Betting on American Innovation over EPA Mandates

Posted by Don Fullerton on Nov 7, 2009

Filed Under (Environmental Policy)

In 2007, the Supreme Court ruled that the Environmental Protection Agency (EPA) has the authority to regulate greenhouse gas (GHG) emissions under the Clean Air Act (link).  This fall the EPA announced its plan to regulate GHG emissions, including carbon-dioxide, by requiring large emitters to adopt state-of-the-art, best-practice pollution abatement technologies (link).  Yet the EPA’s new regulatory plan may rely upon costly methods of reducing GHG pollution.

Under the Clean Air Act, the EPA can only promulgate rules or “mandates” to control pollution.  Requiring every emitter to adopt best-practice pollution abatement technology is an example of a mandate, where the regulator dictates how the emitter must reduce its pollution.

In contrast, economists have long advocated market based approaches to pollution abatement – either a carbon tax or a cap-and-trade system.  Indeed, it is a cap-and-trade policy that passed the House during the summer and is currently being debated in the Senate.

The “cap” sets a hard limit on total pollution, and it then gets tighter and tighter over time, reducing emissions gradually.  Meanwhile, the “trade” part of the policy allows private markets to allocate pollution rights (permits) efficiently among thousands of emission sources.  Capping emissions causes pollution rights to become scarce, and thus the ability to pollute has economic value.  This value is the price at which permits are bought and sold.  If a company holds permits and can reduce GHG emissions more cheaply than the prevailing price, then it sells permits and makes money on the difference; otherwise it may buy permits.  This allows for companies with only expensive pollution abatement options to buy the right to emit at a price lower than they would otherwise incur, thus reducing the cost to society.

In addition, the explicit price on pollution induces profit-maximizing firms to research and implement new and cheaper ways of reducing GHG emissions.  This is a key difference when comparing cap-and-trade vs. mandates.  The price signal of the market based approach induces innovation.  Individual entities acting in their own self-interest will have the incentive to find new and cheaper forms of pollution abatement.  Those future innovations cannot be foreseen, and thus the cost projections of current legislative proposals cannot take them into account.  The costs of reducing GHG emissions are real, but under a cap-and-trade system, U.S. ingenuity and innovation will lower the cost of compliance relatively to current projections.  Why am I confident?  It has happened before.  The cap-and-trade policy to reduce sulfur dioxide pollution from coal-fired power plants cost one-fourth of the project price tag precisely due to unanticipated adaption and innovation by U.S. businesses (link).