Whither Markets for Environmental Regulation?

Over the past 60 years, regulators have implemented market-based programs for air pollution, water pollution, land management, and other environmental policy problems at local, state, federal, and—in the case of greenhouse gas regulation—international levels. Some applications hew more closely than others to ideal market-based policy design, as defined by economic theory, and programs have met with varying degrees of success. In this symposium, drawn from discussions at RFF’s December 2012 First Wednesday Seminar, four RFF scholars draw lessons from the successes—of which there have been few—and the many failures. They also consider the desirability, feasibility, and design of market-based environmental policy in the future.

Dallas Burtraw on Air Quality Trading

In the standard undergraduate and graduate economics classrooms, the failings of regulation are made a caricature. The regulatory approach is erased and replaced with the market, and the problem is assumed solved.

The flaw in this caricature is the exclusion of any role for an expert agency in the implementation and management of economic ideas.

The US sulfur dioxide (SO2) market is a good example. Surely, the US Environmental Protection Agency (EPA) did a beautiful job implementing the SO2 Trading Program through its Clean Air Markets Division. The program achieved virtually 100 percent compliance, and the costs were much lower than expected. And by 1995 the marginal benefits of the program were estimated by RFF and EPA to be 30 to 50 times greater than the marginal costs.

So let’s pause and ask, “What’s wrong with this picture?” Specifically, how can a program with marginal benefits 30 to 50 times greater than marginal costs be considered an economic success?

The problem is that substantial costeffective improvements to health and the environment were not taken advantage of under the market-based program. In fact, by 2015 more than half the reductions in SO2 that will have been achieved since 1990 will have occurred through the regulatory authority of the Clean Air Act, not the emissions trading market.

Fortunately, EPA retained its role as an expert agency and used its regulatory authority under the Clean Air Act to realize tens of billions of dollars in health improvements and net benefits per year.

To fix the program would seem simple enough. Title IV of the 1990 Clean Air Act amendments needed to delegate to the expert agency the role of considering new scientific information in adjusting the cap accordingly. But this role is not typically envisioned in economic advice, which mostly treats environmental policy as a one-time problem, not an ongoing process in a dynamic policy context. On the other hand, regulation under the Clean Air Act does so explicitly.

Going forward, I think the challenge for economists in the next decade of air regulation is a move away from the mental model of markets replacing regulation. Instead, the big opportunity is to consider how incentives can be infused into the regulatory process.

Art Fraas on Opportunities for Market-Based Regulation

An important feature of the US Office of Management and Budget (OMB) review is to encourage agencies to incorporate economic incentive approaches in their rules. When I was at OMB, serving as chief of the Natural Resources, Energy, and Agriculture Branch in the Office of Information and Regulatory Affairs, marketable permits and trading were toward the top of our list of best approaches.

Over the years, we suggested a number of economic incentive approaches to the agencies, only some of which were adopted. One that was not adopted was a cap-and-trade program for the industrial use of asbestos as a response to the draft EPA Asbestos Ban Rule under the Toxic Substances Control Act. EPA’s rule was not an absolute ban of asbestos. It provided for some uses of asbestos that are absolutely critical to certain industrial processes and for national defense.

Implementing a cap-and-trade program for these uses would have had a number of advantages. The proposed program would have focused on industrial and government uses—and would not have applied to consumer products in order to limit general population exposure. There were a number of market participants, with heterogeneity across industrial and governmental users. Knowledge was dispersed among the various users. In fact, a number of uses for asbestos were secret, especially in the defense area.

These attributes made a cap-and-trade approach attractive. Cap-and-trade would direct asbestos to the highest-valued uses. The price of allowances would provide an incentive for innovation to reduce asbestos use. And the cap-and-trade program would provide EPA with information about how stringent the program was and allow it to calibrate any further phase-down of asbestos use.

Despite these advantages, EPA came back to us after several months of due consideration and responded that a cap-and-trade program would be too complicated. Monitoring and enforcing the proper use of an asbestos allowance, the agency said, would be too burdensome. Instead, it issued the Asbestos Ban and Phaseout Rule in 1989 without including trading. EPA’s final rule was overturned in court two years later in part because EPA failed to consider less burdensome approaches as alternatives to an absolute ban.

There are some lessons to draw from this experience. The first is that the economic incentive approach has to be acceptable from a policy standpoint. I think EPA viewed the Asbestos Ban Rule as a slam dunk, so from the agency’s perspective, it didn’t need a better rule. Another factor is that users would have to pay for their allowances. After we proposed our approach, we heard from our colleagues on the budget side at the Department of Justice’s National Security Division. With a little bit of incredulity in their voices, they said, “You know, the Department of Defense would have to buy allowances for their users of asbestos.” And we said, “So?”

The SO₂ cap-and-trade program and its successors provide an additional cautionary tale. The original program, implemented under Title IV of the 1990 Clean Air Act Amendments, is a living legend—it achieved substantial cost-effective reductions in national SO₂ emissions from the electric power sector. Now that’s something to be excited about. But a recent paper suggests that trading may have increased damages because, ton-for-ton, trading did not take into account the location of damages.

A key problem of the successor programs, the Clean Air Interstate Rule (CAIR) and the Cross-State Air Pollution Rule (CSAPR), has been a concern with these location-specific damages. In order to ensure that downwind states are adequately protected, CSAPR adopted very stringent limits on the extent of interstate trading and the use of banked credits. So if you celebrated the economic incentive advantages of the Title IV SO₂ Program, there’s no basis for celebrating CSAPR with its stunted banking and trading programs. If CSAPR survives court challenge, banking and trading will be negligible—a ghost of the earlier trading programs.

There is a fundamental tension between the environmental goals of the regulators and the requirements for a well-functioning and efficient market-based approach. Where there is a conflict, my experience suggests that the preferences and prerogatives of the regulators will dominate. Market-based approaches will perform best where established through statute and structured to respond to the environmental goals of regulators.

Margaret Walls on Transferable Development Rights

Land markets are a local story because private markets are regulated through zoning codes, building codes, and a variety of regulations that are established at the local level.

The use of market mechanisms at the local level is in the form of programs for transferable development rights (TDR). In a TDR program, the ownership of development rights is separated from ownership of the land itself. Landowners are permitted to sell those rights in a marketplace separate from actually selling their land. In general, these sellers are the people who are going to put an easement on their property and protect it. The demanders are developers who are then going to use those rights and develop somewhere else.

There are about 180 such programs in communities across the country, and they’re designed in various ways. They’re targeted to achieve a variety of different outcomes, including protecting farmland, limiting sprawl, and preserving environmentally sensitive sites.

As with air and water, the literature on landmark TDR programs tells the same story. Regulations are very command-andcontrol oriented and have lacked flexibility. So trading theoretically should engender cost savings and efficiency enhancements.

What are the outcomes we’ve seen in TDR programs? So far, among these 180 programs, I could count on one hand the number in which trades have taken place. The primary reason, in my view after studying these for many years, is related to the demand side of the marketplace.

Often the programs have been overprescribed and over-regulated by the local planners who set them up. They can’t let go of the zoning idea, so they restrict who is allowed to use the rights and develop more densely. As a result, a market never develops. Another problem is the markets are established within an individual county or municipality level, so you have a fairly thin market.

Even the successful programs are subject to controversy. These are the ones that have managed to protect, in many cases, tens of thousands of acres of land at zero cost to the government. One example is a very flexible TDR program in Calvert County, Maryland. It has protected about 23,000 acres of land and is the most market-like TDR program I’ve found.

Yet there are many critics of that program. Why? In my view, it’s that no one knows the counterfactual. I look at the program, and I see that 23,000 acres were protected. I see that trades were made. That must mean voluntary purchasers and sellers made themselves better off by engaging in a trade; otherwise, they wouldn’t do it.

But the planners don’t like the Calvert program because it hasn’t led to farming, which they have as a goal, and there is still quite a bit of development in the county. So some people see sprawl where I see voluntary trades that have been made to everyone’s benefit. Our measures of success need further elaboration.

Len Shabman on Water Quality Trading

Most water quality trading programs today bear little resemblance to the market-like effluent tax or cap-and-trade policy designs long advocated by economists. Most are basically designed to force regulated sources of pollution and their customers to pay for pollution-reduction practices at unregulated non-point sources—that is, on farms and ranches. As such, these so-called trading programs are not performancebased or outcome-oriented. They do not give dischargers the flexibilities that would allow them to innovate.

The principal reason lies with the passage of the Federal Water Pollution Control Act Amendments of 1972, which—unintentionally, perhaps—are hostile to any form of trading or effluent tax. The amendments reflect the notion that the only acceptable discharge is zero discharge. At the time the amendments were written, that vision applied only to what were defined as point sources: factories, sewage treatment plants, and the like. To push these regulated sources toward zero, the act set up a particular permitting system that is the antithesis of flexibility. The regulator would decide when the technologies that should be used in waste control were attainable. Then as new technologies came along, the regulator would ratchet down and continually drive the regulated sources toward zero.

Non-point sources were not considered significant in the 1972 law and are outside the reach of the regulatory program. So what regulators wound up doing—and are continuing to do—was seeking to reduce agricultural sources with US Department of Agriculture and state cost—share subsidiary programs. These programs essentially pay farmers and ranchers a certain amount of the implementation costs associated with practices that are predicted by models to make a difference in water quality. The design of most, but not all, water quality trading programs is basically to force urban water customers and customers of affected industries to subsidize the installation of these farm and ranch best-management practices.

Let me quickly evaluate this tradingas-funding approach: I’m a skeptic. Even leaving aside the very real monitoring and evaluation challenges, the revenue potential of trading for funding for these best practices is extremely limited. Consider one illustration from the Gulf of Mexico.

Ten percent of the total pollution load going into the Mississippi Basin and causing the hypoxia problem in the Gulf comes from point sources. If those 10 percent didn’t even have to ratchet down anymore and instead were pushed to pay agriculture for some offsets, we wouldn’t make a dent in the water quality problems that are being caused by agriculture in the Gulf of Mexico. So this idea that trading is going to somehow generate revenue falls flat, let alone other issues that could be raised.

Further Reading

Burtraw, Dallas. 2013. The Institutional Blind Spot in Environmental Economics. Resources 182: 30–35.

Shabman, Leonard, and Kurt Stephenson. 2011. Rhetoric and Reality of Water Quality Trading and the Potential for Market-Like Reform. Journal of the American Water Resources Association 47(1) 15-28.

Walls, Margaret. 2011. Markets for Development Rights: Lessons Learned from Three Decades of a TDR Program. Discussion paper 12-49. Washington, DC: Resources for the Future.