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### Draft Charge Questions for Science Advisory Board Panel on the Role of Economy

- Wide Modeling in U.S. EPA Analysis of Air Regulations

In accordance with Executive Orders 12866 and 13563, EPA evaluates the benefits, costs, and economic impacts of major air regulations to inform the policy process and the public of their likely economic effects. While cognizant of limited resources and dat a, EPA strives to rely on the best available science when estimating these economic effects using both benefit

- cost analysis and economic impact analysis.

Air regulations considered by EPA vary widely with respect to the types of pollution addressed, sec toral and geographic scope, regulatory design, stringency, types of benefits and costs, and across other dimensions. EPA considers these characteristics when gauging which analytic tools can be applied in a practical and analytically defensible way to esti mate costs, benefits, and economic impacts within a particular regulatory context.

For nearly all benefit

- cost analyses conducted by EPA in support of air regulations, the costs are estimated using engineering or detailed partial equilibrium sector mod els which are compared to benefits that are likewise estimated through partial equilibrium models. EPA has evaluated , and will continue to evaluate
, the appropriate role for economy

- wide modeling in informing the regulatory
process . While the Advisory Coun cil on Clean Air Compliance Analysis review of the Second Prospective Study of the Clean Air Act Amendments stated that inclu sion of benefits in the economy

- wide model that was specifically adapted for use in that study “ represent[ed] a significant step fo rward in benefit

cost analysis,” EPA recognizes that serious technical challenges remain when attempting to evaluate the benefits and costs of potential regulatory actions using economy

- wide models. 1

P olicy makers and the public also have a keen interest in the distribution of social costs and benefits across households and sectors (i.e., economic impacts) through mechanisms such as energy prices or labor market impacts

. In response, some external entities have conducted analyses employ ing economy

wide mo dels to estimate how the costs of regulation are distributed, but these exercises have not incorporate d benefits. The accuracy and defensibility of such analyses is also highly dependent on the quality of the assumptions and data used to represent regulation s in the model , and on the inherent strengths and weaknesses of the particular model employed

.

Therefore, we ask the Panel to examine the technical merits , technical challenges , and potential value added
, relative to other modeling approaches
, of us ing economy

- wide models in a regulatory setting ; to advise the Administrator of the results of this examination so that future EPA decisions on the use of
economy

- wide models can be more fully informed ; and to identify potential paths forward for imp rovements in economy

- wide models that could address their existing limitations and increase their potential utility as analytic tools to support regulatory decisions

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1 EPA Advisory Council on Clean Air Compliance Analysis ( 2010). Review of the Final Integrated Report for the Second Section 812 Prospective Study of the Benefit s and Costs of the Clean Air Act , EPA

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### Challenges in the us e of economy - wide models to evaluate the social costs of an air
regu lation

When examining the value of a proposed government policy, the social cost s can be compared with the social benefit s in a benefit

- cost analysis, or compared with the social costs of alternative policies that achieve similar goals in a cost effectiveness analysis. C omputable general equilibrium (CGE) model s provide one potential tool for estimation of the social costs of a policy

.

1. EPA has extensive experience using a wide range of economic models to evaluate air regulations

. These models ar e generally tailored to the scope and timeframe of the regulation s , ranging from
static partial equi librium models that estimate costs in a single product market in a single year
, to dynamic CGE models that estimate costs for multiple markets over time. G iven this context, w hat are the advantages and drawbacks of a CGE approach (versus an engineering or partial equilibrium approach) for estimating social cost s , including the differences in social cost s between alternative regulatory options ?

2. Model choic e and the appropriateness of us ing an economy

- wide approach to evaluate the economic effects of policy are dependent on many factors. For example, a CGE model may be more appropriate for use in the analysis of a regulation that is implemented over several years and that constitutes a large

- scale intervention in the economy, requir ing relatively large compliance expenditures that impact multiple sectors, either directly or indirectly. How does each factor listed below affect the technical merits of using an economy

- wide model for estimating social cost s ? Please consider the relative importan ce of these factors separately.

o Relative magnitude of the abatement costs of the rule

.
o T ime horizon for implementation of the rule

.
o Number and types of sector (s) direct ly and/or indirectly affected by the regulation , and the magnitude of these potential market effects

.
o L evel of detail needed to accurately represent the costs of the rule (e.g., I s it credible to assume more aggregate model parameters used in CGE are vali d for a subset of the industry ? W hen is it important to include a detailed represent ation of a particular sector, such as the power sector? W hen is it important to include transition costs? )

.
o A ppropriate degree of foresight (e.g., W hen is it appropriate to use a recursive dynamic model or a n intertemporally optimizing model? I f only one type is available, to what degree can alternative foresight assumptions be approximated?)

.
o H ow a model is closed , particularly how international trade is represented (e.g. W hen is a detailed representation of the rest of the world important for estimates of social cost s ?)

.
o C onsiderations relevant to the availability and cost of an economy

- wide model versus alternative modeling approac hes (i.e., to inform analytic choices that weigh the value of information obtained against analytic expenditure s when resources are constrained )

.
o A bility to incorporate and appropriately characterize uncertainty in key parameters and inputs (e.g., enginee ring costs).3

3. Are other factors beyond those listed above relevant to consider when assessing whether and how
to model the social costs of a regulatory action in an economy

- wide framework ?

4. Most EPA regulations do not operate through price ; instead they ar e typically emission

- rate and/ or technology

- based standards. What are the particular challenges to representing regulations that are not directly implemented through price in an economy

- wide framework? Under what circumstances
is it particularly challenging to accurately represent such regulations in these models ?

5. EPA has previously used CGE models to estimate the social cost s of regulation by calculating equivalent variation (EV) but has also reported changes in other aggregate measures such as GDP and household consumption. Setting aside benefits for the moment, what are the appropriate metrics to measure social costs? What are the advantages or drawbacks of using an EV measure vs. GDP or household consumption to approximate a change in welfar e?

6. EPA recognizes that , in some circ umstances, the use of multiple models may be advantageous when characterizing the costs of regulation. For instance, a partial equilibrium model can provide needed sector detail while a CGE model accounts for pre

- existi ng market distortions and how compliance
costs in one sector affect other sectors of the economy

. What conceptual and technical issues are important to consider when assessing the potential linking of detailed sector cost models or bottom

up engineering es timates of abatement costs with a general equilibrium framework?

7. When EPA has estimated the economic effects of regulation s on multiple markets it has relied primarily on CGE models
, such as the EPA

- developed EMPAX and the Jorgenson

- developed IGEM model s. Are there other economy

- wide modeling approaches beside CGE that EPA should consider for estimating the social costs of air regulations (e.g., input

- output models, econometric macro models, dynamic stochastic general equilibrium models) ? What are the potential strengths and weaknesses of the se alternative approaches in the e nvironmental regulatory context?



### Challenges in the use of economy

- wide models to consider the benefits of an air regulation

The Second Prospective Analysis of the Clean Air Act Amendments (also known as the Section 812 study) modeled the macroeconomic impacts of air quality

- related health improvements by focusing on three specific effects: (1) the change in household time endowment from pollution

- related mortality impacts, (2) th e change in household time endowment from pollution

- related morbidity, and (3) the change in medica l expenditures associated with pollution

- related morbidity. 2 This is admittedly an incomplete list of poten tial benefits , and EPA seeks guidance as to the incorporation of benefit s estimates into
economy

- wide modeling frameworks

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2 U.S. EPA (2011). The Benefits and Costs of the Clean Air Act from 1990 to 2020

. http://www.epa.gov/air/sect812/feb11/fullreport_rev_a.pdf

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1. Setting aside costs for the moment, w hat are the main conceptual and technical hurdles to representing the benefits of an air regulation in a general equilibrium framework (e.g. data requirements, developing detailed subsections of the model such as more realistic labor market s , scale and scope)? What would be required to overcome them?

2. For the Section 812 study, EPA model ed mortality and morbidity impacts (e.g., the benefits from reduced premature mortality due to reduced PM2.5 exposure ) in a CGE framework as a change in the household time endowment

. Is it appropriate to continue modeling the mortality and morbidity impacts as a change i n the time endowment ? If not, what other approach es warrant consideration ?

3. Approximately 95 percent of monetized benefits of air regulations arise from willingness to pay for reductions in the risk of premature mortality , which is not equivalent to the value of the change in the household time endowment

. Is there sufficient empirical research to su pport the incorporation of other representations of mortality and morbidity impacts or additional benefit categories? What approaches c ould be used to incorpor ate these additional benefits?

4. When individuals experience changes in medical expenditures, this changes the budget available to the consumer for other goods and services. However, the consumer could also experience changes in their relative preferences f or these goods and services (e.g., outdoor activities) as a result of a change in their health and/or life expectancy . Is this a change that could be captured in a CGE model ? Under what circumstances would the expected impact be too small to be of importan ce to the quantitative results ? If this effect cannot be modeled, how can the approach to incorporat ing the change in medical expenditures
, as employed in the Section 812 study
, be improved upon ?

5. Some potential benefits, such as productivity gains of the workforce due to cleaner air , are not typically quantified. I s there a sufficient body of empirical research to su pport development of a technique for incorporating productivity gains and other benefits that have not been typically quantified into a CGE fr amework? If so , a re there particular approaches that EPA should consider?

6. Impacts on non

- market resources are not typically incorporated into CGE framework s , though research by Carbone and Smith (20 08, 2013 ) 3 has indicated that these impacts could be important in th is context . Is there a sufficient body of empirical research to support the development of technique s for incorporating these impacts into existing CGE models that may be available to EPA? What are the particular challenges to incor porating non

- use benefits into a general equilibrium framework (e.g. non

- separability)?

3 Carbone, J.C. and V. K. Smith (2008). "Evaluating Policy Interventions with General Equilibrium Externalities." Journal of Public Economics , 92 (5

- 6); Carbone, J.C. and V. K. Smith (2013). "Valui ng Ecosystem Services in General Equilibrium." Journal of Environmental Economics and Management, 66(1), 72

– 89.5

7. What insights does a CGE model provide when the benefits cannot be completely modeled? How should the results be interpreted when only some types of benefits can be re presented in a CGE modeling framework ?

8. EPA’s benefits modeling commonly takes into account the spatial distribution of environmental impacts to quantify the impacts on spatially distributed human populations. How would one capture the spatial component of health or other benefits in a n economy

- wide framework?



### Challenges in the use economy - wide models to inform economic impacts analysis for an air regulation

EPA has available to it a range of methods and tools already in use to evaluate the way in which positive and negative economic impacts associated with a n air regulation are distributed (e.g., across sectors, households, and time ) in accordance with a variety of Executive Orders (i.e., 12866, 13563, and others)

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1. CGE models often assume forward

- looking rational agents and instantaneous adjustment of markets

to a new , long run equilibrium (for instance, most assume full employment). A 2010 peer review of the ADAGE and IGEM models indicated that this is “ probably a reasonable assumption as these models should be viewed as modeling scenarios out forty or more years for which economic fluctuations should be viewed as deviations around a full

- employment trend. ” In this context and relative to other tools EPA has at its disposal
, to what exten t a re CGE models technically appropriate for shedding light on the economic impacts of a n air regulation, aside from its welfare or efficiency implications ? In particular, p lease consider the following types of economic impacts :

o S hort and long run implic ations of energy prices for households and firms

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o S ectoral impacts (including price and quantity changes, plant openings and closures)

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o T ransition costs in capital or labor markets (e.g. representation of rigidities in the labor and capital markets)

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o Equilibrium impacts on labor supply or demand

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2. External organizations have also used CGE models to assess the economic impact of recent EPA regulations. These studies vary in quality : methods are often not based on first

- principles of economics and signi ficant differences in assumptions can meaningfully affect the results. These studies also have not incorporate d benefits. What criteria should be used to evaluate the scientifically defensib ility of CGE models to evaluate economic impacts? What are the adv antages and challenges or drawbacks of using a CGE or other economy

- wide modeling approach (versus a more detailed partial equilibrium approach) to evaluate these types of economic impacts ?

3. Are there other economy

- wide modeling approaches that EPA c ould consider in conjunction with CGE models to evaluate the short run implications of a n air regulation (e.g., macro

- economic
, disequilibrium , input/output models)? What are the advantages or disadvantages of these approaches?6



### Consideration s for generating directly comparable estimates of social costs, benefits, and economic impacts using economy

- wide modeling

The benefit

- cost framework as employed in EPA analyses compares the monetized health and welfare benefits of a regulation with the social costs of the compliance measures necessary to meet the standard. I n light of the detailed discussions you have had

– pursuant to the preceding charge questions

– on representing social costs, benefits, and economic impacts in an economy

- wide fra mework, please answer the following questions.

1. Compared to other modeling tools at EPA’s disposal, w hat are the technical merits and challenges of using economy

- wide models to evaluate the social cost s, benefits, and/or economic impacts of relevant air re gulation s ? What criteria c ould be used to choose between different economy

- wide models/frameworks? What features are particularly desirable?

2. Are there potential interactions between the cost and benefit sides of the ledger (e.g. because of channels throug h which benefits operate) that make it difficult to make defensible comparisons between costs and benefits when:

o Social costs are estimated using a CGE framework but benefits are estimated using a partial equilibrium framework.

o Some of the benefits are n ot captured in the CGE framework include long

- lived benefits (e.g. climate benefits).

What is the potential for mis

- estimation of the costs or benefits in these cases (either under or double

- counting)?

3. When benefits are included in a CGE model, it is possible for economic welfare measure s for the economy as a whole to be positive even when there is a negative impact on GDP (for instance , in the
Section 812 study). 4 Relying on net measures obscures the costs and benefits of the policy that are typically reported separately in a regula tory analysis as well as how costs and benefits are felt throughout the economy (e.g., benefits and costs are often distributed differently). In the case where EPA does not have a tool that defensibly incorpora tes benefits into an economy

- wide framework, there is also the risk that policymakers and the public may mistakenly interpret the results as net measures when they only represent the cost side of the ledger

. What are the potential drawbacks of using econo my

- wide models to present information on costs where there is not a corresponding capability to estimate benefits? If the SAB advises that the use of economy

wide models may be appropriate in certain circumstances
, a re there particularly useful ways in which results from a CGE model could be presented to the public and policy makers ?

4 See Exhibits 13 and 14 of the 812 study at http://www.epa.gov/oar/sect812/feb11/graphicsstack.pdf

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o Given the many assumptions and uncertainties inherent in modeling the impacts of a regulation in a CGE or other type of economy

- wide f ramework, are absolute measures of welfare, social costs, and benefits more scientifically defensible or should the focus be on relative comparisons across proposed regulatory alternatives? (Should we have greater confidence in the estimated welfare change between baseline and policy scenario or in the relative difference in welfare across policy scenarios?)

o What are the technical limitations to present ing both general equilibrium and partial equilibrium measures when assessing the net benefits of a regulat ion?

4. The Nat ional Academy of Science s (2013) identifies three type of uncertainty: statistical variability and heterogeneity (or exogenous uncertainty); model and parameter uncertainty, and deep uncertainty. 5 How can these types of uncertainty be addressed in an economy

- wide modeling framework? H ow can EPA be reasonably confident that it is producing credible welfare or economic impact estimates?

o How can uncertainty be characterized when reporting the results from an economy

- wide model?

o Are sensitivity analyses of important model parameters and/or model assumptions a reasonable way to assess uncertainties involved in this type of economic modeling? Are there circumstances in which the use of multiple economy

- wide models should be considered ?

o Are the models precise enough to accurately represent the general equilibrium welfare effects of a regulation that has relatively small engineering costs or monetized benefits? What about for evaluating economic impacts? If yes, under what circumstances?

5. Bearing in mind current and future resource limitations, what should EPA prioritize as its longer
term research goals with respect to improving the capabilities of economy

- wide models to evaluate social costs, benefits, and/ or economic impacts ?

5 National Research Council (2013). Environmental Decisions in the Face of Uncertainty. Washington, DC: The National Academies Press. Available at http://www.nap.edu/catalog.php?record_id=12568

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