The Institutional Blind Spot in Environmental Economics

At least among economists, one often-heard lament is that those who develop and implement environmental policy rarely follow economic advice. Once a policy goal is established, economists typically feel confident that economic approaches to environmental policy can help achieve the goal at less cost, which should be good for everyone. Why, then, are economic methods not the central tools for implementation of environmental policy?

One reason is that these tools often have been developed in an intellectual laboratory that, for the most part, is free from consideration of institutions that influence how they will be used. Confidence in the outcome of any policy approach requires full consideration of its broader institutional setting. Economic methods may not work exactly as anticipated, in part perhaps because institutional influences are not addressed in most economic writing. To resolve this issue, economic discourse must incorporate a more sophisticated understanding of institutions (broadly defined) than is usually achieved.

I consider three institutional relationships that strongly influence how economic tools can be used in environmental policy. One such institution is the federalist nature of governmental authority, especially with respect to issues central to the management of the environment and natural resources. A second is how this federalist structure interacts with the economic alternatives of cap and trade versus emissions fees. A national emissions cap on carbon dioxide, for example, would undermine actions by local and state governments that would go above and beyond that cap. Third, another core institution is the venerable Clean Air Act, which since 1990 has outperformed market-based approaches to curbing emissions.

The Federal Structure of the US Government

A common dilemma for regulators is how to promote the adoption of state-of-the-art technology without providing incentives for deviant or unintended responses. Economists have an answer: use prices to provide incentives for investors to align their actions with social interests. In principle, a set of prices that accurately reflects the damage from various investment choices, including the continued operation of an existing facility, will accomplish just that. But honestly, after providing a recommendation like that, economists like me often feel our work is done. We offer guidance that is logical and compelling. Why is it rarely adopted?

One obvious answer is that the status quo has its own constituency. In any context, a change in the rules will create losers who will act to obstruct such a change. More deeply, though, existing rules and institutions strongly affect our ability to implement new ideas. Although institutions can be painfully recalcitrant, it might be useful to think of them as the watchtowers that protect the precedents and values of previous social decisions.

"Although institutions can be painfully recalcitrant, it might be useful to think of them as the watchtowers that protect the precedents and values of previous social decisions."

A relevant core institution is the federal structure of governance in the United States. Most economic analysis suffers from a lack of understanding of how price incentives are transmitted to markets through different levels of government. For instance, the way in which environmental prices would propagate through and provide incentives for the consumers and producers of electricity varies importantly among states that have regulated cost-of-service versus competitive electricity markets.

We have even less understanding of how price signals under a national policy directly affect other layers of government. There is evidence that mobile resources, such as labor and new capital investment, move to jurisdictions that are less expensive and/ or provide better services, which gives an economic incentive for efficient government. Similarly, when facing a national emissions price, a locality has the incentive to choose a cost-effective response. But the myriad layers of institutional authority mean that the response of individual bureaus may not be efficient or timely. Generally, local regulatory institutions are organized to modify the influence of price signals, not to transmit or amplify them.

Furthermore, local governments conduct a variety of functions with substantial environmental consequences that federal authorities could not possibly provide based on the information available to them. For example, local authorities decide the alignment of streets and building footprints, they implement building standards that affect heating and cooling needs, and they determine land use and transportation systems that influence where people live in relation to their work. The sum of these subnational activities pervasively shapes the long-lived infrastructure that will constrain our options to address issues such as climate change for decades into the future. The influence on the global climate, in the aggregate, is profound.

Compound layers of agency exist between national-level policy, fuel markets, and local decisionmakers. Information asymmetries between multiple layers of government imply that a cost-effective outcome is dependent on decentralized policies and behavior such as those that occur on a subnational level. Hence, state and local governments are uniquely positioned to implement many aspects of an overall climate strategy. The institutional question is whether a price signal would provide incentive for these governmental actors to do so. One can anticipate that economic forces will ultimately influence local tastes in planning functions. The difficulty is that one may have to wait for prices to rise high enough and persist long enough to evoke changes in infrastructure investment—and then wait decades longer for new infrastructure to take shape. If one’s concern is climate change, the process may feel too long because, in the meantime, local decisions using conventional planning tools continue to lay the foundation that constrains society’s options for decades to come.

Subnational Policy under an Emissions Cap versus a Tax

A persistent parlor question in economic thinking is the relative advantage of cap and trade versus an emissions tax. For the most part, economic advice considers the two approaches fairly equivalent, with nuanced issues favoring one or the other policy in the face of uncertainty about benefits or costs. The answer to this question almost never addresses the influence of each instrument within a federalist system of governance. However, the two approaches are dramatically opposed when it comes to transmitting incentives to affect behavior by subnational levels of government.

Under an emissions cap, because maximum emissions are fixed at the national level, the actions of subnational government cannot affect the overall level of emissions. Although described as an emissions cap, such a policy is also effectively an emissions floor because any effort to reduce emissions by one entity, including state and local governments or private parties, does not affect the overall level of emissions. In effect, a cap-and-trade program at the national level preempts efforts to achieve additional emissions reductions at the local level.

In contrast, the same issues do not arise under a national emissions fee. A jurisdiction with a greater willingness to pay for emissions reductions could adopt ancillary measures that would result in additional reductions. Unlike under a quantity constraint, net reductions in emissions can be achieved.

Economic advice typically has not considered the interaction of policy design at the national level with the incentive or need for subnational action. If one believes that prices are perfectly salient and the national government can set the optimal policy, there is no role for subnational action; one effectively embraces a unitary model of government. However, if prices are not perfectly salient, the ability of policy to provide incentives to subnational levels of government is important. A tax instrument at the national level would have strong advantages over cap and trade in this regard.

This example illustrates that new ideas are usually not born fully formed and can have their own unanticipated outcomes. Few advocates of a cap-and-trade program have anticipated that this approach is likely to diminish greatly the incentives for local innovation in climate policy. Whether this characteristic is a disadvantage or not depends on one’s point of view, but the fact is that it is generally unappreciated in economic discourse.

Regulation versus Economic Tools

Traditional approaches to regulation under the Clean Air Act are disparaged by many economists for their inefficiencies. But for environmental advocates, a remarkable attribute of the act is that it provides a safety ratchet promoting incremental environmental progress without backsliding. Perhaps surprisingly, this is evident even where economic approaches have ostensibly had their greatest influence—the innovation of emissions allowance trading for sulfur dioxide. Indeed, the sulfur dioxide trading program is trumpeted for providing a cost-effective implementation of substantial reductions in emissions and is the leading example of the use of economic instruments in environmental policy.

The trading program was statutorily created in the Clean Air Act Amendments of 1990 and led to cost reductions of roughly 40 percent compared with traditional approaches under the Clean Air Act. However, the program had what literally became a fatal flaw: namely, an inability to adjust to new scientific or economic information. Information current in 1990 suggested that benefits of the program would be nearly equal to costs; today the Environmental Protection Agency would argue that benefits are more than 30 times the costs. Unfortunately, changing the stringency of the program requires an act of Congress, at least according to the DC Circuit Court. The act locked in the emissions cap, and despite several legislative initiatives to change the stringency of the trading program, none have been successful.

The failure to amend the statute is emblematic of the limitation of legislative actors to finely manage scientific information, a role that is usually left to expert agencies. If the nation’s fate with respect to sulfur dioxide emissions were left to Congress, tens of billions of dollars in additional environmental and public health costs would have been incurred in the last few years and into the future. Fortunately, the inability of Congress to act was backstopped by the regulatory ratchet of the Clean Air Act that triggers a procession of regulatory initiatives based on scientific findings.

The sulfur dioxide cap-and-trade program was intended to reduce emissions from power plants from anticipated levels of 16 million tons per year to 8.95 million tons per year by 2010. However, evidence based on integrated assessment suggests an efficient level would be just over 1 million tons per year. In the absence of legislative action, regulatory initiatives have taken effect and driven emissions from power plants to 5.157 million tons, as measured in 2010. By 2015, the Clean Air Interstate Rule and the Mercury and Air Toxics Standard will further reduce emissions to 2.3 million tons per year. The emissions constraint under the 1990 Clean Air Act Amendments has become irrelevant, and the price of those tradable emissions allowances has fallen from several hundred dollars a ton to near zero.

The sulfur dioxide cap-and-trade program is the flagship example of the use of economic instruments in environmental policy. However, since its adoption in 1990, although the sulfur dioxide trading program gets most of the credit in textbooks, fully half of the emissions reductions that have been achieved and will occur are due to regulation. Without the Clean Air Act in place, the flagship program in emissions trading would have left unrealized substantial benefits to public health and the environment.

A New Round of Thinking

Economic advice for the design of environmental policy emphasizes cost-effectiveness, a criterion that is centrally important in facing the most challenging environmental issue of our time, climate change. A virtue of economic approaches is that they are typically simple and, in principle, cost-effective. However, for economic advice to reach its full influence requires consideration of the role of institutions and their complexity that determines how economic policies ultimately will function. The success of economic prescriptions for environmental policy depends on a new round of sophisticated thinking about institutions and how they interact with the policy tools at our disposal.