically Acceptable?

The track record of 50 carbon-pricing policies cited above should be contrasted with the 176 countries with renewable energy policies or energy efficiency standards, as well as another 110 national and sub-national jurisdictions with feed-in tariffs.  Hence, carbon pricing has not in general been the favored approach to climate change policy.  Why is this the case?  Survey and other evidence indicates that public perceptions – some of which are inaccurate – are primary factors behind aversion to carbon taxes:  “personal costs too great; policy is regressive; could damage economy; will not discourage carbon-intensive behavior; and government just want the revenues.”  So, one way to improve public acceptance could be through better information, that is, education.

But another way forward could be through judicious policy design, which may well depart from first-best design, including:  phasing in taxes/caps over time (which was effective in California and British Columbia); earmarking revenues from taxes/auctions to finance additional climate mitigation, in contrast with optimizing the system via cuts in distortionary taxes; and/or using revenues for fairness purposes, such as with lump-sum rebates or rebates targeted to low-income and other particularly burdened constituencies (a carbon tax with “carbon dividends” or a cap-and-trade system in the form of “cap-and-dividend”).

Has the Defeat of National CO2 Cap-and-Trade Initiatives Provided Openings for Carbon Tax Proposals?

Political polarization has decimated the key source of Congressional support for environmental/energy action, the political middle.  And the successful political battle against the Obama administration’s CO2 cap-and-trade legislation featured the effective demonization of that instrument as “cap-and-tax.”  Does the consequent reputational loss for cap-and-trade provide a meaningful opening for the other carbon-pricing instrument – a carbon tax?

It would seem that large budgetary deficits ought to increase the attraction of new sources of revenue, but existing carbon tax proposals have largely been revenue-neutral.  That said, it is surely true that there has been increased attention to carbon taxes from the “policy community,” with support coming not just from Democrats, but also from prominent Republican academic economists and former Republican high government officials.  But – finally – what about in the real political world of those currently holding elective office in the federal government?

It is presumably good news for carbon tax proposals that they are not “cap-and-trade.”  Perhaps that helps with the political messaging.  But if conservative opposition could tarnish cap-and-trade as “cap-and-tax,” surely it will not be difficult to label a tax as a tax!  And in addition to such opposition from the political right, it is – as of now – questionable whether the new left will want a carbon tax to be part of its “Green New Deal.”

Hence, in the short term, national carbon pricing of either type will likely continue to face an uphill battle.  Therefore, in addition to considering second-best carbon-pricing design (as I recommended above), economists can work productively to catch up with political realities by considering better designs of second-best non-pricing instruments, such as clean energy standards.

But, at some point the politics will change, and it is important to be ready, which is why – for the longer term – ongoing research on carbon-pricing is very much warranted, particularly if it can be carried out in the context of real-world politics, and focus on policies that are likely at some point to prove feasible.

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When Reasonable Policy Discussions Become Unreasonable Personal Attacks

Recently I was reminded of the controversy that erupted late in 2014 about remarks made by the distinguished health economist, Jonathan Gruber, professor at MIT for two decades. Professor Gruber, one of the country’s leading experts on health policy, had played an important role in the construction of the Obama administration’s Patient Protection and Affordable Care Act, subsequently derided by its political opponents as “Obamacare.”

A brief but intense political controversy and media feeding-frenzy erupted when videos surfaced in which Professor Gruber – largely in a series of academic seminars and conferences – explained how the Act was crafted and marketed in ways that would make it easier to develop political support. For example, he noted that insurance companies were taxed instead of patients, fundamentally the same thing economically, but vastly more palatable politically. He went on to note that this was possible because of “the lack of economic understanding of the American voter.” His key point was that the program’s “lack of transparency is a huge political advantage.” Is that a controversial or even unique observation?

A Truism of Political Economy

Any economist who has worked on the development or analysis of public policy – in areas ranging from health care policy to environmental policy to financial regulation – recognizes the truth of the key insight Gruber was communicating to his audiences. It is inevitably in the interests of the advocates of a policy to make the policy’s benefits transparent and to make its costs vague, even unobservable; just as it is in the interests of the opponents of a policy to make that policy’s benefits obscure and its costs as clear as the light of day.

The specific construction of hundreds of public policies are explained by this truism. In the United States, Corporate Average Fuel Economy Standards (or “CAFE standards”) have been a bipartisan Congressional success, despite the fact that the costs they place on the American public per unit of fuel savings are vastly greater than the costs of a commensurate increase in gasoline taxes. Likewise, when conservative opponents of CO2 cap-and-trade wanted to stop the House-passed bill in its tracks, they resorted to demonizing it as “cap-and-tax.”

So, the central lesson Professor Gruber was offering is hardly controversial, and its enunciation ought not lead to the terrible attacks that he suffered. He doesn’t need me to defend him, but he was unfairly demonized, simply because people disagreed with him politically regarding the merits of the public policy he had helped develop and support.

Unfortunately, I was reminded of this recently when I found myself subject to attempted demonization, because someone did not agree with a policy I supported. What happened to me is trivial compared with what Professor Gruber has gone through, but it prompts me to write about it today.

Can We Agree to Disagree?

I have written before at this blog about the reasons why I support my university’s decision not to divest its endowment of its fossil-fuel company holdings. I won’t repeat those arguments here, but will note that I have gone out of my way not to draw conclusions or make recommendations about what other universities or other institutions ought to do in this regard, including when I agreed to write an essay on the subject for Yale Environment 360. My analysis and conclusions were not developed in spite of my decades of research, teaching, and outreach on global climate change policy; rather, they were developed because of my years of work in this area.

There are people, some of whom I greatly respect, who have different perspectives on this issue, and have come to very different conclusions than have I. We have essentially agreed to disagree. They haven’t cast aspersions on me, nor I on them. As my writings on this topic have illustrated, there are many facets to the issue, including economics, politics, ethics, and even religion. No one has cornered the market on wisdom.

And What About the Keystone XL Pipeline?

Likewise, on a quite different topic, on January 8, 2015, Coral Davenport wrote a story in the New York Times about the political debates in Washington regarding the proposed Keystone XL pipeline, and stated that “… most energy and policy experts say the battle over Keystone overshadows the importance of the project as an environmental threat or an engine of the economy. The pipeline will have little effect, they say, on climate change, production of the Canadian oil sands, gasoline prices and the overall job market in the United States.” She went on to quote me (accurately) as having said, “The political fight about Keystone is vastly greater than the economic, environmental or energy impact of the pipeline itself. It doesn’t make a big difference in energy prices, employment or climate change either way.” What I said was consistent with the evidence at the time (note, however, that as oil prices fall, the possibility increases that the Canadian oil sands would be uneconomic to develop without the pipeline). Once again, the analysis is not one-dimensional, and reasonable people can respectfully disagree.

When Policy Debates Become Personal Attacks

But these two topics – the Keystone XL pipeline and fossil-fuel divestment – have increasingly become engulfed in highly-charged campaigns and exceptionally heated political debates. As part of this, my integrity was recently attacked, because of my views.  A young and – I’m sure – well-intentioned climate activist and journalist, writing in the Huffington Post, implied that my assessment in the New York Times of the Washington political debates regarding Keystone XL and my support for Harvard’s divestment policy, are because “Stavins has done consulting work for Chevron, Exelon, Duke Energy and the Western States Petroleum Association.”

The author of the Huffington Post piece selected those three companies and one trade association from a list of 92 “Outside Activities” that I voluntarily provide as a means of public disclosure. The author chose not to note that the vast majority of my outside engagements are with universities, think tanks, environmental advocacy NGOs, foundations, the U.S. Environmental Protection Agency, other federal agencies and departments, international organizations, and environment ministries around the world (not to mention a set of Major League Baseball teams, but that’s another story altogether).

But what about the four he did choose to highlight? First, I am very proud of my work supported by Chevron and the closely-related Western States Petroleum Association, in which I have carried out a series of analyses studying how to strengthen and improve California’s climate policy under AB-32. That’s right – developing and assessing ways to make the AB-32 cap-and-trade system and the related suite of “complementary policies” more environmentally effective, more cost-effective, and more equitable (I’ve written about this work several times at this blog).

Likewise, my work supported by Duke Energy began a decade ago when I helped the former CEO bring home to his senior management the importance of climate change and the importance of well-designed public policies (in particular, carbon cap-and-trade) to address it. All of my subsequent work supported by Duke Energy likewise has focused on the design of better market-based instruments – cap-and-trade – to reduce CO2 emissions.

And, finally, what about Exelon? This was interesting and important work I carried out with my friend and colleague, MIT Professor Richard Schmalensee, Dean Emeritus of the Sloan School of Management (I wrote about this work at this blog and at the Huffington Post). In 2011, with support from Exelon, Professor Schmalensee and I analyzed EPA’s proposals for new rules to regulate the interstate transport of sulfur dioxide and nitrogen oxides emitted from electric power generation facilities. You can read in detail about our multi-faceted assessment, but the bottom-line is that we provided strong support for a stringent rule. Our brief summary at the University of Pennsylvania’s RegBlog concludes: “In sum, while imposing incremental costs to achieve reductions in SO2 and NOX emissions, the Transport Rule would produce significant benefits in terms of improved health outcomes, and better environmental amenities and services, which studies estimate significantly outweigh the costs.”

Sadness and Empathy

It is nothing less than absurd – and, frankly, quite sad – that someone would suggest that my views on divestment and my New York Times quote on the politics of Keystone XL were somehow due to my having received previous support for analytical work for an oil company, a trade association, and two electric utilities. This was an unfortunate move to question my credibility and damage my reputation in a misguided attempt to demonize me, rather than engage in reasonable discussion and debate. Unfortunately, most of those who have read the activist/journalist’s original commentary and have possibly repeated his claims to others will not see the essay you have just read.

This is surely nothing compared with what Professor Gruber has gone through, but it has certainly increased my empathy for him, as well as my admiration.

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Personal Attacks: An Even Sadder Epilogue

It’s nearly two months since I wrote the essay above, but a series of recent events prompts me to add this sad epilogue.  My family and I have recently been subject to cyber-bullying, harassment, and threats, because of my public stance in support of Harvard’s decision not to divest from its endowment portfolio its holdings of fossil-fuel company stocks.

In particular, the most recent message sent to me said in part: “You may be assured that I will have a lot to say about your vocal public support of Harvard’s fossil fuel investments, … and that I have a particular interest in making sure that [your] financial connections to the fossil fuel industry are made fully public …” This threat to tarnish my reputation by publicizing a supposed conflict of interest is striking for a number of reasons:

  • In several essays at this blog and elsewhere, I have carefully explained my reasons for supporting Harvard’s decision not to divest;
  • In several essays at this blog and elsewhere, I have been completely up front about receiving support for (publically available) analytical work I’ve carried out for private-sector companies (and have long provided a list of all outside engagements at my website);
  • In the essay above, I documented the fundamentally pro-environment, policy-analytic work I had done for the specific companies mentioned; and
  • The claim that my position regarding Harvard divestment has somehow been influenced by my work with an oil company and an industry trade association defies logic.

The last item on this list – the fundamental illogic of such a claim – merits explanation. People on all sides of the divestment issue (including leaders of the student movement, and including the person who wrote the threat I quoted above) acknowledge that divestment will have no direct financial impacts on the respective companies. Rather, the merit of divestment that is most frequently cited by supporters is its symbolic value. Because divestment has no financial impacts on the fossil-fuel companies, those companies don’t care much about it. They would not care one way or the other what I might have to say on the topic. Hence, even if I did want to curry favor with those companies, that would not lead me (or anyone else) to take a particular position on the divestment issue.

The more important question to ask is whether my research, teaching, and outreach initiatives on climate change economics and policy have been biased by my having carried out consulting assignments for an oil company and trade association (two of a hundred outside engagements over the past several years)? That is, if there really was a conflict of interest, then in an effort to make those companies happy, I would presumably pull my punches regarding recommendations of what does matter to those companies – public policies that will reduce their profits by increasing their costs of doing business and/or by reducing demand for their products. But nothing could be further from the truth!

For a decade or more, my research, teaching, and outreach have focused on more enlightened, stronger, and better climate change policies. I have been outspoken in regard to the pressing need for well-designed carbon-price instruments at the national and sub-national levels, and for the need for better, more effective international climate policies, both under the United Nations Framework Convention on Climate Change and through other venues. This is reflected in my published research, my teaching, and my outreach efforts, including through this blog.

It is ironic, offensive, and sad that anyone would suggest that my support of Harvard’s divestment position is somehow tied to my outside engagements. That suggestion – and the recent threats I have received – defies logic and is contradicted by the record.

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EPA’s Proposed Greenhouse Gas Regulation: Why are Conservatives Attacking its Market-Based Options?

This week, 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.

The Fundamentals in Brief

Through a carefully designed formula, EPA’s proposal lists specific targets for each state, under Section 111(d) of the Clean Air Act. States are given broad flexibility for how to meet their targets, including:  increasing the efficiency of fossil-fuel power plants; switching electricity dispatch from coal-fired generating plants to natural gas-fired generating plants; developing new low-emissions generation, such as new natural gas combined cycle plants, more renewable sources (wind and solar), nuclear, or coal with carbon capture and storage; and more efficient end-use of electricity.

States are also given flexibility to employ (in their implementation plans to be submitted to EPA) any of a wide variety of policy instruments, including but by no means limited to market-based trading systems.  Furthermore, states can work together to submit multi-state plans.

The proposed regulation will be finalized after receipt of comments one year from now (June 30, 2015).  Then states will have until July 2016 to submit their plans, and can request one-year extensions (or two-year extensions for multi-state plans). Compliance commences in 2020.

A Big-Picture Assessment of the Proposed Rule

Let’s start by acknowledging that the proposed policy will be less effective environmentally and less cost-effective economically than the economy-wide approach the Administration previously tried with the Waxman-Markey bill, which passed the U.S. House of Representatives in 2009, but failed to receive a vote in the U.S. Senate.  Electricity generation is responsible for about 38 percent of U.S. CO2 emissions, and about 32 percent of U.S. greenhouse gas (GHG) emissions.

Given ongoing political polarization in Washington and the inability of Congress to approve that more comprehensive and more cost-effective approach, this is probably the best the administration could do.  Together with the motor-vehicle fuel efficiency and appliance energy efficiency standards previously put in place, this is certainly a step in the right direction.

More broadly, the importance of these U.S. moves in the international context should not be underestimated.  Although the United States accounts for only about 17% of global CO2 emissions (second to China’s 26% in 2010), these steps by the U.S. government can help international efforts to bring the large emerging economies (China, India, Brazil, Korea, South Africa, and Mexico) on board for a future (Paris, 2015) agreement under the Durban Platform for Enhanced Action.

Domestically, EPA’s proposed state-by-state approach does not guarantee cost-effectiveness, because under the formula employed, marginal abatement costs will initially vary across states.  However, freedom is given to the states to employ market-based instruments, in particular, cap-and-trade systems (with carbon taxes presumably also an option).  And EPA has emphasized its willingness to consider multi-state implementation plans (think, for example, of the existing Regional Greenhouse Gas Initiative – RGGI – the cap-and-trade system operating in nine northeast states; and the likelihood of a future linked policy bringing together California’s AB-32 cap-and-trade system with policies in Oregon and Washington).

The ability of states to develop under EPA’s rule such linked systems of market-based instruments, as well as the freedom for states and regions to subsequently establish linkages means that although EPA may not be guaranteeing cost-effectiveness, it is certainly allowing for it, indeed it is facilitating it.

Response from Environmental Advocacy Groups and Industry

Much of the response this week has not been surprising.  The major environmental advocacy groups have been supportive of the proposed rule, despite the fact that they would prefer even greater ambition.  Many in industry have also offered praise for the approach, particularly because of the flexibility that EPA has given for the means of achieving emissions reductions.  In fact, some electricity-sector executives have been supportive, precisely for this reason, and appear to be encouraging the adoption of cap-and-trade systems.  At a minimum, leading electric utilities, including some that are fossil-heavy, such as FirstEnergy Corporation and American Electric Power, Inc., have taken a “wait-and-see” attitude, rather than attacking the proposal.

Also not surprising has been strong opposition from the coal industry, as well as some prominent industry trade associations, including the U.S. Chamber of Commerce.  Once the rule has become final (about a year from now), lawsuits will surely be filed by some of these private industry opponents and by a number of resistant states.

I will leave it to the lawyers to comment on the likely grounds of those anticipated lawsuits, as well as their probabilities of success.  But, clearly, for the plan to succeed it will need to survive those legal challenges, which will work their way through the courts over several years.

Also, a significant change in the senate majority and in the party holding power after the next presidential election could result in progress being slowed to a crawl, if not the abandonment of the approach proposed by the current administration.

None of that is particularly surprising, but what should be surprising is the fact that conservative attacks on EPA’s proposed rule have focused, indeed fixated, on one of the options that is given to the states for implementation, namely the use of market-based instruments, that is, cap-and-trade systems.  Given the demonization of cap-and-trade as “cap-and-tax” over the past few years by conservatives, why do I say that this fixation should be surprising?

The Irony of Conservatives Targeting Cap-and-Trade

Not so long ago, cap-and-trade mechanisms for environmental protection were popular in Congress. Now, such mechanisms are denigrated. What happened?  Professor Richard Schmalensee (MIT) and I recently told the sordid tale of how conservatives in Congress who once supported cap and trade had come to lambast climate change legislation as “cap-and-tax.” Ironically, in doing this, conservatives have chosen to demonize their own market-based creation.

In the late 1980s, there was growing concern that acid precipitation – the result of SO2 and, to a lesser extent, nitrogen oxides (NOx) reacting in the atmosphere to form sulphuric and nitric acids – was damaging forests and aquatic ecosystems, particularly in the northeast U.S. and southern Canada. In response, the U.S. Congress passed (and President George H.W. Bush signed into law) the Clean Air Act Amendments of 1990. Title IV of this law established the SO2 allowance-trading system.

By the close of the 20th century, the SO2 allowance-trading system had come to be seen as both innovative and successful.  However, the successful enactment and implementation of the SO2 cap-and-trade system in 1990 combined with the subsequent Congressional defeat of CO2 cap-and-trade legislation 20 years later has produced a striking irony. Market-based, cost-effective policy innovation in environmental regulation – in particular, cap-and-trade – was originally championed and implemented by Republican administrations from that of President Ronald Reagan to that of President George W. Bush.  But in recent years, Republicans have led the way in demonizing cap-and-trade, particularly as an approach to limiting carbon emissions.

For a long time, market-based approaches to environmental protection, such as cap-and-trade, bore a Republican label.  In the 1980s, President Ronald Reagan’s EPA put in place a trading program to phase out leaded gasoline. It produced a more rapid elimination of leaded gasoline from the marketplace than had been anticipated, and at a saving of some $250 million per year, compared with a conventional no-trade, command-and-control approach. Not only did President George H.W. Bush successfully propose the use of cap-and-trade to cut SO2 emissions, his administration advocated in international forums the use of emissions trading to cut global CO2 emissions (a proposal initially resisted but ultimately adopted by the European Union). In 2005, President George W. Bush’s EPA issued the Clean Air Interstate Rule, aimed at reducing SO2 emissions by a further 70% from their 2003 level. Cap-and-trade was again the policy instrument of choice.

From Bi-Partisan Support to Ideological Polarization

When the Clean Air Act Amendments were being considered in the Congress in 1989-1990, 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. Thus, the Clean Air Act Amendments of 1990 passed the Senate by a vote of 89-11 with 87% of Republican members and 91% of Democrats voting yea, and passed the House of Representatives by a vote of 401-21 with 87% of Republicans and 96% of Democrats voting in support.

But twenty 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 House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454) – the Waxman-Markey bill – that included an economy-wide cap-and-trade system to cut CO2 emissions. The Waxman-Markey bill passed the House by a narrow margin of 219-212, with support from 83% of Democrats, but only 4% of Republicans. In July 2010, the Senate abandoned its attempt to pass companion legislation. In the process of debating this legislation, conservatives (largely Republicans and some coal-state Democrats) attacked the cap-and-trade system as “cap-and-tax,” much as an earlier generation of liberals had denigrated cap-and-trade as “selling licenses to pollute.”

It may be that some conservatives in Congress opposed climate policies because of disagreement about the threat of climate change or the costs of the policies, but instead of debating those risks and costs, they chose to launch an ultimately successful campaign to demonize and thereby tarnish cap-and-trade as an instrument of public policy, rendering it “collateral damage” in the wider climate policy battle.

Today that “scorched-earth” approach may have come back to haunt conservatives.  Have they now boxed themselves into a corner, unable to support the power of the marketplace to reduce their own states’ compliance costs under the new EPA CO2 regulation?  I hope not, but only time will tell.

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