Addressing issues concerning energy and the environment: A short course

on energy policy analysis

David J. BjornstadFellow for Energy & Envirommental Policy

Alexandra BrewerGraduate Assistant

Fall 2012

Baker Center Board

Cynthia BakerMedia ConsultantWashington, DC The Honorable Howard H. Baker Jr.Former Ambassador to JapanFormer United States Senator The Honorable Phil BredesenFormer Governor of Tennessee

Sam M. BrowderRetired, Harriman Oil Sarah Keeton CampbellAttorney, Williams & Connolly, LLPWashington, DC

Jimmy G. CheekChancellor, The University of Tennessee, Knoxville AB Culvahouse Jr.Attorney, O’Melveny & Myers, LLPWashington, DC

The Honorable Albert Gore Jr.Former Vice President of the United StatesFormer United States Senator Thomas GriscomCommunications ConsultantFormer Editor, Chattanooga Times Free Press

James Haslam IIChairman and Founder, Pilot CorporationThe University of Tennessee Board of Trustees Joseph E. JohnsonFormer President, University of Tennessee Fred MarcumSenior Adviser to Senator Baker The Honorable George Cranwell MontgomeryFormer Ambassador to the Sultanate of Oman Regina MurrayKnoxville, Tennessee Lee RiedingerVice Cancellor, The University of Tennessee, Knoxville

John SeigenthalerFounder, First Amendment Center, Vanderbilt University Don C. Stansberry Jr.The University of Tennessee Board of Trustees The Honorable Don SundquistFormer Governor of Tennessee William H. SwainThe University of Tennessee Development Council The Honorable Fred ThompsonFormer United States Senator Robert WallerFormer President and CEO, Mayo Clinic

Baker Center Staff

Matt MurrayDirector

Nissa Dahlin-BrownAssociate Director

Michelle Castro Development Director

Patti RebholzBusiness Manager

Elizabeth WoodyOffice Manager

Carl PierceDirector Emeritus & Senior Fellow for Baker Studies

About the Baker CenterThe Howard H. Baker Jr. Center for Public Policy is an education and research center that serves the University of Tennessee, Knoxville, and the public. The Baker Center is a nonpartisan institute devoted to education and public policy schol-arship focused onh energy and the environment, global security, and leadership and governance.

Howard H. Baker Jr. Center for Public Policy1640 Cumberland AvenueKnoxville, TN 37996-3340

bakercenter.utk.edu865.974.0931bakercenter@utk.edu

The contents of this report were developed under a grant from the US Department of Education. How-ever, these contents do not necessarily represent the policy of the US Department of Education, and you should not assume endorsement by the federal government. Findings and opinions conveyed herein are those of the authors only and do not necessarily represent an official position of the Howard H. Baker Jr. Center for Public Policy or the University of Tennessee.

It is my pleasure to welcome you to the new Policy Brief series of the Howard H. Baker Jr. Center for Public Policy. An informed electorate is essential to active engagement in the political process and the effective operation of our system of democracy. It is often difficult for the public to identify objective, timely and bipartisan resources to inform healthy political debate and discourse. It is the purpose of the Policy Brief series to help fill this void. Researchers and policymakers who are affiliated with the Baker Center will present essays on a range of subject matter that is at the center of public debate. These essays will seek balance while at the same time presenting contrasting views of public policy problems and their potential solutions. It is my hope that you will find these Policy Briefs to be both provocative and informative.

Howard H. Baker, Jr.

The Howard H. Baker Jr. Center for Public Policy is a non-partisan institute at the University of Tennessee, Knoxville, dedicated to education, research and civil discussion of policy issues. This Policy Brief series is intended to disseminate and communicate research findings to diverse audience – to review and assess current literature and to stimulate discussions and reflection on these issues so critical to our nation.

This Policy Brief series will include short papers or essays written by Baker Center Fellows and others affiliated with the Baker Center, The Briefs are intended to be short, policy relevant, timely and accessible to a large US and international audience. The Briefs will supply hypertext links to source materials, reference lists and suggestions for further readings. Readers will be invited to comment on the Briefs, and comments will be moderated in an effort to encourage spirited, informed, and respectful dialogue, following the ideals espoused by Senator Baker.

Matthew N. Murray, PhD Director

Baker Center for Public Policy Policy Brief 1

Addressing Issues concerning energy and the

environment: A short course on energy policy analysis

David J. Bjornstad

Alexandra Brewer

Executive Summary

As the presidential election nears, the two major candidates will refine their positions toward pressing energy and environmental issues, with the goal of drawing distinctions between themselves and their opponents, while reasserting their personal concerns with these important topics. The Howard H. Baker Jr. Center for Public Policy has prepared this Policy Brief to describe the advice offered to the candidates by three important energy and environmental policy groups, to suggest some tools that can be used to help organize and assess the proposals the candidates make, and to suggest some key issues likely to arise. While we refrain from critiquing the candidates’ positions, we invite readers to offer their thoughts on the contents of this Brief, its applicability to the national energy and environmental debate, and helpfulness regarding the readers own conclusions concerning sound public policy.

The Brief is divided into a short introduction and three topical sections. The first section provides a short overview of the inputs offered by three influential groups to the debate over energy and environmental policy choices. The first of these groups, the American Petroleum Institute, puts forth four principles, around

which it argues the debate over policy should be organized. The first principle, a commitment to access federal lands, calls for opening the potential energy portfolio to broad development. The second principle, a commonsense regulatory environment, calls for greater regulatory certainty. The third principle calls for removing barriers to private sector energy investments, and the fourth calls for sustainability, interpreted as shifting the energy decision making balance from the public to the private sector. In all, the approach avoids specific recommended actions, and recognizes the need for public oversight, while deferring key choices to the private sector.

The second group, whose collection of work is provided in Daedalus (Spring 2012), seeks to reframe energy and environmental choices as integrating the private costs of energy production and use that are compensated through the prices paid by energy consumers, e.g., the payments to productive factors – land, labor and capital –with the uncompensated social costs that result from production and consumption, e.g., pollution, carbon emissions, damages to environmental resources, and the like. It is notable that regulations effectively internalize some of these costs; the key is to choose the proper level of regulation.

The third group, a collection of papers by Brookings Institution scholars, seeks to reframe energy and environmental topics within the larger debate over taxes, federal debt, and job creation. It would call, minimally, for carbon taxes that would provide incentives for carbon abatement while contributing to debt reduction, and for sensitivity to the global leadership role of the United States.

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The second section delves into the “tool box” that economists use to frame, constrain, and analyze policy topics. In its simplest form, the economic approach seeks to define the choices to be made, to measure the entirety of costs and benefits these choices affect, and to analyze the fundamental tradeoffs that different choices imply. The values of the governed are then used to evaluate tradeoffs. For example, are the health risks to coal miners compensated or uncompensated costs? How should regulators balance the personal choices of miners with the interests of the larger national community? The conclusion is ultimately a value judgment, but one that should be reduced to its most fundamental terms to facilitate explication of basic choice elements and communication with affected stakeholders. Other topics in this section include: market failure, benefit-costs analysis, considerations of future stakeholders, and conflicts between values and uncertainties.

The third section introduces four topics that are likely to rise to the forefront as the energy/environment policy debate evolves. These include: climate change, regulation of fracking, choices over energy saving technologies and products that embody them, and the smart grid. In each case, the elements of advice contained in section one can be applied to shape choice outcomes, and the tools of section two can be used to untangle the advice, or perhaps to tangle it more, at the user’s discretion.

In all, it can be argued that there are no singular answers to energy/environment choices, because answers follow from values, but that for any value set, choices can be improved through an open dialogue. We encourage readers’ comments, criticisms, and suggestions that may stimulate that dialogue. Please visit our website at www.bakercenter.utk.edu to post your comments.

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I don’t like markets, especially energy markets, but they are the only way I know to get energy prices right. I wish I could let prices float over in a small corner of the economy, so we could get an idea as to the right levels. We could then use those levels to fix prices in the rest of the economy. Paraphrased from a government official speaking at a mid-1970’s meeting of the International Association for Energy Economics, during a period marked by price controls on energy products.

With the political conventions at a close and the election drawing near, the candidates will further clarify and refine their platforms. Various news outlets, pundits, and bloggers will dissect each element of each position according to a variety of litmus tests. Will the proposal increase or reduce the numbers of jobs? Will it affect the debt? Will it add burdensome regulations? Valid tests are difficult to develop and interpret and are sometimes fraught with misconceptions. Have we really progressed very far from the above quotation?

Our goal in this Brief is to prepare an interested observer, assessing proposed solutions to energy and environmental issues, with a sample of the current commentary on reoccurring issues, a process that will help define the nature of the issue, alternative solutions, and the details that determine outcomes. Examples of these details include the following:

• How should we characterize energy and environmental issues?

• How do energy markets influence these issues?

• Why can markets fail to solve these issues?

• What policies can address these issues?

• How can benefits and costs be organized and compared?

• What about future generations?

• Can we reconcile factual and value uncertainties?

In concluding, we suggest a few additional, somewhat controversial, topics likely to arise during or after the campaign.

…………………………………….…. To begin, we review a sample of the advice

already offered to this electoral dialogue. Virtually every organization with significant standing has prepared materials to describe their own energy and environmental platforms, whether to present their own conclusions or to challenge the conclusions reached by others. Many argue from the same premises only to reach quite different conclusions. The differences lie in the logic and information employed by the contributors and the values they embody.

For example, the American Petroleum Institute (API) has prepared an agenda it suggests is appropriate to either party and is composed of four principles:

(1) A commitment to access federal lands; (2) A “commonsense” regulatory

environment; (3) Investment in America’s future, and (4) A sustainable energy future. Access to federal lands would call for a very

broad commitment to oil and gas development including the eastern Gulf of Mexico, the continental shelves, much of Colorado, and the Arctic National Wildlife Refuge. Commonsense federal regulations would rest on “legitimate” benefit-cost analysis, good science, removal of duplicative regulations, and greater regulatory certainty among other things. Investment in

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America would call for removal of federal barriers to private investment as would be addressed in points (1) and (2). A sustainable energy future would call for a commitment to allow the market (rather than the federal government) to pick winning and losing energy technologies and ending “punitive” taxes on the oil and gas industry.

This is not a radical agenda, and it is hard to argue against good science, efficient regulation, cost-benefit analysis, and market-driven choices. The agenda emphasizes the role of the petroleum industry in the economy and the steps the industry sees necessary to maintain that role. It focuses on what we describe below as private costs and benefits. It does not, however, highlight the detailed process of developing commonsense, legitimate and/or sustainable choices and futures. It does propose delegating greater regulatory discretion to states, an outcome that could lead states to compete with one another over regulatory stringency. The agenda also emphasizes the importance of job creation. It does not call for more or less government spending, though the policy choices by the states or Federal agencies would imply greater or lesser costs to consumers to compensate or reduce what we describe below as social costs. It minimizes concern over the costs to present and future generations that could be generated by open access, coupled with market-driven criteria for sustainability. Implementing the API proposal could lead to very different futures, depending on the choices made to implement it. It identifies tradeoffs between higher standards for resource and environmental management practices and the prices consumers pay for energy products. It also implies tradeoffs between the current husbandry of non-renewable resources or irreversible environmental impacts and future

availabilities of resources and environmental amenities.

Other authors suggest greater focus on the detailed costs of energy product production and consumption costs that the API document recognizes, but does not quantify. A recent Special Edition of Daedalus addressed this topic in some detail. Edited by Robert W. Fri and Stephen Ansolabehere, this edition provides estimates of the “full costs” of energy production and consumption and asserts that a principal element in the weak foundation for energy policy in the United States is an unwillingness to face up to the complete package of benefits and costs that the energy system delivers. Michael Greenstone and Adam Looney, for example, seek to quantify “external costs” (the costs that using or producing energy products imposes on others, such as polluted water, unhealthy air, or improper waste disposal) for several fuels taking into account impacts on health, safety, climate and other things. Drawing a distinction between private costs, the costs a buyer pays at the pump, and social costs, private costs plus external costs, Greenstone and Looney suggest that private costs may account for only about one half of total costs for some fuels, such as coal. To be fair, it should be recognized that Greenstone and Looney employ a damage-based estimation approach in calculating social costs. An alternative approach, using willingness-to-pay as a metric, could reach different conclusions, because it would be based on the value consumers place on avoiding damages rather

Consumers of energy products pay a price that reflects the cost to produce the product, including labor, capital, fuels, and profits. These are termed private costs.

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than on estimates of consumers’ costs of bearing them. It also includes costs from climate change, a topic which most scientists find real and impending and many members of the lay public find abstract and exaggerated. Finally, the valuation metric is ethically-laden because many external costs are borne disproportionately by the weaker and most vulnerable members of society, who also are poorer, with less ability and, therefore, less willingness, to pay. The point is that regardless of whether people pay to avoid bearing external costs or pay by bearing them, their existence is a fact of life, the costs they impose are real, and their management is a policy issue.

Based on their work, Greenstone and Looney offer four recommendations:

(1) Appropriately price the external costs of energy production and use;

(2) Fund basic research, development, and demonstration;

(3) Make regulations more efficient, and (4) Address climate change on a global

scale.

Other contributors to the Fri and Ansolabehere Special Edition proffer policies that generally complement this advice. Policies working through markets, such as excise taxes and/or cap and trade mechanisms are recommended as providing efficient regulatory outcomes, a topic we discuss further below. The document also contains interesting pieces on shale oil, technological change that supports

green energy sources, and public attitudes toward climate change analyses. In addition, it calls for gaining a better understanding of consumer attitudes and behavior concerning energy-related choices as tools for informing policy. Again, the analysis is not radical, but it focuses on social costs that could be added to private costs of energy production and therefore rests heavily on the methodologies used in estimating the costs and benefits of alternative energy sources. Its conclusions, if followed, would represent a fundamental change in energy policy and to conventional lifestyles. Certainly, a proposal to adopt policies that would increase energy prices by large measures would be controversial.

A third approach is to embed key energy issues into the larger policy context and adopt general policies that support broad national goals, while reducing detailed attention on situation-specific regulations, taxes and subsidies. Ted Gayer, Charles K. Ebinger and Govinda Avasarala, and Katherine Sierra each approach this from different directions in a series of essays featured on the Brookings Institution website.

Gayer recalls that during the 2008 Presidential campaign public support of cap and trade policy solutions to global climate concerns led both candidates to feature energy and environmental topics prominently in their platforms. Since that time, however, public support for a comprehensive energy strategy has declined as attention has refocused on economic and health care delivery issues. Gayer also notes that four years later a search of President Obama’s and Mitt Romney’s campaign websites reveals no mention of climate change. Romney’s website does, however, promote the elimination of regulations promulgated in pursuit of carbon

In addition to private costs the production and consumption of energy products creates social costs, imposed on society at large. Social costs include pollution, damages to the environment, and other costs.

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control. Instead, Gayer suggests that the current websites reveal a focus on green energy as a source of jobs, on tax reforms and on spending reductions. For these reasons, Gayer proposes focusing on pursuit of a small set of high impact activities – a carbon tax with revenues used for deficit reduction, less emphasis on subsidizing green technologies, and less emphasis on green job creation, which he discounts. If opportunities present themselves, he recommends that market-based policies should be developed.

Sierra agrees that comprehensive energy policy would be an unlikely outcome of the current election but points out that even bare bones reforms will generate costs and force tradeoffs. She argues that pricing carbon will create winners and losers, and losers will seek political relief. Pricing carbon would increase the United States’ leadership position on global environmental topics, but dropping subsidies to green technologies would reduce options for private responses to more costly carbon emissions. Fewer technologies developed to a less mature state would also increase the cost of the global response to mitigate greenhouse gas production. Moreover, all of this would ignore producing alternatives for climate adaptation measures.

Finally, Ebinger and Avasarala point out that energy and environmental issues go beyond pricing carbon. The Arab Spring served to reinforce the complexities of the world oil markets and vulnerabilities from hostile export markets. The world-wide crude oil price spike due to disruption of Libya’s relatively minor share of world crude production served notice of the value of alternatives to imported fossil fuels. The Fukushima nuclear power disaster reduced the acceptability of the nuclear-electricity alternative and led to tighter world

gas markets as Japan sought energy sources to replace its abandoned base-load reactors. The emergence of fracking as an enhanced oil and gas recovery option has opened up previously unproductive fields in the U.S. and will likely find applicability across the globe. These examples highlight the interdependency of world oil and gas markets and suggest that benefits from new gas and oil production technologies will place bounds on the hegemony traditionally enjoyed by Mideast producers. While weakening United States dependence on Mideast oil, enhanced oil and gas production will also weaken political bonds between Mideast producers and American consumers and could create a power vacuum in which large, developing nations such as China and India could form new alliances. Finally, the authors note that the political transformations noted by Gayer will militate against addressing climate change, an issue that “best science” regards as a very real environmental threat.

In sum, we have a call for loosening the ties that bind petroleum markets, for a greater focus on adding “social costs” to the current costs of energy products, for integrating environmental issues into the broader debate over federal deficit reduction and jobs creation, and for resisting pressures to reduce an American presence in the global oil political

The regulator evaluates damages from social costs and takes steps to reduce them through regulations. This raises costs of production and use, effectively converting social costs to private costs. Because private costs must be paid they create incentives for more efficient behavior, such as reducing energy use, switching fuels, or using different technologies.

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arena. Any number of additional advisory pieces could have been added to or substituted for those chosen. See, for example, a report produced by Resources for the Future, which provides extensive quantitative analyses of numerous different policy combinations.

…………..……………………………. The question thus arises: Is it possible to

reconcile the conclusions raised by the types of policy analysis reviewed above? Is there a single bottom line which informed discourse would reach? Or, are all suggestions simply justifications for answers that various players have long since embraced? In each case the answer is a qualified no. At some point, all policy discourse can be reduced to beliefs and values, and beliefs and values are not shared universally. Moreover, positions by individuals and groups can change, as when unacceptably high unemployment concerns overshadow other topics viewed as less immediate. What is needed is not a grail, an overriding principle that can be applied universally, but rather a process that can point out errors of omission and commission and identify opportunities for competing parties to compare, discuss, and perhaps compromise their policy positions. The goal of this piece is not to review the entirety of this process, but to suggest a few starting points.

• Energy and related environmental issues arise over choices by energy consumers and producers

The principal issue that arises over energy production and consumption is that some costs and benefits directly caused by production and consumption are not reflected in market prices. Those costs that are contained in market prices are termed private costs and include the costs

of producing and delivering energy products to consumers, including costs due to existing regulations and environmental controls. Costs not reflected in market prices, but which are borne by society at large are termed social costs. Social costs are also referred to as “negative externalities” to reflect that their impacts are external to the choice that led to their creation. In the studies reviewed above, external costs were considered in different ways. In the API document, they were recognized as real, but subsidiary to a commitment to continue using oil and gas to meet significant fractions of our energy needs (API). In contrast, in the Daedalus edition, external costs were viewed as factors that if properly integrated would lead to rethinking this commitment and cause a shift from oil and gas to other energy forms. Hence, a significant element in energy and environmental policy is to determine which costs to internalize, that is, to reflect in market prices.

It is also noteworthy that the nation already has an extensive and complicated set of policies and regulations that govern energy production and consumption. The issues can therefore often, though not always, be cast as trading off the costs of an additional “unit” of control relative to its benefits. In other cases, however, the issue is whether or not to bring new categories of pollutants under control. Choices over greenhouse gas emissions abatement constitute one such issue.

• Consumer and producer choices interact through markets

Over and over we hear that reliance on markets is key to resolving energy issues. One reason for this is that market prices provide information on the costs of producing energy products and the values buyers place on the

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products, and create incentives for both buyers and sellers to act on this information. The API document, for example, called for a greater reliance on markets. If the solution is so simple, why is it not also obvious?

To begin, consider that energy markets are very specific institutions through which energy products are bought and sold. Three attributes of the products are important:

(1) Energy products are commodities; (2) They are valued for the services they

provide rather than for themselves, and (3) As we have noted, energy production

and use generates externalities. Energy products are commodities in the

sense they are close or equal substitutes to one another and compete in consumption and business uses. As a first approximation, we would expect energy products within a given category to sell for about the same price in the same geographical markets, and energy products in different categories to reflect differences in energy content and other relevant attributes, subject to existing capital stocks and other factors. Examples of product categories are crude oil, natural gas, and coal. Electricity is a special case because it is an energy product that can be produced using other fuels. When electricity is generated, the energy content of the fuels used in generation is somewhat dissipated, such that the energy content of the electricity output is less than that of the input fuels, an outcome termed an efficiency loss. Further efficiency losses accrue to transmission and distribution. Opportunities to store electricity are limited. The energy content of other fuels is similarly dissipated when used to produce energy services, such that burning oil, as in an auto, leads to an efficiency loss.

A significant goal of energy policies is to reduce inefficiencies, that is, to reduce energy losses in producing energy services. Interfuel efficiency comparisons can be troublesome, for example, comparing the efficiencies of autos fueled by gasoline and those fueled by electricity. Driving a car fueled by electricity can be viewed as fueled by the fuel used to generate the electricity. To a large extent this means that many electric cars are actually coal-powered.

A second consideration is that the demand for energy products is derived from the services they provide. Consumers are largely indifferent as to how their electricity is generated, and the value they place on energy products derives from the value they place on its services. Thus, ethanol is an acceptable substitute for gasoline, other things being equal, and electricity generated by natural gas is a substitute for that generated by nuclear power. But, often, other things are not equal. Powering electrical generation by coal, yields different by-products than doing so by nuclear-generated steam, by natural gas, wind, or other energy sources. Comparing fuel cycles reveals different costs from fuel extraction, required capital, and from by-product disposal. Some of these costs are private and internal, that is, reflected in the price paid by the consumer, and others are external, that is, borne by others who are unfortunate enough to be unable to avoid smoke, ashes, carbon dioxide, or whatever other negative by-products are produced.

Third, in principle, external costs can be valued and measured, but left to themselves, markets will not take them into account.

In addition markets may be geographical, such as world-wide or regional, political, such as within a nation or other jurisdiction, or within

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the influence of powerful players, such as OPEC. In a world-wide market, such as that for crude oil, one would expect that a policy to lower the price of domestic United States crude oil relative to that in other markets would lead to arbitrage, that is, the shipment of products from one market to another to take advantage of price differentials. This would tend to generate a single, world-wide price, with low-cost producers earning the largest profits and marginal producers earning the smallest profits. The notion that increasing domestic production of, for example, crude oil can be used as a means to lower domestic oil prices below that of world prices, in any but the nearest term, is a myth. However, crude oil production is dominated by a few large offshore players who, to a degree, can coordinate production behavior to hold overall oil prices at levels that serve their best interests. The oil prices and quantities generated by markets are said to represent equilibriums, in the sense that they are, at any point in time, representative of supplies and demands and the values that consumers and producers place on them.

Moreover, not all players in the market for crude oil directly produce or use crude oil. Futures markets for crude oil were designed to permit energy sellers and users to lock in future prices and quantities, thereby stabilizing market transactions over time, much like insurance markets permit individuals to pool the risk of significant losses. But speculators can also affect price levels. Some analysts discount the impact of speculation, relative to fundamental forces. Other analysts now estimate that only about 30 percent of crude oil futures transactions are by actual users and suppliers, while the remainder is comprised of various sorts of speculators, for example, hedge funds seeking protection from inflation or investors speculating on future world economic

outcomes. If this is so, oil price swings may be influenced by whatever events affect inflation or world financial uncertainty, such as political tensions, weather events, and economic downturns, in addition to demand and supply fundamentals. The complicated, and to an extent, poorly understood markets through which futures trades take place make it difficult to reach firm conclusions.

• Markets can also “fail”

As objectionable it may sound to some, when markets fail to incorporate social costs, the price and quantity equilibriums they produce are not optimal, and consideration should be given to undertaking policies that add omitted social costs into market processes. In other words, markets can fail to reach socially desirable prices and quantities because they do not take into account the full costs that energy product production and use incur. Costs might be the effects of pollution related to health and well-being or any of the various negative impacts that Greenstone and Looney discuss. Naturally, there are numerous details that must be taken into account to implement policies to reduce these effects. As an example, it is commonly argued that the socially optimal level of pollution is generally not zero, because the unit costs of pollution abatement increase as the amount of pollution is reduced and at some point the value of resources devoted to one type of abatement might better be spent in other ways. The policy choice is therefore not the quantity of the pollutant, but the value that society places on its abatement.

Note that this argument rests on the belief that people actually discriminate among types of pollution in the environment – the air, water, and soils – and have values that lead to willingness-to-pay to avoid them. The bulk of

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the literature suggests that people do have such values and are, for example, willing-to-pay to reduce lead in exhaust emissions that reduce their children’s’ ability to learn, to reduce the likelihood that rivers in industrial cities occasionally catch on fire, and as so on. However, willingness-to-pay for these external costs differs among individuals and has limits. The debate over who should pay, how much they should pay, and through what mechanism has been heated, but despite this the Clear Air, Water, and related Acts have found broad acceptance over time. Nevertheless, extending pollution abatement policies to new external costs will always be disputed. In particular, the debate over policies to deal with climate change presents a significant challenge.

A separate type of “market failure” is characterized by a failure of households and other consumers of energy products to avail themselves of technologies that could cost-effectively reduce energy consumption. The matter is cast as follows: if it is possible to purchase an energy-using product that saves enough energy to compensate premiums in the original purchase cost of the product (more energy efficient products typically cost more than less efficient products) and a consumer fails to do so, should government enact policies to promote the purchase of the energy efficient products? The matter is roughly opposite that of negative externalities wherein third parties suffer from choices made by buyers and sellers. Sometimes termed “positive internalities,” these choices presume that buyers defer opportunities for gain for poorly understood reasons, for example, a lack of information

about opportunities to save energy, uncertainties about the performance of the products, the future behavior of energy prices, or a simple disinterest in saving energy.

• Well-designed policies can address market failures

Two general classes of tools are available to policy makers to address emissions from the production and use of energy services. The first type of policy, which we referred to above as rule-based, is variously called command and control, direct regulation, and standard-setting. It consists of telling those who emit or otherwise degrade environmental resources exactly what they have to do to comply with a regulation. The second approach makes use of taxes and/or permits, works through market incentives, and enables those subject to regulation to make choices over how best to comply. Both share the attribute that regulators must set pollution targets, implement a system to meet these targets, and monitor the behavior of those subject to regulation.

Consider, for example, a policy seeking to reduce carbon dioxide emissions from a class of coal-fueled water boilers. The rule-based approach might calculate a target level of emissions that could feasibly be achieved using combinations of technology (such as CO2 scrubbers), mixtures of coals, and appropriate operating procedures. A governing agency might prepare a rule requiring that each boiler falling into the regulated class would use a specific scrubber, mixture of coals and a predetermined set of operating procedures. Under such a rule, each boiler in the category would be treated in the same manner. The regulating agency would only have to verify that the three required practices were in place. It

Regulators can use rule-based policies or market-based policies. Rule-based policies prescribe specific behavior.

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would not measure CO2 emissions. This approach also provides a firm with a defense in the event the rule-based approach fails. Rule-based systems work best when flexibility on the part of the regulated is less of an issue than meeting the emission target. Rules can also be effective when individual contributions to a common goal are small (and therefore often ignored by consumers) but taken as a whole add up to a significant savings, such as energy efficiency performance standards for appliances. In any case, rules treat all regulated agents in the same prescriptive manner.

The second general approach works through markets, and essentially creates a price for emissions of some undesirable product which in turn triggers efficient behavior on the part of the regulated. This approach can be carried out in two general ways, each of which can be implemented in a number of different specific methods. In either case the, the underlying strategy is the same. By charging a price for an emission, the firm has an incentive to consider the costs of pollution when choosing its overall production strategy. If the firm can abate inexpensively, it can choose to emit little or none of the pollutant. If it has higher costs of abatement it can choose to pay the price of emissions. By introducing the flexibility, the firm can take advantage of its own knowledge about its business and develop unique strategies to comply with the regulation.

The first market approach, a tax on emission quantities, requires the regulator to

determine a policy target of (for example) industrial CO2 emissions and the cost to the industry of abatement. Then, the regulator would determine a single tax to be levied on the quantity of CO2 emitted by each firm in the industry. Individual firms emitting CO2 would evaluate whether it would be more cost effective to abate emissions through some combination of technology, coal mixes, and procedures or to pay the tax. Higher taxes would lead to greater abatement and vice versa. The point of using this approach is that boiler operators have different costs of abatement and the approach encourages those who can abate most economically to do so, and those who have high costs of abatement to pay the tax. Thus, by using their own knowledge of their business, mangers can achieve virtually any overall level of abatement at a lower cost than could be obtained by the rule. The key to a successful tax on emissions is to choose the tax that would achieve the acceptable level of emissions. The challenge is to monitor firms’ emissions.

The second market approach would be to choose a level of permissible emissions and to sell or otherwise distribute permits to emitters that would permit a total level of emissions equal to the permissible level, a so-called cap and trade mechanism. Permit holders who found that they could reduce emissions for lower costs than the permits cost would then sell permits to emitters who found it less costly to buy permits than to reduce emissions. Trading would continue until there were no more opportunities to reduce emissions cost-effectively. As it turns out, the tax policy and the cap and trade policy can be made equivalent (for simple applications) with the optimal price of emissions equal to the equilibrium price of emissions permits for the same level of abatement. In either case,

Market-based policies use taxes and cap and trade mechanisms to provide incentives for firms to comply. Monitoring is required to ensure compliance occurs.

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regulators must monitor carbon emissions by firms.

So, how should we choose market-based policies over command and control rules? The reasons can be summarized as follows. The command and control policy reduces uncertainty to firms and costs to regulators. Because a uniform rule is issued industry-wide, players all do the same, irrespective of cost differentials. The rule-based approach provides firms with less flexibility to reduce pollution at least cost and less incentive to do so. Less overall monitoring is typically required and specific targets can be met. Many different specific practices can adapt rule-based regulations to a broad range of regulatory needs.

In contrast, tax/cap and trade policies are much more difficult to implement. The regulatory agency must again be able to estimate emissions targets, choose a quantity (for cap and trade) or a carbon tax that would lead to this quantity. The regulator must also be able to observe and monitor pollutants for individual firms because each firm will likely have a somewhat different set of costs given their particular circumstance and will emit a different amount. For cap and trade, regulators must hold auctions and for emissions taxes they must collect revenues based on emissions. If the agency cannot accurately estimate the cost/pollutions reduction parameters, they may have to make successive adjustments to achieve their targets. The complications of managing the details of the pricing policies are numerous.

Why would an agency then choose a tax/cap and trade regulatory solution? The simple answer is that in many applications, the tax/cap and trade approach reduces emissions at a fraction of the total cost of the command and control system. Many studies have shown this. This is because under the market-based model firms have strong incentives to optimize emissions control and in doing so can make use of their own, private information to make emissions reduction choices. Furthermore, because firms have incentives to optimize, they also have incentives to purchase the control technologies most suitable to their own circumstances, and firms producing emissions technologies have incentives to be innovative and produce technologies suitable to different firm circumstances. But it should also be noted that regulatory agencies also face a number of other difficult choices. It is always possible for policies to fail to achieve their targets, an outcome sometimes termed policy failure.

Finally, taxes are not popular in the current U.S. political scene and typically face significant opposition. The cap and trade solution does not solve this because tax-like revenues from permit sales will be generated. Additional government spending for regulatory purposes is also not popular. Might the highest overall cost, least efficient solution, command and control, be most attractive to the electorate? This is possible, but it would be an unfortunate outcome.

• Measuring costs and benefits from alternative policy choices requires appropriate tools

Clearly, what is needed is a template for organizing the costs and benefits that accrue to different policy choices and comparing them to one another, much as was done in the

For many applications, market-based policies can reduce the costs of compliance drastically.

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Resources for the Future document referenced above. Moreover, programs play out over time. Sometimes startup costs front-load the calculations. Sometimes benefits occur in early years while costs occur later on. Moreover, different policies are subject to different types and levels of uncertainties.

Fortunately, the analytical tool, benefit-cost analysis was created for just this purpose. This tool can address all of the concerns just noted and others, but it also requires good data for analysis and good judgment in execution. For example, suppose a policy creates benefits from pollution abatement and also requires greater amounts of labor to implement. Abatement is a benefit that can be measured, but labor costs are typically viewed as a cost. But what if job creation is also a desired end point, in other words, a benefit? Does this mean policy should favor tools that create greater employment opportunities, even if it is more expensive? Moreover, what about the workers who are displaced by the policy? Resolving this issue is beyond the scope of this Brief, but it should not be assumed that policies requiring more workers necessarily are better choices than those that require fewer workers.

Also, consider the role of future costs and benefits. Traditionally, benefit-cost analysis uses discounting to compare accruals that occur at different points in time. Discounting works as follows. A dollar today is worth one dollar, but an obligation to pay a dollar in the future is

currently worth less than a dollar. Presumably, one would require a discount to loan a dollar for some period of time, but how much? Solving this problem requires establishing a discount rate, a rate similar to an interest rate, say 5 percent, and using it to accumulate values for benefits and costs over time. A parallel approach to the benefit-cost analysis can be used to determine energy product cost-effectiveness, that is, the least cost alternative for meeting some specific objective. Note that the stakes in failing to predict consumer behavior regarding the purchase of cost-effective energy saving products can be high. The DOE uses measures of cost-effectiveness to help guide its technology development programs.

But also consider this. If one discounts future benefits for a long enough period, the result is a small number, perhaps one approaching zero. For a current individual, determining a mortgage, such a discount rate may be the proper metric to use. But what rate should be used when undertaking current investments that would benefit future generations?

• Do future generations matter?

Addressing the role that the well-being of future generations should play in current policy decisions is beyond the scope of this Brief, but the answer involves evaluating costs to the current generation relative to benefits for future generations. The transfer is one-way in the sense that it is irreversible and could potentially be unfair to either generation. We have reason to believe that in addition to environmental considerations, the future would benefit from many different current sacrifices, for example, for research into advanced medical treatments, preservation of

Most pollutants are already subject to regulation and experience only minor regulatory adjustments. Bringing an unregulated pollutant under control, such as carbon dioxide, is much more costly.

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endangered species, and a larger capital stock. In a sense, all of these options compete. Future generations are also likely to possess more material wealth and better technologies than current generations, save for the environmental resources that climate change or other policy choices might dissipate. In all these choices, we cannot measure future willingness-to-pay, nor can we act in complete certainty. It is also the case that there are current unmet needs – hungry children, immigrants displaced by war and tyranny, and many other concerns. One approach to addressing the tradeoff between current costs and future benefits is termed sustainability. Sustainability attempts to provide guidelines for judging the implications of current decisions on the future by developing ways that the current generation can meet its needs without compromising the ability of future generations to meet their own needs.

• Conflicts between values and uncertainties

At the outset of this section it was noted complete resolution of differences was unlikely because we will typically not have complete certainty as to physical cause and effect relationships, and we will not approach choices with identical values. But it is also the case that the difference between interpretation of facts and the imposition of values is quite fine. When facts are uncertain, one can choose to make decisions in the face of uncertainty, recognizing that adjustments must be made as uncertainty abates over time. In some cases opportunities will be seized and in others efforts may be wasted. At one extreme some combination of strong environmental values, confidence in government’s ability to design and manage the needed carbon abatement programs, and acceptance of the conventional wisdom in climate science may combine to promote a strong carbon abatement response. At another

extreme, the same environmental values coupled with a lack of confidence in government’s ability to design and manage the needed programs and a cynicism over the ability to predict the behavior of a very complex environment could lead one to reject current actions. Are these choices information-based or value-based?

The difference can be significant because a responsible dialogue over the science, the ability of public programs to promote environmental goals, and the appropriate approach for confronting uncertainty in public decision-making are precursors to evaluation of the tradeoffs acceptable in the pursuit of carbon abatement. Without this dialogue we will certainly miss opportunities both for climate change and any number of new environmental challenges that are emerging. As an example of a successful dialogue, several years ago the debate over regulation of ozone- destroying chlorofluorocarbons in spray cans and other uses was trumped by a breakthrough in the science. As a result, a political consensus arose in favor of strict regulations limiting the use of this chemical. Would such a consensus be possible today?

…………………………………………. Finally, it is instructive to speculate on a few

of the topics left of off the Presidential websites, but which are likely to attract attention during the next administration. These topics logically define the path forward that the criteria just discussed would be used to evaluate. What steps might help shape the public dialogue over these topics?

First, using virtually any criteria, climate change topics would come toward the top of this list. The current administration has taken a large number of actions to reduce fuel use that

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promotes greenhouse gas production. As examples, it has issued Executive Orders to increase the corporate average fuel economy standards (CAFE) to levels that would have significant impacts on emissions by autos and trucks. It has also established ceilings on mercury emissions and carbon emissions from electricity generation facilities. Many analysts believe that under the new standards, no further coal-fired generators will be built in the U.S. Moreover, these standards, at present, apply only toward new generation facilities. The current stock of generators is about one-half coal-fired so that the regulations would leave the bulk of generation untouched. A debate over a decision to extend these rules to existing plants is inevitable. The difficulty in resolving the climate change debate was described above, and this lack of resolution underlies the administration’s need to implement its policies through Executive Orders rather than through legislation. As such, these Orders could be revised or reversed at a moment’s notice, a circumstance that compounds the uncertainty facing the economy. Achieving consensus on the elements of the climate change debate is key to both environmental and economic policy making.

It is noteworthy that given an opportunity to refine their stated policy positions toward climate change, the two Presidential candidates responded less differently than one might suppose. (http://green.blogs.nytimes.com/2012/09/05/).

President Obama responded by recounting his recent executive orders dealing with carbon, mercury, corporate fuel efficiency standards, and his support for energy efficiency research, but stopped short of calling for a cap and trade response. Governor Romney stated “I am not a scientist myself, but my best assessment of the data is that the world is getting warmer, that human activity contributes to that warming and that policymakers should therefore consider the risk of negative consequences.” He called for continued debate and investigation within the scientific community. He added that a strict rule on carbon emissions would essentially bankrupt the coal industry, raise manufacturing costs, and drive jobs offshore. He supported continued research into clean energy technology and supported regulations that would promote faster development

A second topic of interest is the federal regulatory posture toward the use and expansion of fracking methods of enhanced oil and gas recovery. This mode of enhanced recovery opens the possibility for expansion of oil and gas production domestically and beyond. Under almost any circumstances reductions in the price of oil and gas benefit the economy and concomitant labor markets. Many analysts describe energy costs as parallel to a national sales tax for which a large fraction of the proceeds are exported to other countries. Increasing production from fracking therefore can be viewed as reducing a national sales tax and creating attractive, new domestic jobs in the oil and gas industry. It is hard for anyone, and especially public officials during an election year, to take a public stand in favor of higher gas and oil prices.

However, lower gas and oil prices fly in the face of national policies to abate greenhouse gases because they remove incentives to

The significant energy/environmental debate during the current election season will center on costly new control targets, such as carbon abatement, enhanced oil and gas recovery, and electricity generation.

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substitute more efficient energy use technologies for current technologies, and reduce any cost-related comparative advantages that renewable fuels source, such as biomass, might be gaining. Virtually any expansion of oil and gas production, whether due to new pipelines, expanded drilling, looser regulations on refining, and any of a number of policies to expand production from renewable technologies leads to a discussion over the tradeoff between greenhouse gas emissions and “jobs.” At present, jobs are a key driver of energy policy and uncertainties over employment-related benefits from energy policy can potentially stymie progress on a national climate change consensus or other environmental issues.

A third topic concerns DOE’s R&D programs to develop cost-effective energy-saving technologies that have long been a major aspect of Federal energy policy. Simply put, it has consistently been observed that consumers are reluctant to purchase many of these technologies, despite their putative cost-effectiveness. Current advances in understanding the psychological and economic drivers of consumer behavior, such as those that lead to rejection of cost-effective energy-saving products, could lead to more effective policies to promote these products’ adoption by markets. But to what extent is consumer behavior an appropriate target for programs that promote technological change? Should these advances be used to design products more attractive to the market or to stimulate changes in behavior that drives purchase decisions?

Finally, the advent of the smart grid offers many unanswered questions. The smart grid is a term used to describe the increasingly interconnected national power transmission

network and the ability of this network to interact with consumers. In the past, the electric utility sector viewed its mandate to provide generation assets to follow loads, basically taking loads as given. To the extent green power generation becomes an increasing share of generation capacity on the grid, the ability to follow loads may be reduced. This leads to placing additional value on the ability of the grid to shape loads in addition to following them. Shaping loads could include marginal cost (time of day) pricing, the ability to control use cycles for energy-using products remotely, or the development of advanced technologies for electricity storage. However, these technological changes significantly alter the relationship between power consumers and power producers. How should the industry frame the debate over this altered relationship in a manner that permits stakeholders early access to proposed changes and a voice in key decisions?

In sum, the emerging issues, much like the existing topics discussed above, will have elements of the need to accommodate past choices (much like the API position) will prompt questions of significant departure from past norms (as raised in the Daedalus piece) and are integrated into the nation’s economic and political fiber (as described in the Brookings symposium). The need for an open dialogue over these critical topics has never been greater. We at the Baker Center encourage comments, criticisms, and suggestions on this Brief that contribute positively toward such a dialog.

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References (cont’d.) History of Sustainability. (2012). EPA. Accessed September 6, 2012. http://yosemite.epa.gov/r10/oi.nsf/8bb15fe43a5fb81788256b58005ff079/398761d6c3c7184988256fc40078499b!OpenDocument Mishan, Edward & Euston Quah. (2007). Cost Benefit Analysis. New York: Routledge. “Obama and Romney Guardedly address climate change”. (2012). http://gree.blogs.nytimes.com/2012/09/05 Obama’s website. (2012). http://www.barackobama.com/ OPEC Homepage. Accessed September 6, 2012. http://www.opec.org/opec_web/en/ Ozone Layer Protection Glossary. (2010). EPA. Accessed September 6, 2012. http://www.epa.gov/ozone/defns.html Romney’s website. (2012). http://www.mittromney.com/ Sierra, Catherine. (June 11, 2012). “World Leadership for an International Problem.” Accessed September 6, 2012. http://www.brookings.edu/research/papers/2012/06/11-climate-policy-sierra “Toward a New National Energy Policy: Assessing the Options.” (2010). Resources for the Future. Accessed September 6, 2012. http://www.rff.org/Documents/RFF-Rpt-NEPI%20Tech%20Manual_Final.pdf “What is a BTU?” Accessed September 6, 2012. http://www.wisegeek.com/what-is-a-btu.htm