Gayer & Viscusi: Energy efficiency regulations, the environment, and consumer sovereignty

Lynne Kiesling

Ted Gayer of the Brookings Institution and Kip Viscusi of Vanderbilt University have a new Mercatus working paper that is a careful and thoughtful critique of the rationale, the methodology, and the outcomes of federal energy efficiency regulations. Using standard Pigouvian externality theory, most environmental regulations are based on the “market failure” rationale that individual actions create unaccounted-for and uncompensated costs. Gayer and Viscusi begin their argument with the claim that such a rationale for regulation is indeed valid, to the extent that such costs exist. It also matters whether or not those costs are relevant at the margin — would imposing a tax for a cost or a subsidy for a benefit change the individual’s actions in ways that would account for the externality? If not, then it’s an irrelevant externality.

In the case of a relevant externality, we use benefit-cost analysis (BCA) to evaluate policy proposals that are intended to move from the existing outcome toward a more efficient outcome by changing individual incentives and choices. Gayer and Viscusi provide a clear, succinct summary of BCA’s analytical framework. Much of their subsequent argument hinges on something important that they point out early in the paper: while it’s possible that individuals don’t fully take into account the effects of their actions on others, we still assume that the individual is in the best position to evaluate the likely net benefits they will obtain across a range of alternatives. I’ve phrased this statement of rationality quite generally — it doesn’t require full information, nor does it require perfect foresight. All of the rationality that is required to support the consumer sovereignty at the core of BCA is that the individual is better positioned than any other person or set of persons to perform that evaluation.

Here’s where the Gayer and Viscusi analysis is very useful, because from here they open up a critique of how regulatory agencies use the consumer irrationality interpretations of behavioral economics as a further rationale for regulation. This is common practice, and one that I find analytically unacceptable. Moreover, I think it’s common practice in energy policy analysis to conflate the “market failure” argument and the “consumer irrationality” argument; for example, several years ago I attended a talk in which the author took the empirical finding that consumers have high discount rates for vehicle fuel savings (typically they value three years worth but not beyond), and he labeled that fact as a “market failure”! To this day I wish I had challenged him on that false conflation.

This sovereignty/irrationality point is a crucial core of the normative arguments and justifications for legitimate policies and regulations, and it’s an argument that isn’t well-made often enough. Gayer’s and Viscusi’s contribution here is important. They note that

If BCA abandoned the presumption of consumer sovereignty and replaced it with another  assumption about the systematic behavior of consumers, it would lead to the normative implication that the analyst or policymaker decides what is best for each consumer. Given the informational and analytical challenges of finding behavioral failings among heterogeneous individuals, this is a tall order for any analyst or policymaker, especially given that they are also prone to information and behavioral failings. A principal theme of Viscusi’s book, Rational Risk Policy, is that government regulators often institutionalize individual irrationality because policymakers are human and because the pressures exerted by their constituencies push policies in directions away from rational norms. (pp. 7-8)

Here Gayer and Viscusi argue in the spirit of robust political economy — humans have cognitive limitations both in their individual decision-making and in the institutions they design and the political/policymaking roles they perform. Their analysis in this paper presents an argument, and provides supporting evidence, that individual sovereignty should remain our analytical standard in the BCA methodology that regulatory agencies implement to evaluate policies. As they state, this standard implies that

A shift away from the principle of consumer sovereignty will also lead to regulations focused more on correcting self harm than on internalizing environmental harm. For example, it would place greater weight on regulations that ban energy-inefficient products than on regulations that raise the price of pollution. … Therefore, the burden of proof for any BCA conducted as part of a review of regulatory proposals should be placed heavily on justifying any presumption of a deviation from consumer sovereignty. The agency preparing the BCA needs to demonstrate a systematic deviation from consumer rationality rather than just presuming that the regulator is better equipped to make decisions that protect individuals from themselves. (pp. 8-9)

They then evaluate four specific applications of energy efficiency policies designed to close the “energy efficiency gap” — the high discount rate implicit in the tradeoff facing consumers between near-term capital costs of energy-efficient devices and longer-term energy savings (as in the example I alluded to earlier). In evaluating energy efficiency regulations for vehicles (CAFE standards), room air conditioners, clothes dryers, and incandescent light bulbs, they examine both the academic literature and agency analyses to see whether the regulations internalize environmental harm or correct self-harm, to use their language.

Their analysis of agency (and, by implication, national lab) studies shows a recurring pattern of emphasis on engineering analyses that compress the treatment of consumer benefits into energy-efficiency-focused dimensions and ignore other aspects of consumer preferences. For example, in performing vehicle analyses, regulatory studies will incorporate data on the transportation function of the vehicle, fuel costs, and the energy efficiency of the vehicle. Omitted from the analyses are variables like comfort, number of seats, volume of cargo capacity, mortality statistics and safety ratings, maintenance ratings and costs, and performance variables such as acceleration. Omitting these variables from the analysis implies that the agency’s policymakers do not believe that such variables should factor in to consumer technology choices, and that energy efficiency is the most important variable. Gayer and Viscusi argue that agencies should make that argument based on evidence of external costs and market failure, and not based on arguments that policymakers know better than individuals what choices are most in their self interest.

My summary does not do their argument justice; the entire paper is well worth your time. Mercatus has also generated some policy briefs to accompany this longer paper: this four-page policy brief that summarizes the analysis, and this graphic that illustrates their estimate of the effects of energy efficiency regulations. If the purported objective of energy efficiency regulations is reducing environmental harm, this analysis suggests failure.

 

I would add another arrow to their analytical quiver. Taking as given the cognitive limitations of humans and the evidence we see from behavioral economics, which institutional framework is more likely to lead to more efficient error correction? If their analysis is correct and most of the outcomes of energy efficiency regulation are “protection from self-harm” and not reduction in environmental harm, what’s the most effective means of enabling individuals to correct those errors? Imposition of choice-restricting regulations is less likely to do so than either market processes or, in the cases where the “self-harm” results from incomplete information, regulations that focus instead on providing clear information and comparisons of the effects of different alternatives.

 

Green urban infrastructure can save green(backs)

Lynne Kiesling

Some of the best environmental projects also save money. This post at The Atlantic’s Cities blog highlights urban green infrastructure such as permeable pavement projects, including a recent study finding that they can also be economical:

Looking at 479 case studies of green infrastructure projects around the U.S., the report finds that the majority of projects turned out to be just as affordable or even more so than traditional “grey” infrastructure. About a quarter of projects raised costs, 31 percent, kept costs the same and more than 44 percent actually brought costs down.

Here’s the logic: suppose you are, as Chicago is doing, using permeable concrete now when repaving alleys. Permeable concrete is more expensive than traditional concrete, but because it allows rainwater to return to groundwater, it reduces the water flow into storm drains, the sewer system, and wastewater treatment facilities. So you have to evaluate the higher construction costs versus the lower wastewater treatment cost and other reduced costs of storm runoff, including lower operating and maintenance costs. As reported in the post:

The costs of traditional infrastructure are especially pronounced in cities and regions with combined sewer systems that collect both sewage and stormwater. During heavy rainfall, these systems are often overwhelmed, pouring sewage-laden water into drinking water sources and greatly increasing water treatment costs.

Technologies like permeable pavements and rain gardens can capture, naturally treat and filter stormwater back into the ground, preventing overflows and reducing reliance on treatment centers. Chicago’s existing green infrastructure, including its green alleys, diverted about 70 million gallons of stormwater from treatment facilities in 2009, according to the report.

I can attest to the existing strains on the sewer/storm runoff system in Chicago; we live just off of a main north-south surface street, and after a heavy rain like last night’s there are substantial pools of water backed up onto the street around several of the storm drains (my neighborhood hasn’t had our alleys repaved yet). Moreover, this runoff frequently overflows from the sewer system into Lake Michigan, leading to beach closures on the days following rainstorms. I could channel my inner John Whitehead to do a travel-cost estimate of the value of the lost recreation, which reinforces the value of permeable concrete. One thing we don’t know yet, though, is if it’s as durable as traditional concrete, or if it depreciates more quickly.

All of this reminds me that I have to get the KP Spouse moving on that rain barrel …

Praise for a New York Times article on natural gas fracking (Or, How property rights help mitigate potential environmental harms)

Michael Giberson

I’m writing in praise of a New York Times article on natural gas fracking. Yes, really! Even more surprising, I’m writing in praise of a New York Times on fracking written by Ian Urbina. Yes, really!

What is this marvel, you ask? I answer, “Rush to Drill for Natural Gas Creates Conflicts With Mortgages.”

What is so marvelous about this article? I answer, the way it highlights how property and contract laws can serve to regulate potential environmental harms from gas drilling and hydraulic fracturing.

Of course, as the headline suggests, the focus of the article concerns mortgage restrictions which may be violated if a property owner leases part or all of the property for oil or gas development. Mortgage lenders usually include such limiting provisions in loan contracts to help ensure protection of the property, which typically serves as collateral for the loan. Obviously mortgage contracts differ and the article notes that only sometimes will leasing violate a mortgage. The article further notes that lenders who don’t secure such restrictions in their mortgages, or who fail to closely police compliance with such restrictions, may find it difficult to resell their mortgages in the secondary market.

But here is the deal: almost all of the well-documented environmental harms from natural gas drilling and hydraulic fracturing happen within a few hundred feet of an active well: cases of methane in groundwater, spills from holding ponds filled with produced water from fracking, and so on. If the landowner owns the surface and mineral rights free and clear, and owns a large enough piece of property that effects on neighbors are unlikely, then most of the potential hazards from drilling and fracking are faced by the property owner who can weigh the trade-offs between the costs and benefits and negotiate reasonable protections within the lease with a developer. Actions taken by the developer in response to such a contract to mitigate the likely harm to the property-owner will also almost inherently serve to mitigate any possible harm to neighboring properties. If methane doesn’t migrate from the well into the groundwater immediately around the well, it can’t subsequently migrate across a property line some tens or hundreds of feet distant.

When a landowner borrows against the land, the lender naturally gains an interest in protecting the land’s valueas a tool to help ensure the loan’s repayment. In may be the case, as the article mentions, that the a lease enhances the value of a property and the resulting income makes loan repayment more likely. On the other hand, gas drilling and fracking may reduce the value of the surface property. The point is that – working in the context of contracts and property law –  landowners, lenders, and gas development companies have a natural interest in trying to work out these issues in an way that should naturally reflect most of the potential costs and benefits from exploitation of the shale resource.

Not every potential hazard will be well contained within a mortgage contract and a mineral lease. For example, the landowner may not care too much what the developer does with produced water from fracking operations so long as it is safely removed from her property. Other issues may depend on rights to surface water crossing a property or the contribution to any local air pollution hazards. In such cases liability rules and potential litigation by neighbors might be the efficient regulator, but government-provided regulation is also sometimes the efficient response.

I praise the New York Times article for highlighting (even if only indirectly) the way that decentralized decision making in the context of the rights and responsibilities attendant to property and contract law can serve to regulate environmental harm. The next step, from the view of government policy, is to refocus the efforts of government regulators on just those harms that are not well addressed within the scope of voluntary decentralized decisions.

[NOTE: For additional commentary on Urbina’s NYT reporting on natural gas fracking, none of it laudatory, see this search of the KP archives.]

A Coasian look at pesticide and genetic drift

Michael Giberson

A few weeks back Lynne drew attention to an interesting property dispute between neighboring farmers in Minnesota, currently the subject of legal action (see news summary here, related court decision here). In brief, the issue is pesticide drift from conventionally farmed crops onto a neighboring organic farm, and whether the organic farm can sue the conventional farm for pesticide-drift trespassing. Appeals court says yes.

David Conner wrote about a very similar hypothetical case a few years back in “Pesticides and Genetic Drift: Alternative Property Rights Scenarios,” when considering a Coasian approach to resolving such issues:

Imagine the following hypothetical dispute between Cameron Conventional and Olivia Organic, two farmers with adjacent fields. Cam­eron is a cutting-edge, high-tech farmer, an early adopter of new technologies, making him a low­ cost producer of grains and legumes. “Back to the land” Olivia grows organic specialty orops for sale at a local farmers’ marker.

Someone tests an ear of Olivia’s sweet corn and determines that it is contaminated by pesticides and pollen from GE corn. Her upset consumers begin to boycott her. The belief that she is an organic producer is stripped away. She must now sell her produce conventionally at a much lower price. What are her options?

Conner then explores the case in “Coasian” fashion, considering various scenarios depending upon who would be the least-cost avoider of the conflict and who held what rights.

Lomborg and Haab on light bulbs and technology

Lynne Kiesling

Thanks to Tim Haab for pointing us to this excellent observation from Bjorn Lomborg about innovation, regulation, and environmental quality:

Real reductions in carbon emissions will occur only when better technology makes it worthwhile for individuals and businesses to change their behavior. CFLs and other advances can take us part of the way, but there are massive technological hurdles to overcome before fossil fuels generally become less attractive than greener alternatives. …

Limiting access to the ‘wrong’ light bulbs or patio heaters, ultimately, is not the right path. We will only solve global warming by ensuring that alternative technologies are better than our current options. Then, people the world over will choose to use them.

Hear, hear.

Learn Liberty: Tragedy of the Commons

Lynne Kiesling

Here’s another great video from Learn Liberty: Sean Mulholland introducing the “tragedy of the commons”, which, as he accurately notes, is more accurately called the problem of open access. If you teach a class where you talk about this problem, or want to learn more about this fundamental ill-defined property rights foundation of environmental problems, this video is a good resource.

Coase, legal liability, and pesticide drift

Lynne Kiesling

A ruling last week from Minnesota’s Court of Appeals provides an interesting case study in using common law and legal liability (a la Coase) in an environmental case. As summarized in the St. Cloud Times, the issue at hand is pesticide drift — when pesticide spray on one field is carried over to another field by wind. In the case of an organic farm, such pesticide drift has a significant economic cost, because the organic farmer cannot sell the affected produce, and may even have to take affected acreage out of rotation for several years to clear the pesticide and retain the foundation of the organic attribution (usually defined by law).

Here’s a bit more about the fact pattern:

The Johnsons turned their farm into an organic one in the 1990s to take advantage of the higher prices organic crops and seeds bring at market. They posted signs noting that the farm was organic, created a buffer between their property and neighboring farms and asked the co-op to take precautions to avoid overspraying, according to the Court of Appeals opinion.

But the co-op violated state law four times from 1998-2008 by spraying chemicals that landed on the Johnson’s organic farm, the opinion said. The opinion said that the co-op was cited four times by the Minnesota Department of Agriculture for violating pesticide laws that make it illegal to “apply a pesticide resulting in damage to adjacent property.”

A 2002 overspray led to the Johnsons selling their crops at lower, nonorganic prices and taking the tainted field out of production for three years. In 2005, 2007 and 2008, the overspray led the Johnsons to destroy alfalfa and soybeans and plow under and take out of production for three years parts of their fields, according to the Court of Appeals opinion.

What’s interesting to me about this case is the Johnsons’ use of the common law — they filed a lawsuit claiming nuisance and trespass. The district court found against them, but this appeals ruling negates that and sends it back to the district court:

The Court of Appeals opinion Monday decided that what the co-op did could be considered a trespass because it met the two elements necessary — that the Johnsons had rightful possession of their fields and that the cooperative’s unlawful spraying of the pesticide, causing it to drift onto the Johnsons’ otherwise chemical-free fields, constitutes an unlawful entry.

Looks to me like an application of Coase to the pesticide drift question — clarifying who has legal liability for the consequences of actions when those actions affect others, use of the common law concept of nuisance — with the result that the pesticide sprayer is liable for the costs of the consequences.

In a case like this, with two adjoining plots of land, the identification of the actors and the actions is pretty straightforward, so it’s a textbook low transaction cost case. But what happens if, say, the organic farm is adjacent to three other farms, and the issue is not pesticide drift, but is rather GMO propagation drift? If all four farms plant corn, but three of them plant the same strain of drought-resistant GMO corn, some seed propagation across property boundaries is likely. How do you assign liability with multiple potential actors? Is there a way to avoid such a cost, and if so, who is likely to be the least-cost avoider? Or more interestingly, since the GMO corn is drought resistant, how do you net out the beneficial effects of the need for less irrigation against the cost of the corn not being able to be sold as GMO-free any more?

I think I may have just identified a new case study for my fall environmental class …