Why Does Energy Usage Compel Government Intervention?

Optimizing Government Intervention

Examples of Energy Taxes and Regulations

Conclusions: Carbon Tax (Cap & Trade) vs. Command and Control Regulations

A recent article in the NYT, “Saving Energy, and Its Cost” by David Leonhardt, advocates for the use of a carbon tax, rather than command-and-control regulations, as a means of reducing carbon emissions.

Mr. Leonhardt refers to the recently proposed Lugar-Graham bill, which

would mandate specific standards for cars, trucks, homes and offices. It would also give the energy secretary the power to award loans to companies he thought could do a good job of setting up programs to retrofit buildings. State officials would do the same for factories…

Under a command-and-control system, businesses and consumers have to focus not just on carbon use but also on the details of the government’s rules: the intricacies of vehicle and building standards, the types of appliances that qualify for subsidies, the fine print of the Energy Department’s loan applications. Each bit of compliance brings costs.

Mr. Leonhardt instead advocates using a carbon tax, and then letting the markets determine the best way to reduce carbon emissions.  He cites the example of the 1990 tax on sulphur dioxide as a case in point:

[A] 1990 bill signed by the first President Bush forced coal plants to buy permits if they were going to emit the sulfur dioxide that caused acid rain. With the price of emissions suddenly higher, the plants looked for innovative ways to reduce pollution — and succeeded more rapidly and cheaply than experts had predicted.

He notes that the recent move in favor of regulations over taxes is due to the more subtle nature of price increases associated with regulations as compared with those associated with taxes:

Unfortunately, the great economic strength of market systems like cap and trade also happens to be their political weakness. They set prices and allow people to react. In the process, market systems acknowledge that reducing pollution may actually cost a little bit of money.

Politicians don’t like to admit this, because voters don’t like it. Accepting higher costs is especially hard when the economy is weak. So Congressional Democrats have been repackaging their energy bills to make them look less and less market-oriented…

These points led me to ask myself:  “Generally speaking, what are the differences between taxes and regulations regarding impact on the economy, and under what situations are taxes vs. regulations best?”

Why Does Energy Usage Compel Government Intervention?

Let’s start with asking why we would need a tax or regulation on energy usage to begin with.  Government intervention may be called for when there exists some market failure, that is, when the free markets do not generate “efficient” outcomes from society’s point of view.  This can happen when markets encounter information goods, non-competitive markets, externalities or public goods.  In the case of energy usage, market failures occur due to the presence of externalities, which lead people to consume “too much” energy from a social standpoint. As such, government intervention can be used to increase the price of energy, which will decrease each person’s usage from the level that is optimal from the person’s private standpoint down to the lower, socially optimal level.

Externalities occur when one person’s actions affect someone else who was not a party to the first person’s actions.  There are several types of externalities associated with energy usage, and fossil fuel energy in particular.  The first is air quality.  Combustion of fossil fuels creates emissions of noxious elements into the atmosphere.  When someone is deciding as to how much energy to use, he (generally) does not consider the fact that the more energy he uses, the more pollution he’s creating for others.  Since he doesn’t bear all the costs associated with his use of energy, that person will be led to use “too much” energy from a social standpoint.

The second externality associated with energy usage results from the fact that fossil fuels are non-renewable (depletable) resources; that is, their ultimate supply is limited.  This creates public versus private disputes over the optimal rate of depletion of fossil fuels.  One aspect of rate of depletion disputes involves cost of extraction.  The first fossil fuels extracted are the low cost supplies.  As the easy to extract oil or coal becomes exhausted, but demand for fossil fuels continues, suppliers turn to more expensive sources of supply or methods of extraction, such as deep, offshore drilling or fossil fuel extraction from bituminous sands and oil shale.  The means that earlier users of fossil fuels will pay lower prices than later users, and the faster the earlier users consume fossil fuels, the sooner the prices will increase.

Another aspect of rate of depletion involves discrepancies between the interest rates, or discount rates, of society at large versus those of the suppliers of fossil fuels. From “Economic Theory of Depletable Resources: An Introduction” by James L. Sweeney,

A long standing concern in the depletable resources literature relates to biases in the interest rate. It seems generally agreed that if the interest rate used by the owners of depletable resources is higher than the social discount rate, resource owners will extract more rapidly than is socially optimal, and will therefore leave smaller stocks of depletable resources for the future... Although the debate about the appropriate social rate of discount continues … generally interest rates used by corporations can be expected to exceed the socially optimal rates, if for no other reason, because of taxation of corporate profits. Thus the standard analysis concludes that high interest rates do provide an impetus for extracting depletable resources more rapidly than otherwise.

The last externality associated with energy usage is foreign dependence.  Since Americans use more energy than can be supplied from US sources, the US must import a significant portion of their energy usage from foreign countries.  This puts Americans at the mercy of foreign suppliers.  The greater is the rate of US energy usage, the more dependent Americans will become on foreign suppliers.

To reiterate, externalities in the market for US energy usage lead individuals to consume too much energy from a social perspective.  As such, government intervention can be used to increase the price of energy to American users, thereby decreasing national usage down to more socially optimal levels.

Optimizing Government Intervention

Any cost/benefit analysis of government intervention into the free markets (taxes, subsidies, standards, regulations, etc.) should address the following issues:

• What are the total costs of implementation? The costs of implementation include all the costs associated with establishing, maintaining, monitoring, and enforcing the intervention.  The cost will generally be higher, for example, when (1) the intervention constrains the activities of a larger number of people or entities, (2) the activities at issue are more covert (for example, it’s easier to monitor activities or actions that occur out in public as opposed to within the privacy of one’s home or business), or (3) the activities at issue occur later in the supply chain or processing stage (it’s generally easier to monitor inputs than outputs, because outputs are the products of multiple inputs).

• How close will the intervention come to achieving the goal? Regulations that are more diffuse (affect more people or entities) or that have higher costs of monitoring or enforcement will tend to result in more evasion and thus fail to fully achieve the desired goals.
  

• Is the ultimate impact determinate or indeterminate? For example, implementing a cap or limit on carbon emissions will reduce emissions to that (determinate) cap or limit level.  Alternatively, implementing a tax on emissions will reduce the level of emissions from current levels, but the ultimate reduction that will be achieved might not be known – it will depend on how resistant the amount of energy people use is to the price of energy.  If the goal is to achieve a determinate increase or reduction in the level of some activity, then a cap or limit is preferred.  Alternatively, if the purpose is to punish or reward certain activities then a tax or subsidy is preferred.

• Who ends up paying the costs of the intervention (costs of implementation and impact on the economy)?  Is it just those people or entities involved with the activity who pay, or is it the economy as a whole?  More specifically, will interventions into fossil fuel energy markets also end up increasing the price of renewable energy users?  Generally speaking, interventions are less intrusive or considered more “fair” when they only affect the people involved with the activity at issue.

• What distortions or side effects does the intervention introduce into the economy? For example, will people associated with fossil fuel production or processing lose jobs?  Will people who use energy from renewable resources end up paying more due to demand spillover effects?

Examples of Energy Taxes and Regulations

Let’s consider some energy taxes and regulations already in place and see how they have impacted the economy.

The first two examples deal with appliances and automobiles, both of which are goods whose costs includes two components, an up front payment to acquire the goods, together with ongoing costs of usage (electricity or gas costs).  Left to their own devices, when deciding either on whether or not to buy one of the items, or on which of the varieties to buy, many consumers tend to consider only the up-front cost, and not the lifetime value of the ongoing energy costs.  In this case, consumers would not value energy saving products, especially if the up-front costs of the energy savers are greater than those for their energy-guzzling counterparts.  And as a result, suppliers would have a difficult time selling the energy-saving versions.  This failure of consumers to consider the full costs of automobiles and appliances would not, in and of itself, call for government intervention.  However, because the costs that are ignored (energy costs) are associated with externalities (pollution, non-depletable resources, and foreign dependence as described in the section above), government intervention is needed to align private user costs with social costs so as to prevent “too much” energy usage from a social standpoint.

The third example, gasoline taxes, provides an example of a “fair” tax, that is, the parties being taxed are those who benefit from the proceeds, and the amount of taxes they pay are in proportion to the benefits they receive.  The gas tax also has a low cost of implementation, and it results in a minimum amount of distortions, when the proceeds are not ransacked by politicians.

I provide the last example, that of emissions trading systems for various pollutants, because it would be similar to the case of the proposed cap and trade regulations for carbon.

1. Appliances and Commercial Equipment Standards

Energy efficiency standards for appliances provides a good example of a case of government intervention into the free markets that provides a maximum amount of benefits with a minimum amount of costs.

From the DOE’s website, here’s a brief statement on how the movement for energy efficiency standards for appliances was started:

The movement for federal appliance efficiency standards started in the 1970s. At that time, several states, including California, were adopting state appliance efficiency standards. The Energy Policy and Conservation Act of 1975 (EPCA) established a federal energy conservation program for major household appliances by calling for appliance efficiency targets. However, little progress was made to establish standards until the 1980s.

By 1986, appliance manufacturers realized that uniform federal standards were preferable to a variety of state standards. The National Appliance Energy Conservation Act of 1987 established minimum efficiency standards for many household appliances: refrigerators, refrigerator-freezers, and freezers; room air conditioners; fluorescent lamp ballasts; incandescent reflector lamps; clothes dryers; clothes washers; dishwashers; kitchen ranges and ovens; pool heaters; television sets (withdrawn in 1995); and water heaters. Congress set initial federal energy efficiency standards and established schedules for DOE to review these standards.

The DOE’s website further explains that DOE felt the need to intervene in the markets because appliance users did not consider energy usage when making their appliance purchase decisions (emphasis is mine):

The operating cost of an appliance over its lifetime may be several times greater that its initial purchase price. Many consumers do not consider energy or water efficiency when making their purchases. But looking for an energy efficient model can save you money over the long run.

Congress passed laws setting initial federal energy efficiency standards and establishing schedules for DOE to review and revise these standards. Standards benefit consumers by requiring that appliance manufacturers reduce the energy and water use of their products—and thus the costs to operate them…

DOE establishes federal standards to keep consistent, national energy efficiency requirements for selected appliances and equipment. By law, DOE must upgrade standards to the maximum level of energy efficiency that is technically feasible and economically justified. DOE strives to establish standards that maximize consumer benefits and minimize negative impacts on manufacturers and others.

The following graph shows how consumers have benefitted from energy efficiency standards for refrigerators:

2. Corporate Average Fuel Economy (CAFE) Standards

The National Highway Traffic Safety Administration (NHTSA) describes CAFE as follows (emphasis is mine):

Corporate Average Fuel Economy (CAFE) is the sales weighted average fuel economy, expressed in miles per gallon (mpg), of a manufacturer’s fleet of passenger cars or light trucks with a gross vehicle weight rating (GVWR) of 8,500 lbs. or less, manufactured for sale in the United States, for any given model year. Fuel economy is defined as the average mileage traveled by an automobile per gallon of gasoline (or equivalent amount of other fuel) consumed as measured in accordance with the testing and evaluation protocol set forth by the Environmental Protection Agency (EPA)…

The “Energy Policy Conservation Act,” enacted into law by Congress in 1975, added Title V, “Improving Automotive Efficiency,” to the Motor Vehicle Information and Cost Savings Act and established CAFE standards for passenger cars and light trucks. The Act was passed in response to the 1973-74 Arab oil embargo. The near-term goal was to double new car fuel economy by model year 1985…

Congress specified that CAFE standards must be set at the “maximum feasible level.” Congress provided that the Department’s determinations of maximum feasible level be made in consideration of four factors:

       (1) Technological feasibility;

       (2) Economic practicability;

       (3) Effect of other standards on fuel economy; and

       (4) Need of the nation to conserve energy

Wikipedia notes that

Historically, the EPA has encouraged consumers to buy more fuel efficient vehicles, while the NHTSA expressed concerns that smaller, more fuel efficient vehicles may lead to increased traffic fatalities.  Thus higher fuel efficiency was associated with lower traffic safety, intertwining the issues of fuel economy, road-traffic safety, air pollution, and climate change. In the mid 2000s, increasing safety of smaller cars and the poor safety record of light trucks began to reverse this association.

Wikipedia further describes the impact of CAFE on automobile fuel economy as follows (emphasis mine):

In 2002, a committee of the National Academy of Sciences wrote a report on the effects of the CAFE standard.  The report's conclusions include a finding that in the absence of CAFE, and with no other fuel economy regulation substituted, motor vehicle fuel consumption would have been approximately 14 percent higher than it actually was in 2002. One cost of this increase in fuel economy is a possible increase in fatalities, estimated to be 1,300 to 2,600 increased fatalities in 1993, albeit with certain of the committee members dissenting.

A plot of average overall vehicle fuel economy (CAFE) for new model year passenger cars, the required by law CAFE standard target fuel economy value (CAFE standard) for new model year passenger cars, and fuel prices, adjusted for inflation, shows that there has been little variation over the past 20 years…

Simple economics would predict that an increase in gasoline prices would lead in the long run to an increase in the average fuel economy of the US passenger car fleet, and that a drop in gasoline prices would be associated with a reduction in the average fuel economy of the entire US fleet.  There is some evidence that this happened with an increase in market share of lower fuel economy light trucks and SUVs and decline in passenger car sales, as a percentage of total fleet sales, as car buying trends changed during the 1990s, the impact of which is not reflected in this chart. In the case of passenger cars, US average fuel economy did not fall as economic theory would predict, suggesting that CAFE standards maintained the higher fuel economy of the passenger car fleet during the long period from the end of the 1979 energy crisis to the rise of gasoline prices in the early 2000s. Most recently, fuel economy has increased about one mpg from 2006 to 2007. This increase is due primarily to increased fuel efficiency of imported cars. Similarly, Simple Economics predicts that due to the US's large percentage consumption of the world's oil supply, that increasing fuel economy would drive down the gasoline prices that US consumers would otherwise have to pay—reductions in petroleum demand in the United States helped create the collapse of OPEC market power in 1986.

So the CAFE standards have not had the same unconditionally positive impact on the economy as the appliance energy standards have had.  There have been negative side effects from the policy, namely greater number of deaths due to the lower safety levels of the more energy efficient cars.  Also, some of the greater energy savings that have occurred while the standards have been in force would probably have been achieved by the markets anyway in the absence of government intervention.  In this case the costs of achieving greater energy efficiency have been higher than necessary.

3. Taxes on Gasoline

“Paying at the Pump: Gasoline Taxes in America” by Jonathan Williams provides an excellent history of and theory behind gasoline taxes.  It explains how gas taxes are considered a fair tax because (1) the people who pay the taxes, drivers, are the ones who benefit from their use, that is, the taxes are used to fund the construction and maintenance of roadways, and (2) the amount of gas taxes people pay are proportionate to the benefits they receive.

Early gasoline taxes in the states were explicitly created in an attempt to charge road users for the privilege of using roads. However, from the very inception of gasoline taxation, public officials have faced temptation to divert gasoline tax revenue to projects that are only tangentially related to transportation and that are often purely politically motivated. When lawmakers do overcome the temptations to squander gasoline tax funds, and instead use the revenue strictly for road construction and maintenance, gasoline taxes can serve as a reasonable tax…

For nearly a century, gasoline taxes have played a central role in financing America’s roadways with tax dollars collected from the motorists who utilize them. Today, the federal government taxes each gallon of gas 18.4 cents per gallon. In addition, U.S. states and various municipal governments levy gas taxes of their own. As a result, the combined burden of local, state and federal gas taxes costs American drivers 46.9 cents per gallon on average…

The basic justification for gasoline excise taxes is that they satisfy what economists call the benefit principle of taxation. This is a longstanding justification for the imposition of taxes that dates back to at least Adam Smith’s Wealth of Nations. The benefit principle is also widely accepted in modern public finance theory as representing sound tax policy.

Simply stated, the benefit principle tells us that consumers of government services should be taxed in proportion to the benefit they obtain from those services. For instance, it would make little sense to take income tax payments from elderly retirees to pay for roads they will never use. Similarly, if the benefit principle is to be respected, revenue extracted from motorists in the form of gasoline taxes should be used exclusively to fund roads…

[T]he Deficit Reduction Act of 1984 raised the tax on diesel fuel to 15 cents per gallon. This marked the first time that gasoline and diesel fuels were taxed at different rates. The punitive tax treatment of diesel was at least partly caused by concerns that trucks contributed much of the wear and tear on roadways and were not paying their fair share in road user fees. 

4.  Emissions Trading Programs

A 2007 article, “Regulations Work Better - Emissions Trading: A Mixed Record, with Plenty of Failures” by Gar Lipow, compares various cases of trading systems in the US with command-and-control systems in other parts of the word and finds that the latter are more effective at reducing toxic emissions than are trading systems.  Mr. Lipow finds that trading systems tend to discourage innovation, while producing fewer benefits than “conventional regulation”:

In general, it is not surprising that emission trading discourages innovation. The whole point of spatial flexibility is to encourage use of all cheap means before turning to expensive ones. Simple procedures like using low sulfur coal will usually be cheaper than, say, replacement of coal plants with natural gas plants or wind turbines.

Emission trading does have one advantage: It apparently does lower gross compliance costs to polluters. (For example, it is generally agreed that lead trading saved polluters 20% compared to conventional regulation.) Of course some of that savings comes from trading rules being easier to cheat, rather than being easier to obey…

The dynamic cost of postponing technology innovation is going to be higher in most cases than developing the technology earlier. Normally the long-term trend in standards is to tighten them. If regulations or carbon taxes (or a combination of both) force development and deployment of emissions reduction technology in a few cases that can meet standards no other way, then the price will be lower at a later stage when standards tighten and it must be deployed more widely. Emission trading, on the other hand, by postponing such developments, often will ensure that when tighter standard go into effect the technology is not as mature, and thus much more expensive at the point when it has to be put into widespread use. (In the case of carbon credits, the intention is to continually tighten standards -- so this argument applies even more strongly here than in other cases.)…

There are several ways conventional regulation tends to produce more benefits than emission trading:

• Overshoot and efficiency gains: In the absence of emission trading, it is hard to comply exactly with a stringent regulation. If compliance requires significant capital investment, normally a company will look for something that provides more efficient production (either reducing inputs or increasing outputs) as a side effect of complying. The result often is an emission reduction greater than required, along with an improved process. I think you could argue that U.S. deregulation madness is part of the reason a lot of U.S. industries are losing competitiveness -- not just to nations like China that have access to cheap labor, but high-wage countries which use more effective technologies.

In addition, emission levels are often set more by political pressure than scientific evaluation -- meaning that they are almost always too low. Overshoot, just on the emission level alone, probably provides additional benefits far outweighing additional costs -- in terms of additional lives saved at low additional cost.

Under emissions trading, any company that produces excess reductions will either sell them to another company, or bank them for future use. Thus trading systems almost never end up with a net long-term overshoot.

• Reductions in other pollutants: most solutions that respond to stringent regulation reduce more than one pollutant. For example, substituting natural gas for coal, or wind for natural gas, reduces not just SOx, but NOx, CO2, and even methane.

Conclusions: Carbon Tax (Cap & Trade) vs. Command and Control Regulations

So now I’ve indicated why energy usage compels government intervention in the first place – because there are externalities associated with energy usage, which means that left to their own devices, individuals will use more energy than is optimal from a social standpoint.  Government intervention helps reduce usage from unconstrained levels down to more social optimal levels.

I have also described how to choose types of government intervention that are most efficient.  In particular, the full costs of the intervention – the up-front costs of implementing the regulations plus the on-going costs of maintaining the regulations -- should be considered.  The most efficient types of intervention are those that (1) affect the fewest number of entities, because those require the least amount of compliance monitoring; (2) those that concentrate the cost burdens of the intervention on those individuals who benefit from the associated activities; and (3) those that produce the fewest or least costly distortions or side-effects in the marketplace.

Finally, I have provided some example of energy taxes and regulations that have been used in the past and described why they were or were not the best choice of intervention by considering the issues noted in the previous section on how to choose types of government intervention that are most efficient.

After having reviewed this information, I can now address the question at issue:  Which is the better form of government intervention to reduce the carbon emissions, a cap and trade system, or directed government limits on emissions?

Consider the role that energy usage that generates carbon dioxide emissions plays in the US economy.

The following “GHG Flow Diagram, Global Greenhouse Gas Emissions” was taken from “Navigating the Numbers: Greenhouse Gas Data and International Climate Policy” by Kevin A. Baumert, Timothy Herzog, and Jonathan Pershing:

The diagram makes it clear that carbon dioxide emissions are associated with activities in every sector of the economy, and the levels of carbon dioxide emissions dwarf those of the other greenhouse gases and other regulated emissions.  In particular, the amount of carbon dioxide emissions is 100 times the amount of sulphur dioxide emissions.  The omnipresence of carbon emissions in the global economy means that any type of intervention into the energy markets aim at controlling carbon dioxide emissions will have very large monitoring and compliance costs.  Also, given the amount of money at stake, any system implemented to reduce emissions will end up being fraught with fraud and evasion.  As a result, any form of government intervention will thus probably end up being very costly, result in multiple negative side-effects and distortions, and ultimately not achieve the levels of reduction intended by the government.

So the choice between a cap and trade systems for carbon dioxide emissions and direct limits on carbon dioxide emissions is a lose-lose proposition.  But which of the two choices would be less bad?

I assume that what the government wants is to affect a permanent change in the impact of energy usage on the environment.  In other words, what we’re looking for is a program that will facilitate long-term weight management, as opposed to a short-term crash diet. In this case, what is needed are programs that encourage both (1) permanent forms of energy efficiency and (2) moves toward more environment-friendly sources of energy.

In theory, cap and trade systems should be better than direct government regulations, since the former enable the markets to determine the most efficient way to achieve reductions.  However, it turns out that in reality, cap and trade systems seem to suffer much more from fraud and evasion, which end up adding tremendous costs and stymieing efforts to reduce emissions.  Also, the result that cap and trade systems discourage innovation seems to me to be a fatal flaw of that system.

So given past experiences with domestic and foreign appliances standards, automobile fuel efficiency standards, cap and trade systems, and other direct regulations programs, it seems to me that while still costly and intrusive, direct regulations, have been more effective than cap and trade systems.