Why the benefits of the EPA’s new carbon rule outweigh the costs for the U.S. — just not by as much as you’ve heard

Editor’s Note: The Environmental Protection Agency has been holding public hearings in four cities this week about its recently announced plan to cut carbon emissions from existing U.S. power plants. The proposed regulation has wedged itself into the political debate about climate change, which, at its heart, is about costs and benefits.

Coal-state politicians, for example, are most concerned about the immediate costs of the regulation in terms of jobs and profits lost. Meanwhile, the White House released a report this week showing the high costs of not reducing carbon emissions. Specifically, President Obama’s Council of Economic Advisers estimates that all countries delaying those reductions could increase economic damages by approximately 0.9 percent of global output, which, they calculate is approximately $150 billion of estimated 2014 U.S. Gross Domestic Product.

But Harvard environmental economist Robert Stavins, known on this page for his commentary on Mr. Obama’s climate policy and his dispatches from the U.N. Framework Convention on Climate Change, doesn’t think the cost to the United State would be as high as $150 billion. There is no reason to assume that damages would be spread evenly around the world. And that’s because climate change, by its very nature, is global: there are no borders when it comes to rising temperatures. Stavins has argued that much of the damage would actually be borne by developing countries.

To understand more fully the nuances of calculating the costs and benefits of climate change regulation, Stavins takes us back two months to when the EPA first revealed their proposal. The agency’s own regulatory impact analysis (RIA) found that the benefits of the rule would far exceed the costs – targeting positive net benefits at $67 billion in 2030. But the factors included in those benefits, Stavins explains, aren’t just U.S. savings, and are not just savings from reduced carbon dioxide exclusively.

Stavins has adapted the following column from his blog, and we present it here today as context for interpreting the cost-benefit analysis of climate change regulation.

Simone Pathe, Making Sen$e Editor

On June 2, the Obama administration’s Environmental Protection Agency (EPA) released its long-awaited proposed regulation to reduce carbon dioxide (CO2) emissions from existing sources in the electricity-generating sector. The proposed regulation calls for cutting CO2 emissions from the power sector by 30 percent below 2005 levels by 2030. By providing great flexibility to the states, the proposal allows for cost-effectiveness, but will the regulation be welfare-enhancing?

Cost-effectiveness (achieving a given target at the lowest possible aggregate cost) is one thing, but economists – and possibly some other policy wonks – may wonder if the proposal is likely to be efficient (maximizing the difference between benefits and costs). This is a much higher mountain to climb, and a particularly challenging one for a regional, national or sub-national climate-change policy, given the global commons nature of the problem. We can ask a more modest question, namely whether the proposal will be welfare-enhancing — that is, will its benefits exceed its costs (even if that difference is not maximized)?

The Global Commons Problem

Greenhouse gases (GHG) mix globally in the atmosphere, and so damages are spread around the world and are unaffected by the location of emissions. Any jurisdiction-taking action – in a region, country, state or city — will incur the direct costs of its actions, but the direct benefits (averted climate change) will be distributed globally. Hence, the direct climate benefits a jurisdiction reaps from its actions will inevitably be less than the costs it incurs, despite the fact that global climate benefits may be greater – possibly much greater – than global costs.

But in its 376-page regulatory impact analysis (RIA), the EPA found that expected benefits would exceed costs. Indeed, its central estimate is of positive net benefits (benefits minus costs) of $67 billion annually in the year 2030 (employing a mid-range 3 percent discount rate). How can this be? There are two answers to this conundrum.

First, the EPA does not limit its estimate of climate benefits to those received by the United States (or its citizens), but uses an estimate of global climate benefits instead.

Second, in addition to quantifying the benefits of climate change impacts associated with CO2 emissions reductions, the EPA quantifies and includes (the much larger) benefits of human health impacts associated with reductions in other (correlated) air pollutants.

Now, let’s take a look at the numbers from these two key aspects of the EPA’s economic analysis and the issues surrounding the calculations.

U.S. Versus Global Damages

There are surely ethical arguments (and possibly legal arguments) for employing a global damage estimate, as opposed to a U.S. damage estimate, in a benefit-cost analysis of a U.S. climate policy, but employing a global estimate is a dramatic departure from the precedent of decades of regulatory impact analyses.

If this practice were applied in a consistent manner – that is, in all RIAs – it would result in some bizarre findings. For example, a federal labor policy that increases U.S. employment, while cutting employment in competitor economies, might be judged to have zero benefits. Likewise, if a domestic climate policy had the unintended consequence of causing emissions and economic leakage (through relocation of some manufacturing to other countries), that would not be considered a cost of the regulation (and with diminishing marginal utility of income, it might be counted as a benefit)!

Of course, a counter-argument to this line of thinking is that the usual U.S.-only geographic scope of a RIA is simply inappropriate for a global commons problem. Otherwise, we would simply restate in economic terms the free-rider consequences of a global commons challenge.

I leave it to legal scholars and lawyers to debate the law, and I defer to the philosophers to debate the ethics, but let’s at least ask what the consequences would be for the EPA’s analysis if a U.S climate benefits number were used, rather than a global number.

For this purpose, we can start with the EPA’s estimates (from Table ES-7 on page ES-19 and Table ES-10 on page ES-23 of its regulatory impact analysis of the proposed rule) for 2030 benefits and costs, using a mid-range 3 percent real discount rate. The estimated (global) climate benefits of the rule are $31 billion.

In order to think about what the domestic climate benefits might be, we can turn to the Obama administration’s original calculation of the Social Cost of Carbon in 2010, where the Interagency Working Group estimated a central global value for 2010 of $19 per ton of CO2, and noted (and explained in more detail in a subsequent scholarly paper by several members of the Working Group) that U.S. benefits from reducing GHG emissions would be, on average, about 7 to 10 percent of global benefits across the scenarios analyzed with the one model that permitted such geographic disaggregation.

Taking the midpoint of the Obama Working Group’s 7-10 percent range, U.S. damages (benefits) may be estimated to be 8.5 percent of global damages, which would reduce the $31 billion reported in the new RIA to about $2.6 billion, which is considerably less than the RIA’s estimated total annual compliance costs of $8.8 billion (assuming that the states facilitate cost-effective actions). This validates the intuition, explained above, that for virtually any jurisdiction, the direct climate benefits it reaps from its actions will be less than the costs it incurs (again, despite the fact that global climate benefits may be much greater than global costs).

There are plenty of caveats on both sides of this simple analysis. One of the most important is that if the proposed U.S. policy were to increase the probability of other countries taking climate policy actions (which I believe is probably the case), then the impacts on U.S. territory of such foreign policy actions would merit inclusion even in a traditional U.S.-only benefit-cost analysis. More broadly, although it has been traditional to use a U.S.-only benefits measure in RIAs, the current guidelines for carrying out these analyses from the Office of Information and Regulatory Affairs of the U.S. Office of Management and Budget require that geographic U.S. benefit and cost estimates be provided, but also allow for the optional inclusion of global estimates.

Pending resolution (or more likely, discussion and debate) from lawyers and philosophers regarding the legal and ethical issue of employing domestic benefits versus global benefits in a climate regulation RIA, it is essential to recognize that there is an even more important factor that explains how the EPA came up with estimates of significant positive net benefits (benefits exceeding costs) for the proposed rule (and would have even if a domestic climate benefits number had been employed). That more important factor is the inclusion of (domestic) health impacts of other air pollutants, the emissions of which are correlated with those of CO2.

Correlated Pollutants and Co-Benefits

The Obama administration’s proposed regulation to reduce CO2 emissions from the electric power sector is intended to achieve its objectives through a combination of less electricity generated (compared with a business-as-usual trajectory), greater dispatch of electricity from less CO2-intensive sources (natural gas, nuclear and renewable sources, instead of coal), and more investment in low CO2-intensive sources. Hence, it is anticipated that less coal will be burned than in the absence of the regulation (and more use of natural gas, nuclear and renewable sources of electricity). This means not only less CO2 being emitted into the atmosphere, but also decreased emissions of correlated local air pollutants that have direct impacts on human health, including sulfur dioxide, nitrogen oxides, particulate matter and mercury.

It is well known that higher concentrations of these pollutants in the ambient air we breathe – particularly smaller particles of particulate matter — have very significant human health impacts in terms of increased risk of both morbidity and mortality. The numbers dwarf the climate impacts themselves. Whereas the U.S. climate change impacts of CO2 reductions due to the proposed rule in 2030 are probably less than $3 billion per year (see above), the health impacts (co-benefits) of reduced concentrations of correlated (non-CO2) air pollutants are estimated by the EPA to be some $45 billion a year. (By the way, I assume that the co-benefits estimated by the EPA are based upon a comparison with a business-as-usual baseline that includes the effects of all existing EPA and state regulations for these same local air pollutants. If not, the RIA will need to be revised.)

The Bottom Line

The combined U.S.-only estimates of annual climate impacts of CO2 ($3 billion) and health impacts of correlated pollutants ($45 billion) greatly exceed the estimated regulatory compliance costs of $9 billion per year, for positive net benefits amounting to $39 billion per year in 2030. This is the key argument related to the possible economic efficiency of the proposed rule from the perspective of U.S. welfare. If the EPA’s global estimate of climate benefits ($31 billion per year) is employed instead, then, of course, the rule looks even better, with total annual benefits of $76 billion, leading to the EPA’s bottom-line estimate of positive net benefits of $67 billion per year. See the summary table below.

Graph courtesy of the author.

Chart courtesy of the author.

The Obama administration’s proposed regulation of existing power-sector sources of CO2 has the potential to be cost-effective, and if you accept these numbers, it can also be welfare-enhancing, if not welfare-maximizing.

That said, I assume that proponents of the Obama administration’s proposed rule will take this assessment of the EPA’s regulatory impact analysis as evidence of the sensibility of the rule, and opponents of the administration’s proposed actions will claim that my assessment of the RIA provides evidence of the foolishness of the EPA’s proposal. So it is in our pluralistic system (not to mention, in the context of the political polarization that has gripped Washington on this and so many other issues).