A PUBLICHIOI N OF THE STRATEGIC PLANNING DEPARTMENT

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BYPAUL 

### L. JOSKOW

APUBLICATION OF THE STRATEGIC PLANNING DEPARTMENT

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By Paul L. Joskow

Mitsui Professor of Economics and Professor of Economics and Management, Massachusetts Institute of Technology

Copyright © 1992, Edison Electric Institute 

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# GWITH 

# RO TAL T 

# R ALITIE DO IT RIGHT!

By Paul L. Joskow

Mitsui Professor ofEconomics andProfessor ofEconomics andManagement, Massachusetts Institute ofTechnology

Copyright © 1992, Edison ElectricInstitute

## DEALING WITH EXTERNALITIES,-

B

## y Paul L. Joskow

Mitsui Professor of Economics and Professor of Economics and Management, Massachusetts Institute of Technology

Should we as a society adopt regulatorypolicies to internalize "external" environmental costs? Of course we should. But we should do it right. Unfortunately, a significant number of state public utility commissions (PUCs) are doing it wrong - very wrong. Their reliance on numerical "adders" to reflect environmental impacts will not achieve the goal of improving the environment at the lowest reasonable cost to society. This misguided approach is clearly inconsistent with the PUCs' capabilities and public policy role. The consequences will be bad regulatory policy and bad environmental policy, and it will lead to higher electricity prices and less environmental protection in the long run. No doubt, state PUCs have an important role in the implementation of least-cost environmental policies. This role is consistent with the PUCs' basicobligation to protect the interests of consumers and help them use electricity wisely. It also is consistent with the country's federalist system, wherein certain societal problems are addressed by state and local government agencies that are closest to those particular issues.However, the PUCs' interjection of socalled externality adders and "global and regional" societal costs into the least-cost planning process is inconsistent with all these vital aspects of the nation's regulatory system.

Prepared for the Harvard Northeast Electric Utility Executive Conference, Killington, Vermont, October 17-18, 1991. Research support was provided by the Massachusetts Institute of Technology (MIT) Center for Energy Policy Research. I am grateful to David Harrison for his comments on an earlier draft.

The views expressed in this paper are my own and do not necessarily reflect the views of the Edison Electric Institute or any organization with which I am associated. 

## DEALING WITH ENVIRONMENTAL EXTERNALITIES:

LET'S DO IT RIGHT!

By Paul l. Joskow

Mitsui Professor of Economics and Professor of Economics and Management, Massachusetts Institute ofTechnology

Shouldwe as a society adoptregulatory policies to internalize "external" environmental costs? Ofcourse we should. But

we should do it right. Unfortunately, a significant number of
state public utility commissions (PUCs)

are doing it wrong

- very wrong. Their reliance on numerical "adders" to reflect environmentalimpactswillnotachievethe goal ofimproving the environment at the lowest reasonable cost to society. This misguided approach is clearly inconsistent with the PUCs' capabilities and public policyrole. The consequenceswill bebad regulatory policy and bad environmental policy, and itwill lead to higher electricity prices and less environmental protection in the long run. No doubt, state PUCs have an important role in the implementation of least-cost environmental policies. This role is consistent with the PUCs' basic obligation to protect the interests of consumers and help themuse electricitywisely. It also is consistent with the country's federalist system, wherein certain societal problems are addressedby state and local government agencies that are closest to those particular issues. However, the PUCs' interjection ofsocalled externality adders and "global and regional" societal costs into the least-cost planning process is inconsistent with all these vital aspects of the nation's regulatory system.

Preparedfor the Hmvard Northeast Electric Utility Executive Conference, Killington, Vennont, October 17-18, 1991. Research support wasprovided by the Massachusetts Institute ofTechnology (MIT) Center for Energy Policy Research. I am grateful to David Harrisonfor his comments on an earlierdraft.

The views expressedin thispaperare myown anddo
notnecessarily reflectthe views of the Edison Electric Institute or any organization with which I am associated.2 Issues and Trends Briefing Paper

WHAT 1S EXTERNALITY?

Recent state commission orders on the subject of environmental externalities (e.g., California, Massachusetts, and Nevada), as well as the testimony of "experts" who promote the adder approach, show a lot of confusion about what externalities are, and how regulation should efficiently internalize them. This is not a propitious start for these initiatives. It may come as a surprise to some, but the theory of externalities was not discovered a couple of years ago by former Congressman Richard Ottinger (who is currently promoting the externality adder concept). Externalities have a venerable tradition in the field of economics. The first comprehensive discussion of external costs and benefits is generally attributed to the work of the famous British economist A. C. Pigou in the 1930s. Moreover, various theoretical, empirical, and public policy approaches to externality issues have been an important part of economic thought since at least the early 1950s. Ronald Coase recently received the Nobel Prize in economics in part for his classic 1960 paper, "The Problem of Social Cost," which provided the stimulus for better understanding of how market and legal institutions can deal with externality problems efficiently. Externality problems are the basis for economics

, t e and of environmental h field provide the economic foundation for society's environmental policy initiatives. Externality problems also have important roles in many other fields within economics, including law and economics (the role of liability, property, and contract laws in internalizing externalities), urban economics (zoning and urban planning), transportation economics, research and development (patents, public R&D subsidies, licensing rules), and economic development (macroeconomic benefits associated with infrastructure sectors such as electric power). Although much of this paper is concerned with external environmental costs, it is essential to understand that "externalities" are not limited to the environment, and can include both societal costs and societal benefits. Clean air, clean water, and the like, are scarce resources. In the absence of a market for the use of clean air and clean water, the societal cost of using, depleting, or damaging these resources will be ignored by the producers and consumers of goods and services that have negative environmental impacts. In other words, the external costs are reflected in neither the cost of production nor in the price of these goods and services. From society's perspective, there will be too little investment in pollution abatement and too much consumption of these goods and services. 2 Issues and Trends Briefing Paper

WHAT IS AN EXTERNALITY?

Recent state commission orders on the subject of environmental externalities (e.g., California, Massachusetts, and Nevada), as well as the testimony of "experts" who promote the adder approach, show a lot of confusion about what externalities are, and how regulation should efficientlyinternalizethem. Thisis
not a propitious start for these initiatives. Itmay come as a surprise to some, but the theory of externalities was not discovered a couple of years ago by former Congressman Richard Ottinger (who is currentlypromotingtheexternality adder concept). Externalities have a venerable tradition in the field of economics. The first comprehensive discussion of external costs and benefits is generally attributed to the work of the famous British economist A. C. Pigou in the 1930s. Moreover, various theoretical, empirical, andpublicpolicy approaches to externality issues have been animportant partofeconomicthoughtsince atleastthe early 1950s. Ronald Coase recently received the Nobel Prize in economics in part for his classic 1960 paper, "The Problem of Social Cost," which provided the stimulus for better understanding of how marketandlegal institutions candeal with externality problems efficiently. Externality problems are the basis for thefield ofenvironmentaleconomics, and provide the economic foundation for society's environmental policy initiatives. Externality problems also have important roles in many other fields within economics, including law and economics (theroleofliability,property, andcontract laws in internalizing externalities), urban economics (zoning and urban planning), transportation economics, research and development (patents, public R&D subsidies, licensing rules), and economic development (macroeconomic benefits associatedwithinfrastructure sectors such

as electric power). Although much of this paper is concerned with external environmental costs, it is essential to understand that "externalities" are not limited to the environment, andcanincludebothsocietal costs and societal benefits. Cleanair, cleanwater, and the like, are
scarce resources. In the absence of a market for the use of clean air and clean water, the societal cost ofusing, depleting,

or damaging these resources will be ignored by the producers and consumers of goods and services that have negative environmental impacts. In other words, the external costs are reflected in neither the cost ofproduction nor in the price of these goods and services. From society's perspective, there will be too little investmentinpollutionabatementandtoo much consumption of these goods and services.Dealing With Environmental Externalities 3

However, emissions are not an externality that leads to inefficient producer and consumer decisions simply because those who are harmed are not compensated, as some PUCs have suggested. The critical issue is whether incremental emissions are "priced" in some way so that producers take into account the cost of their environmental impacts when they make decisions that affect how much they pollute, how they control emissions, and what price they charge for their products. Externality problems are a particular form of "market failure" that results from "missing markets" for the rights to use scarce environmental resources. They may be "missing" because of poorly defined property rights, poorly structured liability laws, transaction costs, "common source" characteristics, or other reasons. The economic rationale for any government regulation of power plant emissions is a failure of the unregulated market to force plant owners to take into account the effects of their emissions on air, water, and other environmental resources. There are two ideal solutions to environmental externality problems. One solution is to create a market for the rights to use clean air and water by establishing an emissions cap and issuing tradeable emissions permits that polluters must acquire to "cover" their emissions, which in the aggregate cannot exceed the cap. The other is to simulate the prices for clean air and water resources that would emerge if such a market existed, by imposing effluent fees or emissions taxes. Either solution will internalize the environmental externalities; private firms will treat the costs of emissions permits, fees, and taxes in their production and pricing decisions much the same as any other production cost. Economic theory teaches that the correct quantity of emissions permits, fees, or taxes will solve the externality problem completely.

"Recent state commission orders on the subject of environmental externalities
, as well as the testimony of 'experts' who promote the adder approach, show a lot of confusion.... This is not a propitious start."

Note that, once an externality is fully "internalized," it is still possible to observe residual impacts on the environment. These residual damages are not externalities that lead to inefficient decisions once they are priced properly. They have been internalized and, in the context of externality theory, there is nothing left to be done. Once they have been properly internalized, the value of any further reduction in third-party damages will be smaller than the societal costs incurred to achieve the reduction.1 This last point will be revisited shortly, Dealing With Environmental Externalities 3

However, emISSIOns are not an externality that leads to inefficient producer and consumer decisions simply because those who are harmed are not compensated, as some pues have suggested. The critical issue is whether incrementalemissions are "priced"insome way so that producers take into account the cost of their environmental impacts when they make decisions that affect how much they pollute, how they control emissions, and what price they charge for their products. Externality problems are a particular form of "market failure" that results from "missing markets" for the rights to use
scarceenvironmentalresources. Theymay be "missing" because of poorly defined property rights, poorly structured liability laws, transaction costs, "common source" characteristics, or other reasons. The economic rationale for any government regulation of power plant emissions is a failure ofthe unregulated market to force plant owners to take into account the effects of their emissions on air, water, and other environmental resources. There are two ideal solutions to environmental externalityproblems. One solution is to create a market for the rights to use clean air and water by establishing an emissions cap and issuing tradeable emissions permits thatpolluters
must acquire to "cover" their emissions, which in the aggregate cannot exceed the cap. The other is to simulate the prices for clean air and water resources that would emerge ifsuch a market existed, by imposing effluent fees or emissions taxes. Either solution will internalize the environmental externalities; private firms will treat the costs of emissions permits, fees, and taxes in their production and pricing decisions much the same as any other produ€tioncost. Economic theory teaches that the correct quantity of emissions permits, fees, or taxes will solve the externality problem completely.

"Recent state commission orders
on the subject of environmental externalities, as well as the testimony of 'experts' who promote the adder approach, show a lot of confusion

.... This is not a propitious start."

Note that, once an externality is fully "internalized," it is stillpossible to observe residual impacts on the environment. These residual damages are not externalities that lead to inefficient decisions once they are priced properly. They have been internalized and, in the
context of externality theory, there is nothing left to be done. Once they have been properly internalized, the value of any further reduction in third-party damages will be smaller than the societal
costs incurred to achieve the reduction.I This last pointwill be revisited shortly,4 Issues and Trends Briefing Paper

but it is important to emphasize once again its importance for the issue at hand. Once environmental regulation has been introduced, it is incorrect to infer that there necessarily is an externality problem that leads to inefficient producer and consumer decisions merely because there are residual impacts on the environment. Nor is it correct to assume that the "price" required to internalize any residual externalities can be inferred from the estimated costs of those residual damages. In general, society can expect residual environmental impacts even when externalities have been completely and efficiently internalized. These residual impacts are efficient because the societal costs of reducing them further are greater than the societal benefits. Accordingly, any efforts to superimpose new environmental constraints on top of existing environmental regulations with the goal of internalizing "residual" externalities must not only analyze and measure any residual damages

. Equally important is to examine the effects of existing regulations on the decisions of private firms to determine the extent to which the external impacts have already been internalized. The view that computing the proper adders is simply a matter of getting the right values for residual impacts is wrong.2 Put another way, residual environmental damages are not the same as externalities that create inefficient use of scarce environmental resources except in a world where there are no legal, regulatory, or institutional arrangements to compel private decisionmakers to account for any of the costs of increased pollution. As a result, the accurate measurement of any unpriced residual externalities is highly complex. It requires a great deal of information about both the residual impacts and the characteristics and effects of existing environmental regulations. Before proceeding, it also is worth pointing out a semantic problem that sometimes leads to confusion about this issue

. Economists tend to speak rather loosely about uncompensated third-party effects as "externalities," then distinguish between those that have been properly taken into account by private decisionmakers
, as a consequence of market institutions
, common law, and administrative regulation, and those that have not. Coase taught us that to focus on who is damaged, i.e., that there are uncompensated third

-party impacts
, rather than on the incentives that polluters (and receptors) require in order to take appropriate deterrence or mitigation actions, can lead to confusion and bad policy conclusions.' So to avoid confusion
, it makes themost sense to distinguish between thirdparty impacts that are properly taken into account by private firms when they make production and pricing decisions and those that are not; the term "externalities" should be reserved for situations where 4 Issues and Trends Briefing Paper

but it is important to emphasize once again its importance for the issue athand. Once environmental regulation has been introduced, it is incorrect to infer that there necessarilyis anexternalityproblem that leads to inefficient producer and

consumer decisions merely because there

are residual impacts on the environment. Nor is it correctto assume that the "price" required to internalize any residual externalities can be inferred from the estimated costs ofthose residual damages. In general, society can expect residual environmental impacts even when externalities have been completely and efficiently internalized. These residual impacts are efficient because the societal
costs ofreducing themfurther are greater than the societal benefits. Accordingly, any effortsto superimpose

new environmental constraints on top of existingenvironmentalregulationswiththe goalofinternalizing"residual"externalities
must not only analyze and measure any residual damages. Equallyimportant is to examine the effects ofexisting regulations

on the decisions of private firms to determine the extentto which the external impacts have already been internalized. The view that computing the proper adders is simply a matter of getting the right values for residual impacts is wrong.2 Put another way, residual environmental damages are not the same
as externalities that create inefficient use of scarce environmental resources except III a world where there are no legal, regulatory,orinstitutionalarrangementsto compelprivate decisionmakers to account for any ofthe costs ofincreased pollution. As a result, the accurate measurement of any unpriced residual externalities is highly complex. Itrequires a greatdeal of information about both the residual impactsandthe characteristics andeffects ofexisting environmental regulations. Before proceeding, it also is worth pointing out a semantic problem that sometimes leads to confusion about this issue. Economists tend to speak rather loosely about uncompensated third-party effects as "externalities," then distinguish between those that have been properly taken into account by private decisionmakers, as a consequence of market institutions, common law, and administrative regulation, and those that have not. Coase taught us that to focus

on who is damaged, i.e., that there are uncompensatedthird-partyimpacts,rather than on the incentives that polluters (and receptors) require in order to take appropriate deterrence or mitigation actions, can lead to confusion and bad policy conclusions? So to avoid confusion, it makes the
most sense to distinguish between thirdparty impacts that are properly taken into
account by private firms when they make productionandpricingdecisions andthose that are not; the term "externalities" should be reserved for situations whereDealing With Environmental Externalities 5

the external impacts are not properly priced, are not incorporated into the decisions of private firms, and which therefore have adverse efficiency
consequences.

TEXTBOOK PRINCIPLES FOR INTERNALIZING EXTERNAL COSTS EFFICIENTLY

Economic textbooks describe a simple, but sometimes misunderstood, set of principles that are designed to guide the efficient internalization of environmental externalities in a world where there are no environmental regulations at all. These three principles are discussed here briefly.

PRINCIPLE No. 1:

Any given target level of emissions for a particular pollutant should be achieved at the lowest possible cost for abatement and mitigation.

In other words, society should spend as few resources as necessary to achieve each environmental goal. Note that least-cost emissions control can only be achieved, however, if several conditions are met: First, all sources that produce a particular pollutant in the relevant pollution region (air- or water-shed) must be covered by consistent emissions constraints. Depending on the type of pollution, the relevant geographical area may be local, state, national, or international. Second, each source must achieve its emissions reduction at the lowest possible cost, recognizing that there may be substantial variation in the efficiency of control technologies and control costs across all sources. Third, the marginal cost of control must be equalized within and across all sources - otherwise, it would be more economicalfor a source with relatively high incremental control costs to abate less, and a source with relatively low incremental control costs to abate more. These "efficient clean-up cost"conditions should be reasonably wellknown to students of environmentaleconomics. Indeed, they are so wellknown that the textbook authors sometimes fail to emphasize them when they draw and discuss the standard "marginal cost of control" curve in their texts. Therefore, it is important to emphasize here that the marginal cost of control curve that routinely appears in environmental texts is a least-cost of control curve which implicitly assumes that all the above conditions are met. Moreover, the least-cost of control curve embodies the associated abatement expenses for each level of emissions reduction, and also reflects the resultant changes in product prices. This curve is depicted as MC in Figure 1.4 Dealing With Environmental Externalities 5

the external impacts are not properly priced1 are not incorporated into the decisions of private firms, and which therefore have adverse efficiency consequences.

TEXTBOOK PRINCIPLES FOR INTERNALIZING EXTERNAL COSTS EFFICIENTLY

Economic textbooks describe a simple, but sometimes misunderstood, set of principles that are designed to guide the efficient internalization of environmental externalitiesin aworld where there areno environmental regulations at all. These threeprinciples are discussed herebriefly.

PRINCIPLE No.1:

Anygiven target level ofemissionsfor a particularpollutant should be achieved at the lowestpossible costfor abatement and mitigation.

In otherwords, society should spend as few resources as necessary to achieve each environmental goal. Note that least-cost emissions control can only be achieved, however, if several conditions are met: First, all sources that produce a particular pollutant in the relevant pollution region (air- orwater-shed) must be covered by consistent emissions constraints. Depending on the type of pollution, the relevant geographical area may be local, state, national, or international. Second, each source must achieve its emissions reduction at the lowest possible cost, recognizing that there may be substantial variation in the efficiency of control technologies and control costs

across all sources. Third,themarginalcost ofcontrolmust be equalized within and across all sources

- otherwise, itwouldbemore economical for a source with relatively high incremental control costs to abate less, and a
source with relatively low incremental control costs to abate more. These "efficient clean-up cost" conditions should be reasonably wellknown to students of environmental economICS. Indeed, they are so wellknown that the textbook authors sometimes fail to emphasize them when they draw and discuss the standard "marginal cost of control" curve in their
texts. Therefore, it is important to emphasize here that the marginal cost of control curve that routinely appears in environmental texts is a least-cost of controlcurvewhichimplicitly assumesthat all the above conditions are met. Moreover, the least-cost of control curve embodies the associated abatement expenses for each level of emissions reduction, and also reflects the resultant changes in product prices. This curve is depicted as 

### Me in Figure 1.46 Issues and Trends Brief i ng Paper

If these conditions are violated - as they often are in practice - observable control costs will be higher than the control costs depicted in textbook models. In fact, when the marginal cost of abatement varies significantly across sources, as it often does in practice, there is no well-defined overall marginal cost of control curve.

PRINCIPLE No. 2:

The optimal emissions level for a particular pollutant in the relevant pollution region should be selected by balancing the incremental benefits (or, alternatively, the damages avoided by lowering emissions) against the (least-cost) incremental cost of reduced emissions. The intersection of a marginal benefit or damage cost function (MB) and the appropriate marginal cost of control function (MC) defines both the optimal level of abatement (q*) from uncontrolled levels, and the social value or "price" of additional pollution (t*). (See Figure 1.) Except in extreme cases, the optimal amount of pollution will generally not be

zero. Proponents of PUC adders have used graphs like Figure 1 to argue that "uncompensated damages" still exist and must be assessed against polluting firms in order to attain the right prices and pollution levels. This is wrong. Even when there are residual uncompensated damages, any intervention that brings on additional abatement will only move

Figure 1 

### Internalizing Externalities Efficiently

Cost, Price

t 

## Mc

MB

q q Reduction in Emissions 6 Issues and Trends Briefing Paper

If these conditions are violated

- as they often are in practice

- observable control costs will be higher than the control costs depicted intextbookmodels. In fact, when the marginal cost of abatement varies significantly across sources, as it often does in practice, there is no well-defined overall marginal cost of control curve.

PRINCIPLE No.2:

The optimal emissions level for a particularpollutantin the relevantpollution region should be selected by balancing the incremental benefits (or, alternatively, the damages avoided by lowering emissions) against the (least-cost) incremental cost of reduced emissions. The intersection of a marginal benefit

or damage cost function (MB) and the appropriate marginal cost of control function (Me) defines both the optimal level ofabatement (q*) fromuncontrolled levels, and the social value or "price" of additional pollution (t*). (See Figure 1.) Except in extreme cases, the optimal
amount ofpollution will generally not be

zero. Proponents of PUC adders have used graphs like Figure 1 to argue that "uncompensated damages" still exist and
mustbe assessed againstpollutingfirms in order to attain the right prices and pollution levels. This is wrong. Even when there are residual uncompensated damages, any intervention that brings on additional abatement will only move

Figure 1 

### Internalizing Externalities Efficiently

Cost, Price 

# Me

,. t


### MB

- q ,. q Reduction in EmissionsDealing With Environmental Externalities 7

society away from the optimum, and impose societal costs greater than the environmental benefits. This is clearly illustrated by the graph in Figure 1.

PRINCIPLE No. 3:

Final goods (steel, aluminum, plastics, electricity, etc.) prices and quantities should reflect the costs of achieving the emissions levels defined by Principle No. 2 using the least-cost abatement strategies indicated by Principle No. 1, plus the societal value of the residual emissions that will result from a marginal increase in output evaluated at the optimal emissions level.

By raising prices, the demand for products that involve the production of pollution will be reduced, and any given level of emissions reduction will be achieved at a lower cost than if prices anddemand were assumed to be fixed at "preinternalization" levels. Several types of policy instruments can be used to internalize environmental externalities. They can be grouped into four categories. EMISSIONS FEES . Polluters are required to pay (usually the government) for all measured emissions of a particular pollutant. This approach directly places a price on the pollutant to internalize the relevant externalities. Polluters will respond to the emissions fee by producing less pollution whenever the incremental cost of abatement is lower than the fee. Final goods prices and quantities will change to reflect the higher incremental cost of producing output as a result of abatement and emissions fee costs. If the fees are set too high (over-internalization) there will be too little pollution. If the fees are set too low (under-internalization) there will be too much pollution. TRADEABLE ALLOWANCES. The government establishes a cap on emissions of a particular pollutant, and allocates emission allowances or permits that in total equal the cap amount. A polluter must possess sufficient allowances to "cover" all of that polluter's emissions. These allowances can be traded among sources so that low-cost abaters have an opportunity to abate more and sell their allowances to high-cost abaters, who then need to abate less. An ideal tradeable allowance system will internalize externalities by capping aggregate emissions at the optimal level and by creating a market that forces polluters to pay a direct or opportunity cost for the right to produce pollution. The sulfur dioxide (SO2) control system established by the Clean Air Act Amendments of1990 relies on tradeable emission allowances in this way. OFFSET REQUIREMENTS. Environmental regulations sometimes require new sources to "offset" their emissions by finding some way to induce an existing source to reduce its emissions Dealing With Environmental Externalities 7

society away from the optimum, and Impose societal costs greater than the environmental benefits. This is clearly illustrated by the graph in Figure 1.

PRINCIPLE NO.3:

Final goods (steel, aluminum, plastics, electricity, etc.)prices and quantities should reflect the costs ofachieving the emissions levels defined by Principle No.2 using the least-cost abatement strategies indicated by Principle No.1, plus the societal value of the residual emissions thatwillresultfrom a marginal increase in outputevaluatedat the optimal emissions level.

By raising prices, the demand for products that involve the production of pollution will be reduced, and any given level of emissions reduction will be achieved at a lower cost thanifprices and demand were assumed to befixed at "preinternalization" levels. Several types ofpolicy instruments can be used to internalize environmental externalities. They can be grouped into four categories. EMISSIONS FEES. Polluters are required to pay (usually the government) for all measured emissions of a particular pollutant. This approach directly places a price on the pollutant to internalize the relevant externalities. Polluters will respond to the emissions fee by producing less pollution whenever the incremental cost of abatement is lower than the fee. Final goods prices and quantities will change to reflect the higher incremental
cost of producing output as a result of abatement and emissions fee costs. Ifthe fees are settoo high (over-internalization) there will be too little pollution. If the fees aresettoolow (under-internalization) there will be too much pollution. TRADEABLE ALLOWANCES. The government establishes a cap onemissions of a particular pollutant, and allocates emission allowances or permits that in total equal the cap amount. A polluter
must possess sufficient allowances to "cover" all of that polluter's emissions. These allowances can be traded among
sources so that low-cost abaters have an opportunity to abate more and sell their allowances to high-cost abaters, who then need to abate less. An ideal tradeable allowance system will internalize externalities by capping aggregate emissions at the optimal level and by creating a market that forces polluters to pay a direct or opportunity cost for the right to produce pollution. The sulfur dioxide (S02) control system established by the Clean Air Act Amendments of 1990 relies on tradeable emission allowances in this way. OFFSET REQUIREMENTS. Environmental regulations sometimes require new sources to "offset" their emissions by finding some way to induce

an existing source to reduce its emissions8 Issues andTrends Briefing Paper

to compensate (or more than compensate) for the emissions of the new source. This approach has properties very similar to the tradeable allowances approach, especially when there is active entry of new sources into the relevant geographic area. Offset requirements force new sources to pay a price to pollute, and existing sources to recognize opportunities to emit less and sell their offsets, and thus internalize the relevant externalities. SOURCE

-SPECIFIC STANDARDS. An emissions limit is applied directly to each source of a pollutant in the relevant pollution region to achieve the designated emissions goal. These emission limits may be based on specific control technologies that exist or are expected to become available (S02 scrubbers, selective catalytic reduction, etc.). Source

-specific standards - or the "command and control" approach - have been used extensively by U.S. environmental regulators. They internalize externalities by establishing
caps on a source's aggregate emissions or emission rates and by setting standards based on "available" technologies. With source-specific standards, the extent to which residual damages are internalized is much harder to determine. 5 When source-specific standards are accompanied by a "bubble," the results are similar to those under tradeable allowance or offset systems. To achieve the goal of efficient internalization using any of these approaches requires considerable information on the actual damages caused by different levels of emissions
, and on the abatement costs for diverse sources over a range of emission levels

. Each of the approaches also requires sufficient monitoring and measurement of emissions. Source-specific standards tend to require significantly more information on the abatement costs for individual sources, while the other three approaches work reasonably well using only aggregate abatement cost information. In a world with free and perfect information on all relevant pollution damages and on the costs of control across all sources, and costless measurement and monitoring of pollution, the application of these four alternatives to achieve the goal of efficient internalization of externalities will produce roughly equivalent results.6

ENVIRONMENTAL REGULATION IN PRACTICE

Of course in the real world we do not have free and complete information about all the relevant costs and benefits. Nor can emissions be monitored and measured costlessly

. Even with substantial expenditures, environmental impacts and control costs will be highly uncertain from the perspective of legislators and regulators.7 Furthermore
, the goal of efficient environmental control often must bend to 8 Issues and Trends Briefing Paper

to compensate (ormorethancompensate) for the emissions ofthe new source. This approachhaspropertiesvery similartothe tradeable allowances approach, especially when there is active entry ofnew sources into the relevant geographic area. Offset requirements force new sources to pay a price to pollute, and existing sources to recognize opportunities to emit less and sell their offsets, and thus internalize the relevant externalities. SOURCE-SPECIFIC STANDARDS. An emissions limit is applied directly to each source ofa pollutant in the relevant pollutionregion to achieve the designated emissions goal. Theseemissionlimits may be based on specific control technologies that exist or are expected to become available (S02 scrubbers, selective catalytic reduction, etc.). Source-specific standards

- orthe "command and control" approach

- have beenused extensivelyby U.S. environmental regulators. They internalize externalities by establishing caps on a source's aggregate emissions or emission rates and by setting standards based on "available" technologies. With source-specific standards, the extent to whichresidual damages areinternalizedis much harder to determine.s When source-specificstandardsareaccompanied by a "bubble," the results are similar to those under tradeable allowance or offset systems. To achieve the goal of efficient internalization usmg any of these approaches requires considerable information onthe actual damages caused by differentlevels ofemissions, andonthe abatement costs for diverse sources over a range of emission levels. Each of the approaches also reqUIres sufficient monitoringandmeasurementofemissions. Source-specific standards tend to require significantly more information on the abatement costs for individual sources, while the other three approaches work reasonably well using only aggregate abatement cost information. In a world with free and perfect information on all relevant pollution damages and onthe costs ofcontrol across all sources, and costless measurement and monitoring ofpollution, the application of these four alternatives to achieve the goal of efficient internalization of externalities will produce roughly equivalent results.6

ENVIRONMENTAL REGULATION IN PRACTICE

Of course in the real world we do not have free and completeinformation about all the relevant costs and benefits. Nor

canemissionsbemonitoredandmeasured costlessly. Even with substantial expenditures, environmental impacts and control costs will be highly uncertain from the perspective of legislators and regulators.7 Furthermore, the goal of efficient environmental control often must bend toDealing With Environmental Externalities

the realities of interest group politics. As a result, it should come as no surprise that actual environmental regulations often depart significantly from the textbook model of efficient regulation in terms ofboth substance and complexity. Nor should it come as a surprise that we rely extensively on expert federal and state regulatory agencies working closely with one another - and with regulatory authority over many industries
, pollutants, and states

- to write and enforce the nation's environmental laws. This paper is not the place for a detailed review of state and federal environmental regulations . However, several observations are particularly relevant for understanding the proper role of state PUCs in the broader environmental policy arena. As we shall see, any effort by state commissions to improve the existing regulatory framework must embody anunderstanding of the principles upon which the regulations are based and how they work in practice. OBSERVATION No. 1 . With the exception of carbon dioxide (C02), the emissions that have been subject to these so-called externality adders are also subject to extensive federal and state environmental regulations. These regulations reflect uncertainties about benefits and costs, emissions measurement and monitoring costs, and a variety of political considerations. The regulations rely heavily on the command and control approach, rather than economic incentive-based regulation. They also are highly complex and work in ways that often bear little relationship to textbook models of environmental costs and optimal control policies. By complying with these regulations, utilities have incurred significant compliance costs, which are reflected in the costs of different generation technologies and ultimately in electricity prices. OBSERVATION No. 2 . The great tragedy of environmental regulations of the past two decades is the fact that costs of abatement far exceed what is necessary to achieve these emissions levels efficiently

. That is, environmental regulations depart significantly from the leastcost assumptions in textbook models of efficient internalization of environmental
costs.Consideration of compliance costeffectiveness has not played a significantrole in the setting of source- and industryspecific emissions standards

. Aggregate emission targets for specific pollutants are rarely determined with reference to balancing the costs and benefits of different levels of emissions reduction. The difference between actual compliance costs and the costs associated with the most economical means of achieving the same emissions levels varies from pollutant to pollutant. However, numerous studies have shown that the actual costs of meeting required emissions levels Dealing With Environmental Externalities 9

the realities ofinterest group politics. As a result, it should come as no surprise that actual environmental regulations often depart significantlyfrom the textbook model ofefficient regulation interms ofboth substance and complexity. Nor should it come as a surprise that we relyextensivelyonexpertfederal andstate regulatory agencies working closely with

one another

- and with regulatory authority over manyindustries, pollutants, and states

- to write and enforce the nation's environmental laws. This paper is not the place for a detailed review of state and federal environmental regulations. However, several observations are particularly relevantfor understandingtheproperrole ofstatePUCs inthebroaderenvironmental policy arena. As we shall see, any effortby statecommissions to improvethe eXlstmg regulatory framework must embody anunderstandingoftheprinciples uponwhich the regulations are based and how they work in practice. OBSERVATION No.1. With the exception of carbon dioxide (C02), the emissions that have been subject to these so-called externality adders are also subject to extensive federal and state environmental regulations. These regulations reflect uncertainties about benefits and costs, emissions
measurement and monitoring costs, and a variety of political considerations. The regulations rely heavily on the command and control approach, rather than economic incentive-based regulation. They also are highly complex and work in ways that often bear little relationship to textbook models of environmental costs and optimal control policies. By complying with these regulations, utilities haveincurredsignificantcompliancecosts, which are reflected in the costs of different generation technologies and ultimately in electricity prices. OBSERVATION NO.2. The great tragedy of environmental regulations of the past two decades is the fact that costs ofabatement far exceed what is necessary to achieve these emISSIOnS levels efficiently. That is, environmental regulations depart significantly from the leastcost assumptions in textbook models of efficient internalization of environmental
costs. Consideration of compliance costeffectiveness has not played a significant role inthe setting ofsource- and industryspecific emissions standards. Aggregate emissiontargets for specificpollutants are rarely determined with reference to balancing the costs and benefits of different levels of emissions reduction. The differencebetweenactualcompliance
costs and the costs associated with the
most economical means of achieving the

same emissions levels varies from pollutant to pollutant. However, numerous studies have shown that the actual
costs ofmeeting required emissions levels10 Issues and Trends Briefing Paper

are much higher

- in some cases several times higher

- than what is necessary to achieve the same level of environmental protection. Actual control costs depart from the least-cost solution because most existing environmental regulations violate every condition discussed earlier for achieving a particular aggregate emissions level efficiently

. These regulations fail to equalize the marginal costs of control across all sources, and often fail to allow sources to use the most economical control techniques available. Thus, electricity consumers already pay for pollution control costs far in excess of what they need to in order to achieve current levels of environmental quality.

"The great tragedy of environmental regulations of the past two decades is the fact that costs of abatement far exceed what is necessary to achieve these emissions levels efficiently."

OBSERVATION No. 3 . National Ambient Air Quality Standards (NAAQS) are based on highly stringent health and welfare criteria. For pollutants in areas that are in attainment the residual health damages from pollution are likely to be close to zero ("promote the public health with an adequate margin of safety"). As a result, in attainment areas the marginal cost of control far exceeds the marginal benefits for pollutants subject to NAAQS. In non-attainment areas, new sources may be required to obtain offsets from existing sources to enter the market. When there is an offset requirement, entry of additional sources is likely to reduce emissions in the relevant area because offsets are often required on a more than one-for-one basis. Policies that prevent the entry of new sources can actually increase rather than decrease pollution in the area. OBSERVATION No. 4. The past failures of traditional control methods to obtain environmental benefits efficiently - along with a growing recognition that incentive regulatory approaches are superior to centralized "command and and a control" regulations - make it likely that economic incentive mechanisms will play an increasing role in future environmental regulation. The recent Clean Air Act Amendments rely on a tradeable allowance system to limit SO2 emissions beginning in 1995 (Phase I units) and 2000 (Phase II units) to address concerns about acid rain. These allowances place a price on SO2 emissions and, as a result, the impacts of these emissions are internalized.Similarly, emissions fee, tradeable allowance, and offset approaches to deal with greenhouse gas emissions are attracting serious attention from policymakers in the 

### 10 Issues and Trends Briefing Paper

are much higher

- in some cases several times higher

- than what is necessary to achieve the same level of environmental protection. Actual control costs depart from the least-cost solution because most existing environmental regulations violate every condition discussed earlierfor achieving a particular aggregate ermSSlOns level efficiently. These regulations fail to equalize the marginal costs of control

across all sources, and often fail to allow

sources to use the most economical control techniques available. Thus, electricity consumers alreadypay for pollution control costs far in excess of what they need to in order to achieve current levels of environmental quality.

liThe great tragedy of environmental regulations of the past two decades is the fact that costs of abatement far exceed what is necessary to achieve these emissions levels efficiently.II

OBSERVATION NO.3. National AmbientAir Quality Standards (NAAQS)

are based on highly stringent health and welfare criteria. For pollutants in areas that are in attainment the residual health damages from pollution are likely to be close to zero ("promote the public health with an adequate margin of safety"). As a result, in attainment areas the marginal cost of control far exceeds the marginalbenefits for pollutants subject to NAAQS. In non-attainment areas, new
sources may be required to obtain offsets from existing sources to enterthe market. Whenthereis anoffsetrequirement, entry of additional sources is likely to reduce emissions in the relevant area because offsets are often required on a more than one-for-one basis. Policies that prevent the entry of new sources can actually increase rather than decrease pollutionin the area. OBSERVATION No.4. The past failures of traditional control methods to obtainenvironmentalbenefitsefficientlyalong with a growing recognition that incentive regulatory approaches are superior to centralized "command and control" regulations

- make it likely that economic incentive mechanisms will play

anincreasingrole infuture environmental regulation. TherecentCleanAirActAmendments rely on a tradeable allowance system to limit S02 emissions beginning in 1995 (Phase I units) and 2000 (Phase II units) to address concerns about acid rain. These allowances place a price on S02 emissions and, as a result, the impacts of these emissions are internalized. Similarly, emissions fee, tradeable allowance, and offset approaches to deal with greenhouse gas emissions are attracting serious attentionfrompolicymakersintheDealing With Environmental Externalities 11

United States and other countries. OBSERVATION No. 5. Since there currently are no environmental regulations for CO2 emissions and no other institutions (e.g., liability and property laws) to force firms to take account of such emissions in their production and pricing decisions, impacts from CO2 emissions are clearly an "unpriced" externality of potential policy concern. At the same time, the absence of such regulations (to date) is a reflection of both the scientific uncertainties surrounding global climate change, and the difficulties of achieving effective international policies on this issue. However, most of the PUCs that are monetizing environmental externalities have chosen to include highly ambiguous adders for CO2 emissions; the adder values they have chosen vary by a factor of about twenty. Global climate change is an international problem. There is nothing a single state alone can do that would significantly affect global warming if it does occur (the U.S. electric power industry accounts for about 30% of CO2 emissions in the United States, 6% of world CO2 emissions, and roughly 3% of anthropogenic emissions of greenhouse gasses worldwide). Given the nature of the problem it is much more important to take the time to put sound national and international strategies in place in conjunction with other countries than it is to take actions as quickly as possible. In addition, there are a number of things the United States can and should do now to respond to the potential adverse consequences of global climate change.

"A sound policy on global climate change should ... strive to find the least expensive mitigation and adaptation strategies."

A

A sound policy on global climate change should focus on all greenhouse gasses (not just CO2) and all sources of greenhouse gasses (not just electricitysupplied by new power plants to investorowned utilities), and should strive to findthe least expensive mitigation and adaptation strategies. The adder approach focuses only on CO2, ignoring other greenhouse gasses. It focuses only on new investor-owned utility boilers rather than all sources of CO2. And it has focused attention on the highest control cost methods rather than promoting least-cost control and mitigation. Of most concern, the use of CO2 adders by state PUCs is taking the pressure off of Congress and the Administration in Washington to develop a good greenhouse gas policy. Rather than making the hard choices, legislators find it convenient to point to the efforts of state commissions as an adequate response to the possibility of Dealing With Environmental Externalities 11

United States and other countries. OBSERVATION No.5. Since there currentlyarenoenvironmentalregulations for C02 eIll1SSlOnS and no other institutions (e.g., liability and property laws) to force firms to take account of such emissions in their production and pricing decisions, impacts from C02 emissions are clearly an "unpriced" externality ofpotentialpolicy concern. At the same time, the absence of such regulations (to date)is areflectionofboth the scientific uncertainties surrounding global climate change, and the difficulties ofachievingeffectiveinternationalpolicies

on this issue. However, most of the PUCs that are monetizing environmental externalities have chosen to include highly ambiguous adders for C02 emissions; the adder values theyhave chosenvaryby a factor of about twenty. Global climate change is an internationalproblem. Thereis nothing a single state alone can do that would significantly affect global warming if it does occur (the U.S. electric power industry accounts for about 30% of C02 emissions in the United States, 6% of world C02 emissions, and roughly 3% of anthropogenic emissions of greenhouse gasses worldwide). Given the nature of the problem it is much more important to take the time to put sound national and international strategies in place in conjunctionwith other countries than it is to take actions as quickly as possible. In addition, there are a number ofthings the United States can and should do now to respond to the potential adverse consequences ofglobal climate change.

"A sound policy on global climate change should

... strive to find the least expensive mitigation and adaptation strategies."

A sound policy on global climate change should focus on all greenhouse gasses (not just C02) and all sources of greenhouse gasses (not just electricity supplied by new power plants to investorowned utilities), and should strive to find the least expensive mitigation and adaptation strategies. The adder approach focuses only on C02, ignoring other greenhouse gasses. Itfocuses only onnew investor-owned utility boilers rather than all sources of C02. And it has focused attention on the highest control cost methods rather than promoting least-cost control and mitigation. Ofmost concern, the use of C02 adders by state PUCs is taking the pressure off of Congress and the Administration in Washington to develop a good greenhouse gas policy. Rather than making the hard choices, legislators find it convenient to point to the efforts of state commissions as an adequate response to the possibility of12 Issues and Trends Briefing Paper

global climate change. It is not.

ERRONEOUS ASSUM PTIONS UNDERLYI NG "EXTERNALITY" ADDERS

It is into this complex conceptual, empirical, and public policy cauldron that a number of state PUCs have jumped with their "global and regional" environmental adders. States such as Massachusetts, Nevada, New York, and California have decided they can "fix" what ails existing environmental regulations by appending various externality "adders" to the private costs of new utility resource options. The total cost of each resource option, including both the private cost to the supplier and the adder, is to be used by utilities as the criteria for making new resource decisions. For example, a new coal-fired generating unit might have an adder of 4 cents per kilowatthour added on top of the private cost of 6 cents per kilowatthour to reflect "uncompensated external costs" associated with S02, oxides of nitrogen (NOx), C02, and other pollutants.' The effect of the addersapproach is to tilt utility resource decisions to favor resources that have higher private costs and, the PUCs hope, lower social costs. Higher electric rates are an inevitable result of this process as well. There are two basic problems with these well-intentioned efforts. First, they have proceeded under several erroneous assumptions regarding the ability of a simple adders approach to provide a shortcut around the complexities of environmental regulation that will actually improve social welfare. Second, the PUCs have failed to fully appreciate the inherent difficulties the state commissions must confront if they attempt to supplement existing and anticipated environmental regulations. Let us begin with a discussion of the erroneous assumptions that appear to underlie the adder approach some PUCs have adopted.

ERRONEOUS ASSUMPTION No. 1:

The fact that there are residual environmental impacts necessarily implies that there are 'uunpriced" externalities that need to be "internalized" with the use of adders.

This assumption lies at the heart of recent PUC efforts to use various adders in the resource planning process. Unfortunately, this assumption is wrong. It confuses environmental and health impacts with environmental externalities that lead to inefficient producer and consumer decisions, increasing pollution beyond appropriate levels. Again, the question of whether an environmental or health impact is also an unpriced externality, and the extent to which they 

### 12 Issues and Trends Briefing Paper

global climate change. Itis not.

ERRONEOUS ASSUMPTIONS UNDERLYING "EXTERNALITY" ADDERS

It is into this complex conceptual, empirical, and public policy cauldronthat

a numberofstatePUCshavejumpedwith their "global and regional" environmental adders. States such as Massachusetts, Nevada, New York, and California have decided they can "fix" what ails existing environmental regulations by appending various externality "adders" to the private
costs ofnew utility resource options. The total cost ofeach resource option, including both the private cost to the supplier and the adder, is to be used by utilities as the criteria for making new
resource decisions. For example, a new coal-fired generating unit might have an adder of 4 cents per kilowatthour added

on top of the private cost of 6 cents per kilowatthour to reflect "uncompensated external costs" associatedwith S02,oxides of nitrogen (NOx), C02, and other pollutants.8 The effect of the adders approach is to tilt utility resource decisions to favor resources that have higher private costs and, the PUCs hope, lower social costs. Higher electric rates are an inevitable result ofthis process as well. There are two basic problems with these well-intentioned efforts. First, they have proceeded under several erroneous assumptions regarding the ability of a simple adders approach to provide a shortcut around the complexities of environmentalregulationthatwill actually improve socialwelfare. Second, thePUCs havefailed tofully appreciatetheinherent difficulties the state commissions must confront if they attempt to supplement existing and anticipated environmental regulations. Let us begin·with a discussion of the

erroneous assumptions that appear to underlie the adder approach some PUCs have adopted.

ERRONEOUS ASSUMPTION No.1:

The fact that there are residual environmental impacts necessarily implies that there are "unpriced" externalities that need to be "internalized" with the use of adders.

This assumption lies at the heart of
recent PUC efforts to use various adders

III the resource planning process. Unfortunately, this assumption is wrong. It confuses environmental and health impacts with environmental externalities that lead to inefficient producer and

consumer decisions, increasing pollution beyond appropriate levels. Again, the question ofwhether an environmental or health impact is also an un priced externality, and the extent to which theyDealing With Environmental Externalities

have been internalized, depends on the character of existing environmental laws as well as on tort (liability) and property laws, the nature of property ownership, and the expanse of horizontal and vertical integration of affected industries. These institutional arrangements may vary widely from state to state and from country to country. It is absolutely wrong to equate measured environmental and health impacts with unpriced externalities without a complementary analysis of the institutional arrangements that govern the extent to which the associated emissions are priced in one way or another. A simple example can make this point clear. Consider two identical countries that use coal to generate electricity. In both countries the production of electricity creates emissions of S02 and C02. However, in the first country there are emissions fees, allowances, or offsets affecting all S02 and C02 emissions, while in the second country there are no emissions constraints whatsoever. Assume further that the first country's environmental regulations are set optimally in the usual textbook fashion and electricity suppliers, as well as other polluting firms, respond optimally with least-cost abatement up to the point where the marginal cost of abatement is equal to the fee (allowance, etc.) per unit of these emissions. The electricity suppliers still produce some S02 and C02 but less than they would otherwise produce absent the 13

"Higher electric rates are an inevitable result of this process."

regulations, and less than the suppliers in the second country. In both countries (ruling out corner solutions) it will still be possible to observe environmental impacts caused by S02 and C02 emissions since they are never (optimally) zero. However, the externalities in country number one have been fully internalized by placing the right prices on emissions. Even though residual environmental impacts are still observed in the first country, the costs associatedwith the impacts are not unpriced externalities that lead to inefficient decisions and excessive pollution. The situation is quite different in the second country, where all environmental impacts are properly characterized as unpriced external costs of continuing policy concern; there is no reason for electricity suppliers to treat these costs as anything other than zero since the emissions are completely unregulated. Any effort by the state PUCs to superimpose what effectively are new environmental regulations on top of a complex set of existing regulations mustaccount for both the residual environmental impacts and the effects of existing regulations on the effective price for emissions that private firms recognize in Dealing With Environmental Externalities 13

have been internalized, depends on the characterofexistingenvironmentallaws as well as on tort (liability) and property laws, the nature of property ownership, and the expanse ofhorizontal and vertical integration ofaffected industries. These institutional arrangements may vary widely from state to state and from country to country. Itis absolutely wrong to equate measured environmental and health impacts with unpriced externalities without a complementary analysis of the institutional arrangementsthat govern the
extent to which the associated emissions

are priced in one way or another. A simple example can make this point clear. Consider two identical countries that use coal to generate electricity. In bothcountriestheproductionofelectricity creates emissions of S02 and C02. However, in the first country there are emissions fees, allowances, or offsets affecting all S02 and C02 emissions, while in the second country there are no emissions constraints whatsoever. Assume further that the first country's environmental regulations are set optimally in the usual textbook fashion and electricity suppliers, as well as other polluting firms, respond optimally with least-costabatementuptothepointwhere the marginal cost ofabatement is equalto the fee (allowance, etc.) per unit ofthese emissions. The electricity suppliers still produce some S02 and C02butless than theywould otherwise produce absent the "Higher electric rates are an inevitable result of this process."

regulations, and less than the suppliers in the second country. In both countries (ruling out corner solutions) it will still be possible to observe environmental impacts caused by S02 and C02 emissions since they are
never (optimally) zero. However, the externalities in country number one have beenfully internalizedbyplacing theright prices onemissions. Eventhough residual environmental impacts are still observed in the first country, the costs associated with the impacts are not un priced externalities that lead to inefficient decisions and excessivepollution. The situation is quite different in the second country, where all environmental impacts are properly characterized as unpriced external costs of continuing policy concern; there is no reason for electricity suppliers to treat these costs as anything other than zero since the emissions are completely unregulated. Any effort by the state PUCs to superimpose what effectively are new environmental regulations on top of a complex set of existing regulations must account for both the residual environmental impacts and the effects ofexisting regulations on the effective price for emissions that private firms recognize in14 Issues and Trends Briefing Paper

their production and pricing decisions. The most obvious example of a failure to understand the difference between environmental impacts and externalities is with regard to the treatment of SO2 by several state commissions. State PUCs that are placing adders on SO2 fail to realize that the tradeable allowance system created by the recent Clean Air Act Amendments will place a price on every ton of SO2 emitted by utilities (and industrial sources that may opt-in to the allowance program) by the year 2000.9 There will be residual impacts from the 8.9 million tons of SO2 that are the legal limit after 1999. But these impacts are internalized by the allowance system, which requires new sources to purchase SO2 allowances and existing sources to recognize the opportunity cost of holding allowances. Placing a $1,500 adder on a new affected source of SO2 emissions (as Massachusetts presently does) is inefficient double-counting. It confuses those impacts and damages that decisionmakers already take into account because they arepriced directly or indirectly, with uncompensated third-party impacts and damages that are not properly incorporated in firm decisions. We can argue about whether the 8.9 million ton per year cap is too high or too low, but understanding what an externality is would lead us to understand that the argument is really about whether the price of allowances is too high or too low. This in turn would require us to look at the net difference between the value of the marginal environmental damages caused by SO2 emissions and the price of the SO2 allowances. One would not simply take the gross residual impacts of SO2 emissions, which are at least partially (or over-) internalized, and assume that they represent an appropriate price for an externality adder. Exactly the same issues arise for pollutants in areas where new sources must offset their emissions and would arise in the case of emission fees. Even with emission standards, residual emissions may be fully or partially internalized indirectly through the effects of (perhaps inefficient) emission constraints andcontrol costs on the choice of technologies, fuels, and product prices.

ERRONEOUS ASSUMPTION No. 2:

If state PUCs can just 'get the environmental damage numbers right, " they can confidently use these numbers to construct "appropriate" adders that will efficiently improve environmental quality.

Based on this assumption, the State of New York and the U.S. Department of Energy have commissioned costly studies of environmental damages, which they apparently hope will form the basis for "better" adders. While these damage 

### 14 Issues and Trends Briefing Paper

their production and pncmg decisions. The most obvious example ofa failure
to understand the difference between environmentalimpacts and externalities is with regard to the treatment of S02 by several state commissions. State PUCs that are placing adders on S02 fail to realize that the tradeable allowance system created by the recent Clean Air Act Amendments will place a price on every ton ofS02 emittedby utilities (and industrial sources that may opt-in to the allowance program) by the year 2000.9 There will be residual impacts from the 8.9 million tons of S02 that are the legal limit after 1999. But these impacts are internalized by the allowance system, which requires new sources to purchase S02 allowances and existing sources to recognize the opportunity cost of holding allowances. Placing a $1,500 adder on a new affected source of S02 emissions (as Massachusettspresentlydoes)isinefficient double-counting. It confuses those impacts and damages that decisionmakers alreadytakeinto accountbecausethey are priced directly or indirectly, with uncompensatedthird-partyimpacts and damages that are notproperly incorporated in firm decisions. We can argue about whether the 8.9 million tonperyear cap is too high ortoo low, butunderstandingwhatanexternality is would lead us to understand that the argumentis really aboutwhethertheprice ofallowances is too high or too low. This inturnwould require us to look at thenet difference between the value of the marginal environmental damages caused by S02 emissions and the price of the S02 allowances. One would not simply take the gross residual impacts of S02 emissions, which are at least partially (or over-) internalized, and assume that they represent an appropriate price for an externality adder. Exactly the same issues arise for pollutants in areas where new sources must offset their emissions and would arise in the case of emission fees. Even withemissionstandards,residualemissions may be fully or partially internalized indirectly through the effects of (perhaps inefficient) eIlllSSlOn constraints and control costs on the choice of technologies, fuels, and product prices.

ERRONEOUS ASSUMPTION No.2:

If state pues can just "get the environmental damage numbers right, "they

can confidently use these numbers to construct "appropriate" adders that will efficiently improve environmental quality.

Based on this assumption, the State of New York and the U.S. Department of Energy have commissioned costly studies of environmental damages, which they apparently hope will form the basis for "better" adders. While these damageDealing With Environmental Externalities

studies may turn out to have some value, the resulting numbers cannot just be converted into "shadow prices" and added to the private costs of new S02 producing sources. There are several reasons why. First, the problem with this assumption directly stems from the confusion between residual environmental impacts and externalities that have been fully or partially internalized in the decisions of private firms, as discussed above. Calculating appropriate adders requires both good damage numbers and a complete understanding of how existing environmental regulations affect the decisions (on the margin) of polluters. It is much more complicated than just getting the damage numbers right. Second, the assumption also fails to account for the fact that adders apply only to new electricity resources owned or purchased by electric utilities in states adopting these policies. This type of piecemeal environmentalism can lead to all kinds of unintended consequences that can easily increase rather than decrease pollution. Electric utilities are not the only sources of most pollutants. This approach to externalities will increase the incentives for self-generation, direct service by independent power producers to retail customers, and municipalization, since these producers of electricity generally are not subject to PUC imposed adders. Adders also change the complex 

## is

relationships that exist between the operation of existing resources and the selection of new resources; such changes could actually increase the utilization of existing more-polluting resources beyond what it would have been absent theadders. This is especially likely in interconnected electric power systems that span several states with extensive trade in energy and capacity. Mixing and matching utilities in states with and without adders and states that use different adderslocould have unintended adverse consequences for the environment and at thesame time increase the price of electricity.11

"This type of piecemeal environmentalism can lead to all kinds of unintended consequences that can easily increase rather than decrease pollution."

Third, the assumption fails to account for the consequences of using adders in the context of existing and likely future environmental policies that affect both utility and non-utility sources. Under the S02 allowance system in the recent Clean Air Act Amendments, for example, every source must hold allowances to cover its emissions and these allowances are fully tradeable in a national market. If a state in New England uses S02 adders to deter :j 

### il**~** ;1 ,Dealing With Environmental Externalities 

### 15

studies may turn out to have some value, the resulting numbers cannot just be converted into "shadow prices" and added
to the private costs ofnew S02producing

sources. There are several reasons why. First, theproblemwith this assumption directly stems from the confusionbetween residual environmental impacts and externalities that have been fully or partially internalized in the decisions of private firms, as discussed above. Calculating appropriate adders requires both good damage numbers and a complete understanding of how existing environmental regulations affect the decisions (on the margin) ofpolluters. It is much more complicated than just getting the damage numbers right. Second, the assumption also fails to account for the fact that adders apply only to new electricity resources owned or purchased by electric utilities in states adopting these policies. This type of piecemeal environmentalism can lead to all kinds ofunintended consequences that

can easily increase rather than decrease pollution. Electric utilities are not the only sources of most pollutants. This approach to externalities will increase the incentives for self-generation, direct servicebyindependentpowerproducersto retail customers, and municipalization, since these producers of electricity generally are not subject to PUC imposed adders. Adders also change the complex relationships that exist between the operation of existing resources and the selection of new resources; such changes could actually increase the utilization of existing more-polluting resources beyond what it would have been absent the adders. This is especially likely in interconnectedelectricpowersystemsthatspan several states with extensive trade in energyandcapacity. Mixing andmatching utilities in states with and without adders and states that use different adderslO could have unintended adverse consequences for the environment and at the

same time increase the price of electricity.11

"This type of piecemeal environmentalism can lead to all kinds of unintended consequences that can easily increase rather than decrease pollution."

Third, the assumption fails to account for the consequences of using adders in the context of existing and likely future environmental policies that affect both utility and non-utility sources. Under the S02 allowance system inthe recent Clean Air Act Amendments, for example, every
source must hold allowances to cover its emissions and these allowances are fully tradeable in a national market. Ifa state in New England uses S02 adders to deter16 issues and Trends Briefing Paper

new sources, there will be absolutely no effect on aggregate national emissions, which are fixed at 8.9 million tons per year beginning in 2000.12 At best, the only effect of applying adders to new S02 sources will be to increase the price of electricity in New England. But it could be even worse. In this context, the effect of S02 adders introduced in one or more New England states will be to reduce the demand for and price of allowances, and make it cheaper for utilities in other parts of the country (e.g., Ohio) to emit S02. The end result could be more emissions in the upper Ohio Valley, thereby increasing acid rain affecting sensitive receptor areas in New York State and New England. Moreover, if emissions trading is extended to other pollutants,13 the adverse consequences of applying adders without considering the effects of state and federal environmental regulations would multiply. Similar, but potentially more severe, problems could emerge for pollutants subject to offset requirements. In such situations, new sources are often required to offset emissions at a rate of more than one-to-one. As a result, adders that would deter the introduction of new sources emitting these pollutants will increase rather than decrease emissions of these pollutants.14 If the state PUCs insist on using adders to evaluate new electric generation resources they must recognize that they are intervening in a highly complex economic, institutional, and regulatory system. ere is no simple shortcut to better environmental regulation that can be exploited simply by "getting the adder numbers right."

ERRONEOUS ASSUMPTION No. 3:

The highest cost of control of various pollutants is a reasonable proxy for the residual environmental damages they cause.

Perhaps the greatest falsehood that has accompanied the recent efforts to monetize so-called externalities has been the use of the "highest cost of control" to measure environmental impacts. Advocates of this approach not only maintain that it is alright to ignore the implications of existing environmental regulations and multistate power networks, they also say it is unnecessary to measure environmental damages directly

. Instead, they assert, the environmental damages can be inferred by measuring the highest cost of controlling emissions

. Several state commissions have accepted this approach as a "second

-best" method for estimating damages from pollution. However, the highest cost of control approach produces numbers that haveabsolutely no relationship to environmental damages. They measure nothing but themselves. Every decent economist 

### 16 Issues and Trends Briefing Paper

new sources, there will be absolutely no effect on aggregate national emissions, which are fixed at 8.9 million tons per year beginning in 2000. 12 At best, the only effect of applying adders to new S02 sources will be to increase the price of electricity in New England. But it could be even worse. In this context, the effect of S02 adders introduced in one or more New England
states will be to reduce the demand for and price of allowances, and make it cheaper for utilities in other parts of the country (e.g., Ohio) to emit S02. The end result could be more emissions in the upperOhioValley,therebyincreasingacid rain affecting sensitive receptor areas in New York State and New England. Moreover, if emissions trading is extended to other pollutants,13 the adverse consequences of applying adders without considering the effects of state and federal environmental regulations would multiply. Similar, but potentially more severe, problems could emerge for pollutants subject to offset requirements. In such situations, new sources are often required
to offset emissions at a rate ofmore than
one-to-one. As a result, addersthatwould deter the introduction of new sources emitting these pollutants will increase rather than decrease emissions of these pollutants.14 Ifthe state PUCs insist onusing adders
to evaluate new electric generation resources they must recognize that they

are intervening in a highly complex economic, institutional, and regulatory system. There is no simple shortcut to better environmental regulation that can be exploited simply by "getting the adder numbers right."

ERRONEOUS ASSUMPTION NO.3:

The highest cost ofcontrol ofvarious pollutants is a reasonable proxy for the residualenvironmentaldamages theycause.
Perhapsthe greatestfalsehood thathas accompanied the recent efforts to monetize so-called externalities has been the use of the "highest cost of control" to

measure environmental impacts. Advocates of this approach not only maintain that it is alright to ignore the implications of existing environmental regulationsandmultistatepowernetworks, they also say it is unnecessary to measure environmental damages directly. Instead, they assert, the environmental damages

can be inferred by measuring the highest
cost ofcontrollingemissions. Several state commissions have accepted this approach

as a "second-best" method for estimating damages from pollution. However, the highest cost of control approach produces numbers that have absolutely no relationship to environmental damages. They measure nothing but themselves. Every decent economistDealing With Environmental Externalities

that has examined this approach has recognized that it is fatally flawed. These numbers are not "second-best" measures of environmental damages; they are completely meaningless! Trade press reports indicate that even the Tellus Institute, the leading proponent of the highest cost of control method, now recognizes that it is inappropriate. While there is little purpose in beating a dead horse, a brief explanation of the reasons why this approach should not be used follows, since it still appears to be alive in some quarters. The highest cost of control approach is based on a complete misunderstanding of textbook environmental economics, misconceptions about how environmental regulations work in practice, and a ridiculously naive view of how government makes decisions ("revealed preference"). The Tellus Institute's approach appears to be based on the assumption that existing environmental regulations are "almost optimal." In particular, that the regulations reflect an appropriate balance between the marginal costs of control and the marginal benefits (or avoided damages) from additional abatement. Thus, it is argued, the relevant marginal damages (and therefore the relevant price) can be inferred by measuring the relevant marginal cost ® which, they say, is the highest cost of control observed for any affected source. The only flaw in current regulations, it is asserted, is that the 17

residual emissions are not priced. Every single assumption in this line of reasoning is incorrect. The cost of control curve depicted in economic textbooks is a least-cost of control curve, and thus requires that the marginal costs of control are equated across all sources. As already discussed, this assumption is frequently violated in practice. Further, the highest cost of control that can be observed is not

even on the marginal cost of control curvedepicted in textbooks. Indeed, no welldefined marginal cost of control relationship can be derived from the observed costs of control when the conditions for cost-minimization are violated. Nor is there any reason to believe that the highest cost of control bears any kind of relationship to the residual damages caused by pollution. Indeed, for most of the pollutants that have been the focus of PUC attention, the highest cost of control is likely to be far greater than the relevant damages. Furthermore, as already discussed, merely observing that there are residual emissions does not necessarily imply that the related damage costs are not internalized into utility decisions by existing laws and regulations.

"There is no simple shortcut to better environmental regulation that can be exploited simply by 'getting the adder numbers right."' Dealing With Environmental Externalities 

### 17

that has examined this approach has recognized that itis fatally flawed. These numbersarenot"second-best"measuresof environmental damages; they are completely meaningless! Trade press reports indicate that even the Tellus Institute, the leading proponent of the highest cost of control method, now recognizes that it is inappropriate. While there is little purpose inbeating

a dead horse, a brief explanation of the

reasons why this approach should not be used follows, since it still appears to be alive in some quarters. The highest cost ofcontrol approach is based on a complete misunderstanding of textbook environmental economics, misconceptions about howenvironmental regulations work in practice, and a ridiculouslynaiveview ofhowgovernment makes decisions ("revealed preference"). TheTellusInstitute's approachappears to be based on the assumption that existing environmental regulations are "almost optimal." In particular, that the regulations reflect an appropriate balance between the marginal costs ofcontrol and the marginal benefits (or avoided damages) from additional abatement. Thus, it is argued, the relevant marginal damages (andthereforetherelevantprice)

can be inferred by measuring the relevant marginal cost

- which, they say, is the highest cost of control observed for any affected source. The only flaw in current regulations, it is asserted, is that the residual emissions are not priced. Every single assumption in this line of reasoningis incorrect. The cost ofcontrol

curve depicted in economic textbooks is a 

### least-cost of control curve, and thus requires that the marginal costs ofcontrol

are equated across all sources. As already discussed, this assumption is frequently violated in practice. Further, the highest
cost ofcontrol that can be observed is not

evenon the marginal cost ofcontrol curve depicted in textbooks. Indeed, no welldefined marginal cost of control relationship can be derived from the observed
costs of control when the conditions for cost-minimization are violated. Nor is there any reason to believe that the highest cost ofcontrol bears any kind of relationship to the residual damages caused by pollution. Indeed, for most of the pollutants that have been the focus of PUC attention, the highest cost ofcontrol is likely tobefar greaterthanthe relevant damages. Furthermore, as already discussed, merely observing that there are residual emissions does not necessarily imply that the related damage costs are not internalized into utility decisions by existing laws and regulations.

"There is no simple shortcut to better environmental regulation that
can be exploited simply by 'getting the adder numbers right.'"18 Issues and Trends Briefing Paper

Finally, the "revealed preferences" theory of government that underlies the highest cost of control method proves too much (or it can prove anything). The way to solve an externality problem optimally is to create a market for emissions through the use of tradeable permits or by simulating the appropriate price for pollution through an emissions fee. In either case, the system should apply to all sources of a given pollutant as an alternative to the command and control system we have largely relied upon until recently in this country. Both of these optimal control strategies always have been environmental options. available to state and federal legislatures. By and large, however, legislators have chosen to rely instead on source-specific emission limits and technological standards. Thus, the "revealed preference" of responsible government agencies is not to rely on emission fees charged to residual emissions, but to rely on other control instruments as an alternative. This reflects a host of technical, economic, and political considerations that can be understood only by examining them in detail. It does not reflect a failure to dot the i's on otherwiseoptimal environmental regulations, reflecting an inexplicable failure of an otherwise benevolent government to include what are effectively additional taxes on top of all the other control mechanisms. The logical implication of the revealed preferences theory is that state PUCs should leave well enough alone, unless they are instructed by the legislature to fill gaps in existing environmental statutes. Not only is this revealed preference approach wrong, but the Tellus Institute has also applied it inconsistently. In the case of C02, there are no state or federal regulations to govern these emissions. As a result, the revealed preference theory should produce an adder value of zero for C02 emissions. But Tellus managed to conveniently set the revealed preference theory aside, when it came time to make up numbers for C02 adders.

ERRONEOUS ASSUMPTION No. 4:

The wrong number is better than zero.

One must be suspicious of an argument that it is better to do something wrong than not at all. The wrong number can only be assumed to be better than zero (i.e., no adders at all) if one can demonstrate that placing any old adder on top of the existing control costs willimprove social welfare. There is absolutely no reason to believe this is true here, especially since adders are being superimposed piecemeal on a system already subject to heavy, costly, and complex environmental regulations; we are not starting from zero. By contrast, it is easy to show that using the wrong numbers can lead to inefficient outcomes,increase electricity rates with no environ

### 18 Issues and Trends Briefing Paper

Finally, the "revealed preferences" theory of government that underlies the highest cost ofcontrol method proves too much (orit canprove anything). The way to solve an externality problem optimally is to create a market for emissions throughtheuse oftradeablepermits orby simulating the appropriate price for pollution through an emissions fee. In either case, the system should apply to all

sources of a given pollutant as an alternative to the command and control system we have largely relied upon until recently in this country. Both of these optimal control strategies always have been environmental options. available to state and federal legislatures. By and large, however, legislators have chosen to rely instead on source-specific emission limits and technological standards. Thus, the "revealed preference" of responsible government agencies is not to rely on emission fees charged to residual emissions, but to rely on other control instrumentsas an alternative. This reflects

a host oftechnical, economic, andpolitical considerationsthatcanbeunderstoodonly by examining them in detail. It does not reflect a failure to dot the 

### i's on otherwise optimalenvironmentalregulations,reflecting aninexplicable failure ofan otherwise benevolent government to include what

are effectively additional taxes on top of all the other control mechanisms. The logical implication ofthe revealed preferences theory is that state PUCs should leave well enough alone, unless they areinstructedby thelegislature to fill gaps in existing environmental statutes. Not only is this revealed preference approach wrong, but the Tellus Institute has also applied it inconsistently. In the

case ofC02, there are no state or federal regulations to govern these emissions. As

a result, the revealed preference theory should produce anaddervalue ofzero for C02 emissions. But Tellus managed to conveniently set the revealed preference theory aside, when it came time to make up numbers for C02 adders.

ERRONEOUS ASSUMPTION NO.4:

The wrong number is better than zero.

Onemustbesuspicious ofanargument that it is better to do something wrong than not at all. The wrong number can only be assumed to be better than zero (Le., no adders at all) if one can demonstrate thatplacing any old adder on top of the existing control costs will improve social welfare. There is absolutely no reason to believe this is true here, especially since adders are being superimposed piecemeal on a system already subject to heavy, costly, and complexenvironmentalregulations;weare not starting from zero. By contrast, it is easy to show that using the wrong numbers canlead to inefficient outcomes, increase electricity rates with no environ-Dealing With Environmental Externalities

mental benefits, and even lead to adverse environmental impacts. This argument might have some force if there were no regulation of emissions at all in this country. That is obviously not the case. If the PUCs cannot do it approximately right, they should not do it at all.

FACTORS LIMITING EFFECTIVE GLOBAL AND REGIONAL ENVIRONMENTAL REGULATION BY PUBLIC UTILITY COMMISSIONS

Even if state PUCs recognize these errors, they will still need to change their basic philosophy toward environmental regulation and their role in the larger public policy arena. At this point in the paper, it should be clear that the state commissions are not well-suited to implement effective regulations to govern emissions with global and regional impacts. Whatever authority they have is limited to electric utilities in their individual states; and this authority is only indirect. They have limited expertise in measuring environmental damages, monitoring emissions, and enforcing emission constraints. Their comparative advantage is in economic regulation and local siting issues rather than global and regional environmental regulation. The following is a brief discussion of 19

the most important institutional problems in this regard. ® Sound environmental regulation should apply symmetrically to all sources of a pollutant - both utility and non-utility. However, state PUCs can use adders to constrain emissions from utility sources only. Indeed, the scope of PUC control is often limited to investor-owned utilities (IOUs). Piecemeal controls will lead to unnecessarily high costs to achieve a given level of environmental quality and may shift production from one economic sector to another, thereby reducing or reversing the desired impact on environmental quality. Applying adders to IOUs alonewill artificially induce shifts to selfgeneration, increase incentives for municipalization, and affect competitive conditions among the states. ® Sound environmental regulations that address global and regional concerns should apply to all sources in the relevant pollution region, which can be local, regional, national, or global. Piecemeal controls that are limited to sources in a single state or to certain firm" behavior (e.g., investment versus operation) could shift emissions around in ways that are difficult to predict, and increase rather than decrease emissions. ® Sound environmental regulation should focus on all pollutants that contribute to a particular environmental problem. For example, there should be consistent treatment of all greenhouse gasses, not Dealing With Environmental Externalities 

### 19

mental benefits, and even lead to adverse environmental impacts. This argument might have some force ifthere were no regulation ofemissions at all in this country. That is obviously not the case. If the PUCs cannot do it approximately right, they should not do it
at all.

FACTORS LIMITING EFFECTIVE GLOBAL AND REGIONAL ENVIRONMENTAL REGULATION BY PUBLIC UTILITY COMMISSIONS

Even if state PUCs recognize these
errors, they will still need to change their basic philosophy toward environmental regulation and their role in the larger public policy arena. At this point in the paper, it should be clear that the state commissions are not well-suited to implement effective regulations to govern emissions with global and regional impacts. Whatever authority they have is limited to electric utilities in their individual states; and this authority is only indirect. They have limited expertise III measunng environmental damages, monitoring emISSIOns, and enforcing emISSIOn constraints. Their comparative advantage is in economic regulation and local siting issues rather than global and regional environmental regulation. The following is a brief discussion of the most important institutional problems in this regard.

Ii> Soundenvironmentalregulationshould apply symmetrically to all sources of a pollutant

- both utility and non-utility. However, state PUCs can use adders to constrain emissions from utility sources only. Indeed, the scope ofPUCcontrol is often limited to investor-owned utilities (IOUs). Piecemeal controls will lead to unnecessarilyhigh costs to achieve a given level of environmental quality and may shiftproductionfrom one economic sector to another, thereby reducing or reversing the desired impact on environmental quality. Applying adders to IOUs alone will artificially induce shifts to selfgeneration, increase incentives for municipalization, and affect competitive conditions among the states.

po Sound environmental regulations that address global and regional concerns should apply to all sources inthe relevant pollution region, which can be local, regional, national, or global. Piecemeal controls that are limited to sources in a single state or to certain firm' behavior (e.g., investment versus operation) could shift emissions around in ways that are difficult to predict, and increase rather than decrease emissions.

po Soundenvironmentalregulationshould focus on allpollutants that contribute to a particular environmental problem. For example, there should be consistent
treatment of all greenhouse gasses, not20 Issues and Trends Briefing Paper

just C02, taking account of differences in measurement and monitoring costs. Yet state PUCs have applied adders only to C02, because it appears to be the primary greenhouse gas that is associated with electricity generation. ® Sound environmental regulation can only be developed with sufficient information about abatement costs and the damages avoided by reductions in emissions. The process of obtaining and analyzing the relevant information is highly complex and requires specialized expertise. Furthermore, advances in the state of scientific knowledge about environmental impacts and in abatement and measurement technologies make continual learning and analysis essential. For example, recent scientific evidence suggests that the approach the United States has taken to control precursors of ozone has been misguided because of a failure to properly understand interactions between volatile organic compounds and oxides of nitrogen produced by diverse

sources. State PUCs can only develop the

"Applying adders to investorowned utilities alone will artificially induce shifts to self-generation,increase incentives for municipalization, and affect competitive conditions among the states." necessary expertise if they are willing to substantially increase the resources they devote to this purpose. `T'hey also have not had much experience with emissions monitoring and enforcement, another costly and complex activity.

FIXING THE MOST EGREGIOUS ERRORS IN COMPUTING ADDERS

While the adder approach is misguided, if state PUCs insist on using externality adders for resource planning purposes to reflect monetized values for environmental costs, they should proceed cautiously based on the following guidelines. ® The monetary values for adders should be based on, but not necessarily be equal to (see below), the best estimates of the incremental damages caused by the relevant emissions. The highest cost of control methodology is meaningless, arbitrary, and capricious. It is not a second-best method for measuring environmental damages - it is absolutely worthless! It reinforces the historical reliance on inefficient environmental policies that increase the costs to consumers with no attendant environmental benefits. All that it shows is that existing environmental regulations have imposed excessive costs on some sources. It should be rejected. ® Good damage numbers are only the first step in computing adders that will 20 Issues and Trends Briefing Paper

just C02, taking account ofdifferences in
measurement and monitoring costs. Yet state PUCs have applied adders only to C02,becauseit appears to betheprimary greenhouse gas that is associated with electricity generation.**~** Sound environmental regulation can only be developed with sufficient information about abatement costs and the damages avoided by reductions in emissions. The process of obtaining and analyzing the relevant information is highly complex and requires specialized expertise. Furthermore, advances in the state of scientific knowledge about environmental impacts and in abatement and measurement technologies make continual learning and analysis essential. For example, recent scientific evidence suggests that the approach the United States has taken to control precursors of

ozone has been misguided because of a failure toproperlyunderstandinteractions between volatile organic compounds and oxides of nitrogen produced by diverse

sources. State PUCs can only develop the

"Applying adders to investorowned utilities alone will artificially induce shifts to self-generation, increase incentives for municipalization, and affect competitive conditions among the states." necessary expertise if they are willing to substantially increase the resources they devote to this purpose. They also have
not had much experience with emissions monitoring and enforcement, another costly and complex activity.

FIXING THE MOST EGREGIOUS ERRORS IN COMPUTING ADDERS

While theadderapproachis misguided, if state PUCs insist on using externality adders for resource planning purposes to reflectmonetizedvaluesforenvironmental costs, they should proceed cautiously based on the following guidelines.**~** The monetaryvalues for adders should be based on, but not necessarily be equal to (see below), the best estimates of the incremental damages caused by the relevant emissions. The highest cost of control methodology is meaningless, arbitrary, and capricious. It is not a second-best method for measuring environmental damages - it is absolutely worthless! It reinforces the historical reliance on inefficient environmental policies that Increase the costs to

consumers with no attendant environmental benefits. All that it shows is that existing environmental regulations have imposed excessive costs on some
sources. It should be rejected.**~** Good damage numbers are only the first step in computing adders that willDealing With Environmental Externalities 21

reflect the extent to which residual emissions are not priced properly. The process must also examine the extent to which existing environmental regulations already internalize the external costs, recognizing that residual damages and unpriced externalities are not the same. This necessary analysis is likely to be highly since even those regulatory complex approaches that are not market-based (e.g., command and control) often at least partially force private firms to account for residual emissions in their production, abatement, and pricing decisions. The effects of using externality adders should be evaluated in the context of existing environmental regulations to protect against unintended adverse effects. Furthermore, it should be possible to reduce the adders later to reflect future changes in environmental laws, especially changes that involve market-based mechanisms to directly incorporate residual emission prices or costs. ® The methods for using adders should carefully account for unintended effects resulting from the fact that the constraints individual PUCs can place on emissions are limited to electricity produced for sale by IOUs, and only electricity sold within the boundaries of a single state. Adders will shift generation and customers to selfgeneration and to municipal utilities not covered by adder regulations, and complicate interutility dispatch and energy trade across states with different adder policies. Because adders apply only to

some sources, serious negative economic and environmental responses may result. This implies that adders should not be used in situations where there is a likelihood of significant adverse unintended consequences.

A BETTER PUBLIC UTILITY COMMISSION APPROACH TO ENVIRONMENTAL EXTERNALITIES

While some of the worst aspects of the "externality" adder approach can be corrected somewhat, it makes much more sense to address externalities "right" rather than just less wrong. Quite simply, there are much better ways for PUCs to harmonize their obligations to protect ratepayers and promote the interests of their state, with their concerns about the global and regional environment. While it may not be politically correct to talk about simply discarding the externality adder approach that states like Massachusetts, New York, Nevada, and California have adopted, this is precisely what should be done. There are betterways to promote cost-effective environmental improvement. At the very least, states that have not yet jumped off the adder cliff should consider a more sensible approach to externality problems. The PUCs' embrace of environmentalexternality adders appears to be a conseDealing With Environmental Externalities 

### 21

reflect the extent to which residual emissions are not priced properly. The process must also examine the extent to which existing environmental regulations already internalize the external costs, recognizing that residual damages and unpriced externalities are not the same. This necessary analysis is likely to be highly complexsince eventhoseregulatory approaches that are not market-based (e.g., command and control) often atleast partially force private firms to account for residual emissions in their production, abatement, and pricing decisions.**~** The effects ofusing externality adders should be evaluated in the context of existing environmental regulations to protectagainstunintendedadverse effects. Furthermore, it should be possible to reduce the adders later to reflect future changes in environmental laws, especially changes that involve market-based mechanisms to directly incorporate residual emission prices or costs.

... The methods for using adders should carefully account for unintended effects resulting from the fact thatthe constraints individual PUCs can place on emissions

are limited to electricityproducedfor sale by IOUs, and only electricity sold within the boundaries of a single state. Adders will shiftgenerationand customers to selfgeneration and to municipal utilities not covered by adder regulations, and complicateinterutilitydispatchand energy trade across states with different adder policies. Because adders apply only to

some sources, serious negative economic and environmental responses may result. This implies that adders should not be used in situations where there is a likelihood of significant adverse unintended consequences.

A BETTER PUBLIC UTILITY COMMISSION APPROACH TO ENVIRONMENTAL EXTERNALITIES

While some ofthe worst aspects ofthe "externality" adder approach can be corrected somewhat, it makes much more
sense to addressexternalities "right"rather thanjust less wrong. Quite simply, there

are much better ways for PUCs to harmonize their obligations to protect ratepayers and promote the interests of their state, with their concerns about the global and regional environment. While it may not be politically correct to talk about simply discarding the externality adder approach that states like Massachusetts, New York, Nevada, and California have adopted, this is precisely what should be done. There are better ways to promote cost-effective environmental improvement. At the very least,
states that have not yet jumped off the addercliffshouldconsideramore sensible approach to externality problems. The PUCs' embrace of environmental externality adders appears to be a conse-22 Issues and Trends Briefing Paper

quence of their rejection of traditional regulatory objectives and values. The traditional objectives of state PUCs are well-known. PUCs are supposed to protect consumers from excessive costs and prices that utilities with monopoly franchises might seek to charge; to adopt price structures, service offerings, and other utility requirements to help consumers use electricity wisely; and through the process of facility certification (often in conjunction with other state agencies), to evaluate the local environmental impacts of new electricity production facilities. Also well-known is that PUCs have been able to achieve these objectives only imperfectly.15

"There are much better ways for public utility commissions to harmonize their obligations to protect ratepayers and promote the interests of their state, with their concerns about the global and regional environment."

A
More recently, several state commissions have set aside these traditional objectives in favor of more expansive (and amorphous) objectives, such as "minimizing the global societal cost of producing and consuming electricity." Once it is understood how complex the development and implementation of good environmental policies are, it is clear that state PUCs have neither the expertise nor the policy instruments to embark on a productive strategy of global societal cost minimization. Different governmental institutions have different expertise and different roles to play in the public policy arena. Each can best promote societal welfare if they focus their efforts on problems for which they have a comparative advantage in ways that compliment rather than conflict with one another. Realistically, the best that PUCs can do is to adopt policies in their own special areas of expertise that are consistent with societal cost minimization. It is naive to think that these so-called externality adders can provide a simple shortcut around these complexities, and that state PUCs can become effective global and regional environmental agencies. The adoption of a global societal cost minimization objective also raises concerns about the integrity of the regulatory process and its ability to protect electricity consumers from exploitation by special interest groups. Moving from a regulatory goal of minimizing the cost of supplying and using electricity to a regulatory goal of minimizing global societal costs is a prescription for political mischief. The regulatory process for legal franchised monopolies provides an attractive target of opportunity for interest groups seeking to benefit at the expense of others. 

### 22 Issues and Trends Briefing Paper

quence of their rejection of traditional regulatory objectives and values. The traditional objectives of state PUCs are well-known. PUCs are supposed to protect consumers from excessive costs and prices that utilities with monopoly franchises might seek to charge; to adopt price structures, service offerings, and other utility requirements to help

consumers use electricity wisely; and through theprocess offacility certification (often in conjunction with other state agencies), to evaluate the local environmental impacts of new electricity production facilities. Also well-known is that PUCs have been able to achieve these objectives only imperfectly.IS

"There are much better ways for public utility commissions to harmonize their obligations to protect ratepayers and promote the interests of their state, with their
concerns about the global and regional environment."

More recently, several state commissions have set aside these traditional objectives infavor ofmore expansive (and amorphous) objectives, such as "minimizing the global societal cost of producing and consuming electricity." Once itis understoodhow complexthe development and implementation ofgood environmental policies are, it is clear that
state PUCs have neither the expertise nor the policy instruments to embark on a productive strategy ofglobal societal cost minimization. Different governmental institutions have different expertise and different roles to play in the public policy

arena. Each can best promote societal welfare if they focus their efforts on problems for which they have a comparative advantage in ways that compliment rather than conflict with one another. Realistically, the best thatPUCs

can do is to adopt policies in their own special areas of expertise that are consistent with societal cost minimization. It is naive to think that these so-called externality adders can provide a simple shortcut around these complexities, and that state PUCs can become effective global and regional environmental agenCIes. The adoption of a global societal cost minimizationobjectivealsoraisesconcerns about the integrity of the regulatory process andits ability to protect electricity

consumers from exploitation by special interestgroups. Moving from a regulatory goal of minimizing the cost of supplying and using electricity to a regulatory goal of minimizing global societal costs is a prescription for political mischief. The regulatory process for legal franchised monopoliesprovides anattractivetargetof opportunity for interest groups seeking to benefit at the expense ofothers.Dealing With Environmental Externalities

By capturing or confusing a regulatory agency, well-organized interest groups can persuade regulators to use the regulatory process to effectively tax customers (i.e., raise their rates) in order to finance certain policies. These policies may involve the redistribution of income among different groups of customers, or increases in the cost of electricity for all consumers. This problem is especially. troubling because it comes at a time when competition is being introduced into the generation business in order to benefit consumers with lower costs and rates. The hundred-year history of municipal, state, and federal regulation of public utilities is, unfortunately, filled with examples of such heavy-handed regulatory behavior. And just because today's regulators have the public interest in mind does not ensure that tomorrow's regulators will not take a regulatory process that has been stripped of clear objective standards and pursue ends that run counter to the public interest. Since the late 1930s, state and federal regulators have worked hard to create and enforce objective cost and ratemaking standards, and regulatory procedures that are resistent to special interest manipulation. Society can reject these objective standards and procedures only at great peril; the adoption of ambiguous goals such as "minimizing the global societal costs of producing electricity" will result in higher electricity costs for consumers, have 23

adverse impacts on local and regional economies, and reduce the effectiveness of environmental policies. Further, there is no reason for PUCs to reject their traditional objectives in order to pursue a cleaner environment and a more productive economy. How can PUCs harmonize their efforts to protect consumers from exploitation, encourage least-cost resource decisions, foster wise electricity use, further the development of efficient competitive generation markets, and provide oversight of the local impacts of electricity facilities, with their concerns about regional and global environmental impacts? The answer is quite simple. PUCs have an essential institutional role to play in counteracting what was referred to earlier in this paper as "the great tragedy of environmental regulations of the past two decades" - environmental policies many times more costly than is necessary to achieve the resulting level of environmental quality. PUCs have it in their power to create a regulatory environment that will achieve cleaner air and water for less money. A better framework for PUC action in this area should consist of the following elements: ® PUCs should create the regulatory conditions to provide direction andincentives for utilities to meet environmental constraints at the lowest possible
cost. For example, the S02 emission trading Dealing With Environmental Externalities 

### 23

By capturing or confusing a regulatory agency, well-organizedinterestgroups can persuade regulators to use the regulatory process to effectively tax customers (i.e., raise their rates) in order to finance certain policies. These policies may involve the redistribution of income among different groups of customers, or increases in the cost of electricity for all

consumers. This problem is especially troubling becauseit comes at a time when competition is being introduced into the generation business in order to benefit

consumers with lower costs and rates. Thehundred-yearhistory ofmunicipal, state, and federal regulation of public utilities is, unfortunately, filled with examples ofsuchheavy-handedregulatory behavior. And just because today's regulators have thepublicinterestinmind doesnotensurethattomorrow'sregulators will not take a regulatory process that has been stripped of clear objective standards and pursue ends that run counter to the public interest. Since the late 1930s, state and federal regulators have worked hard
to create and enforce objective cost and ratemaking standards, and regulatory procedures that are resistent to special interest manipulation. Society can reject these objective standards and procedures only at great peril; the adoption of ambiguous goals such as "minimizing the global societal
costs of producing electricity"will resultin higher electricitycosts for consumers,have adverse impacts on local and regional economies, andreducetheeffectivenessof environmental policies. Further,thereis noreasonfor puesto reject their traditional objectives in order
to pursue a cleaner environment and a
more productive economy. How can pues harmonize their efforts to protect

consumers from exploitation, encourage least-cost resource decisions, foster wise electricity use, further the development of efficient competitive generation markets, andprovide oversight ofthe local impacts ofelectricity facilities, with their concerns about regional and global environmental impacts? The answer is quite simple. pues have an essential institutional role toplayin counteractingwhatwas referred
to earlier in this paper as "the great tragedy of environmental regulations of the past two decades"

- environmental policies many times more costly than is necessary to achieve the resulting level of environmental quality. pues have it in their power to create

a regulatoryenvironmentthatwill achieve cleaner air and water for less money. A better framework for pue action in this

area should consist of the following elements:**~** pues should create the regulatory conditions to provide direction and incentives for utilities to meet environmental constraints at the lowest possible
cost. Forexample, the S02emission trading24 Issues and Trends Briefing Paper

provisions in the recent Clean Air Act Amendments create opportunities to meet significantly tighter S02 constraints at roughly half the cost of a source-specific command and control approach. Few commissions have done anything to prod utilities in their jurisdiction to take advantage of these opportunities to properly account for allowance values in their resource plans and operations. The S02 provisions of the Amendments internalize environmental externalities right; state commissions that are truly concerned about the associated externalities should be making every effort to ensure that the allowance system will work and thereby achieve the potential cost savings. ® PUCs should require utilities to account for the costs of likely futureenvironmental regulations in their planning decisions. Environmental regulations will probably continue to be tightened considerably over the next decade, in particular with regard to greenhouse gasses. In addition, it is likely that market-based mechanisms will increasingly replace the command and control approach; this will create opportunities to reduce the costs of achieving the desired improvements in environmental quality (assuming the S02 allowance program is a success). Because electricity production facilities last thirty years or more, utility resource plans should include reasonable assumptions about the costs of future environmental regulations, as they do for future fuel and other O&M costs. As discussed earlier, this provides a rationale for the use of adders, albeit a different rationale than the one currently in vogue.16 ® PUCs should become more active at the state and federal levels as advocates for efficient mechanisms to reduce emissions. Such efforts can increase the likelihood that a cleaner environment can be achieved while placing the smallest burden on consumers and the economy. This suggests support for emission fees, tradeable allowances, offset programs, etc. as appropriate as alternatives to costly command and control regulations. State PUCs should be an important voice for consumers in discussions about thestructure of new environmental regulations. The absence of their voice in the policy formation process makes adoption of least-cost environmental policies more difficult. ® Utilities should be encouraged to experiment with the most efficient approaches to meeting environmental constraints. It is widely recognized that many regulated emissions could be reduced at a substantially lower cost thanis now obtained through rigid sourcespecific regulations. In many cases, the most economical opportunities to reduce emissions are outside the utility sector. By encouraging utilities to experiment with 

### 24 Issues and Trends Briefing Paper

provisions in the recent Clean Air Act Amendmentscreateopportunitiestomeet significantly tighter S02 constraints at roughly half the cost of a source-specific command and control approach. Few commissions have done anything to prod utilities in their jurisdiction to take advantage of these opportunities to properly account for allowance values in their resource plans and operations. The S02 provisions of the Amendments internalize environmental externalities right; state commissions that are truly concerned about the associated externalities shouldbemaking every effort
to ensure that the allowance system will work and thereby achieve the potential
cost savings.

II> PUCs should require utilities to account for the costs of likely future environmental regulations in their planning decisions. Environmentalregulations will probably continue to be tightened considerably over the next decade, in particular with regard to greenhouse gasses. In addition, it is likely that market-basedmechanismswillincreasingly replace the command and control approach; this will create opportunities to reduce the costs of achieving the desired improvements in environmental quality (assuming the S02 allowance program is

a success). Because electricityproductionfacilities last thirty years or more, utility resource plans should include reasonable assumptions about the costs of future environmental regulations, as they do for future fuel and other O&M costs. As discussed earlier, this provides a rationale for the use of adders, albeit a different rationale than the one currently III vogue. 16

II> PUCs should become more active at the state and federal levels as advocates for efficient mechanisms to reduce emissions. Such efforts can increase the likelihood that a cleaner environment can be achieved while placing the smallest burden on consumers and the economy. This suggests support for emission fees, tradeable allowances, offsetprograms, etc.

as appropriate as 

### alternatives to costly command and control regulations. State PUCs should be an important voice for

consumers in discussions about the
structure of new environmental regulations. The absence of their voice in the policy formation process makes adoption of least-cost environmental policies more difficult.

... Utilities should be encouraged to experiment with the most efficient approaches to meeting environmental constraints. It is widely recognized that many regulated eIIl1SSlOnS could be reduced at a substantially lower cost than is now obtained through rigid sourcespecific regulations. In many cases, the
most economical opportunities to reduce emissions are outsidetheutility sector. By encouraging utilities to experiment withDealing With Environmental Externalities

and demonstrate intea- and interindustry offset transactions, it may be possible to establish a sound basis for improved environmental regulation in the future. This approach could be especially valuable for the development of more economical methods to reduce greenhouse gas emissions and the precursors of ozone. ® PUCs should stop using inappropriateexternality adders, establish clear environmental goals, and allow utilities to meet these goals in the most economical manner possible. If state PUCs believe that utilities should achieve environmental goals that are more stringent than required by current state and federal laws, it would make more sense for them towork with the utilities to establish longterm environmental goals and give them the freedom to meet these goals flexibly and at least-cost - this would include the exploitation of all on-system opportunities, plus all opportunities for offsets inside and outside the utility sector. In practice, alternative goals could be clearly articulated, with estimates of their associated cost and rate impacts. The utility and regulators would agree upon the goals that would provide a reasonablebalance between environmental improvement and ratepayer costs. The utility would then have a sufficient measure of freedom to choose the least-cost way to meet these goals. ® PUCs should focus more attention on local site-specific impacts that are not 25

"Utilities should be encouraged to experiment with the most efficient approaches to meeting environmental constraints."

dealt with easily in broad environmental laws and regulations. The U.S. federalist system includes decentralized authoritybetween the federal and state governments. The public interest rationale is that local agencies are likely to be in the best position to deal with local problemsthey are close to, while the federal government is likely to be in the best position todeal with regional, national, and international problems that require multistate or multicountry coordination. While the concerns of state PUCs about global and national environmental problems is laudable, these concerns should not overshadow their attention to the local impacts of siting new power plants and transmission facilities that PUCs have a direct responsibility to address. While these impacts are not as flashy as global warming or acid rain, they are of real concern to real people. These people expect PUCs and other responsible state agencies to pay special attention to their local concerns. Dealing With Environmental Externalities 25

and demonstrate intra- and interindustry offset transactions, it may be possible to establish a sound basis for improved environmental regulation in the future. This approach could be especially valuable for the development of more economicalmethodstoreduce greenhouse gas emissions and theprecursors ofozone.**~** PUCs should stop using inappropriate externality adders, establish clear environmental goals, and allow utilities to meet these goals in the most economical

manner possible. If state PUCs believe thatutilities should achieve environmental goals that are more stringent than requiredby current state andfederal laws, it would make more sense for them to work with the utilities to establish longterm environmental goals and give them the freedom to meet these goals flexibly and at least-cost

- this would include the exploitationofall on-systemopportunities, plus all opportunitiesfor offsets inside and outside the utility sector. In practice, alternative goals could be clearly articulated, with estimates oftheir associated cost and rate impacts. The utility and regulators would agree upon the goals thatwould provide a reasonable balance between environmental improvement and ratepayer costs. The utility would then have a sufficient measure of freedom to choose the least-cost way to meet these goals.**~** PUCs should focus more attention on local site-specific impacts that are not "Utilities should be encouraged to experiment with the most efficient approaches to meeting environmental constraints."

dealt with easily in broad environmental laws and regulations. The U.S. federalist system includes decentralized authority between the federal and state governments. The public interest rationale is that local agencies are likely to be in the best position to deal with local problems they are close to, while thefederal government is likely to be in the best position to deal with regional, national, and international problems that require multistate

or multicountry coordination. While the concerns of state PUCs about global and national environmental problems is laudable, these concerns should not overshadow their attention to the local impacts of siting new power plants and transmission facilities that PUCs have a direct responsibility to address. While these impacts are not as flashy as global warming or acid rain, they

are ofreal concern to real people. These peopleexpectPUCs andotherresponsible state agencies to pay special attention to their local concerns.26 Issues and Trends Briefing Paper

IN CONCLUSION

State PUCs can help in the development and implementation ofpolicies aimed at internalizing environmental externalities efficiently. To do so they must keep their eyes on the right target and recognize where their authority and special expertise can be used with the greatest effectiveness. It is time to stop the use of arbitrary externality adders withuncertain cost and environmental consequences, and adopt policies that willachieve identifiable environmental improvements at the lowest cost to society. 

### 26 Issues and Trends Briefing Paper

IN CONCLUSION

State PUCs can help in the development and implementation of policies aimed at internalizing environmental externalities efficiently. To do so they must keep their eyes on the right target andrecognizewhere their authority and special expertise canbeused with the greatest effectiveness. It is time to stop theuse ofarbitraryexternality adderswith uncertain cost and environmental consequences, and adopt policies that will achieve identifiable environmental improvements at the lowest cost to society.Dealing With Environmental Externalities 27

ENDNOTES

1. Several state commissions have confused the problem of "deterrence" of excessive emissions, which is the primary focus of externality theory, and issues of "compensation" for victims, which is not.

2. New York State's study of environmental damages appears to have proceeded under this erroneous view. A damage study should be viewed as only one input into the quantification of the appropriate price to assess against residual damages.

3. The economics literature distinguishes between pecuniary externalities (third part effects) which are priced properly and, therefore, have no adverse efficiency consequences and non-pecuniary externalities which are not priced properly and, therefore, have adverse efficiency consequences. We normally think of unregulated pollution as a non-pecuniary externality. But once we create institutional arrangements to constrain emission decisions efficiently we transform pollution into a pecuniary externality. Of course both pecuniary and non-pecuniary externalities potentially have distributional consequences.

4. The proper derivation of this curve is a bit more complicated than first meets the eye and is not clearlypresented in many textbook discussions. Conceptually, this curve is derived by simulating the costminimizing response of all polluting firms in a relevant pollution area to progressively higher emissions fees. As the fee increases firms spend more on abatement and the price of their products rises reducing the demand for their products. Both the "supply side" effects of least-cost responses to emissions fees and the "demand side" effects of higher product prices should be reflected in the location of the MC

curve.
5. If we constrain policymakers to use only source-specific standards to control emissions then we must draw a different "second-best" MC curve in Figure 1. If the source-specific standards still equate the marginal cost of control across sources then the "second-best" MC curve lies above the "first-best" MC curve drawn in Figure 1. This is because the effects on final goods prices and demand are attenuated at any given level of abatement cost due to the absence of an appropriate price on residual emissions. The "second-best" optimal emissions reduction will be lower because of the higher costs resulting from the lack of availability of the most efficient control instruments. However, the effects of placing an adder on top of this "second-best" solution can only be determined by examining the precise nature of the standards, how firms are allowed to adapt once it has been imposed, the size of the adder, and how it is applied. These issues are discussed further below.

6. The source-specific standard is inherently less efficient than the other approaches, even when there is free and complete information, because it can price residual emissions only indirectly, and effectively must rely upon a less complete set of control instruments. Any given level of emissions will therefore generally be achieved at a higher cost than if one of the other control instruments were used. See the discussion in the previous footnote.

7. The National Acid Precipitation Assessment Program (NAPAP) has spent over $500

-million studying

the relationship between the emissions from burning fossil fuels, acid deposition
, and the impacts of acid deposition on aquatic life, trees and plants, property, visibility
, and health

. The final "answers" are not yet in.
8. Of course, this private cost already reflects the costs of meeting existing and/or expected environmental regulations. Dealing With Environmental Externalities 27

ENDNOTES

1. Several state commissions have confused the problem of "deterrence" ofexcessive emissions, which is the primary focus ofexternality theory, and issues of "compensation" for victims, which is not.

2. NewYorkState'sstudyofenvironmentaldamages appearstohaveproceededunderthis erroneousview. A damage study shouldbe viewed as only one input into the quantification ofthe appropriate price to
assess against residual damages.

3. The economics literature distinguishes between pecuniary externalities (third part effects) which are pricedproperlyand, therefore, have noadverse efficiencyconsequences andnon-pecuniaryexternalities which arenotpricedproperlyand, therefore, have adverse efficiencyconsequences. We normallythink ofunregulated pollution as a non-pecuniary externality. But oncewe createinstitutional arrangements to constrainemissiondecisions efficientlywe transformpollutioninto a pecuniaryexternality. Ofcourse both pecuniary and non-pecuniary externalities potentially have distributional consequences.

4. Theproper derivation ofthis curve is a bit more complicated thanfirst meets the eye andis not clearly presented in many textbook discussions. Conceptually, this curve is derived by simulating the costminimizing response ofall polluting firms ina relevant pollution area to progressivelyhigher emissions fees. As thefee increases firms spendmore onabatement and thepriceoftheirproductsrisesreducing the demand for their products. Both the "supply side" effects ofleast-cost responses to emissions fees and the "demand side" effects ofhigher product prices should be reflected in the location of the MC

curve.

5. Ifwe constrain policymakers to use only source-specific standards to control emissions then we must draw a different "second-best" MC curve in Figure 1. Ifthe source-specific standards still equate the marginal cost ofcontrol across sources then the "second-best" MC curve lies above the "first-best" MC

curve drawn in Figure 1. This is because the effects onfmal goods prices and demand are attenuated at any given level of abatement cost due to the absence of an appropriate price onresidual emissions. The "second-best" optimal emissions reduction will belower because ofthe higher costs resulting from the lack of availability of the most efficient control instruments. However, the effects of placing an adder on top ofthis "second-best" solution can only be determinedby examining the precise nature of the standards, how firms are allowed to adapt once it hasbeenimposed, the size ofthe adder, and how it is applied. These issues are discussed further below.

6. The source-specific standard is inherently less efficient than the other approaches, even when there is free and complete information, because it can price residual emissions only indirectly, and effectively must rely upon a less complete set ofcontrol instruments. Any given level ofemissions will therefore generallybe achieved at a higher cost than if one ofthe other control instruments were used. See the discussion in the previous footnote.

7. The National Acid Precipitation Assessment Program (NAP AP) has spent over $500-million studying therelationshipbetweentheemissionsfrom burningfossil fuels, acid deposition, andtheimpacts ofacid deposition on aquaticlife, trees and plants, property, visibility, and health. The final "answers" are not yet in.

8. Ofcourse, this private cost alreadyreflects the costs ofmeetingexisting and/or expected environmental regulations.28 Issues and Trends Briefing Paper

9. New generation sources being planned today will spend most of their operating lives under the SO2

allowance system.

10. If we examine the numbers used by different states for standard emissions we observe a very wide variation: for CO2 the high and low values vary by a factor of twenty (there is also confusion between carbon and CO2 which have very different atomic weights); for SO2 the high and low values vary by a factor of more than ten; and for NOx the high and low values vary by a factor of roughly five. These huge variations alone suggest that the numbers being chosen are completely arbitrary.

11. This does not imply that the adder system should be expanded to the operation of existing generating plants. Extending a highly imperfect system to fix one set of problems will just create other problems. We should internalize externalities right in the first place, and doing so should be a primary objective of PUCs.

12. The only way to reduce aggregate SO2 emissions in the long run is to withdraw allowances from the system.
13. The Clean Air Act Amendments provide for an Environmental Protection Agency study of trading between SO2 and NOx.
14. This might suggest that negative adders should be applied to emissions that are subject to more than one-for-one offset requirements. I do not recommend going down this path.

15. Just because PUCs have been able to achieve appropriate objectives only imperfectly does not logically lead to the conclusion that we might as well give them the wrong objectives to pursue.
16. Of course in the context of a competitive bidding system for new generation, competing suppliers willhave to take these expected costs into account when they make their bids unless there are "regulatoryout" provisions in power sales contracts that would be triggered by new environmental regulation. In this case, there would be no reason to impose additional adders since bidders should be expected to have incorporated expectations about future environmental costs into their bid prices. 28 Issues and Trends Briefing Paper

9. New generation sources being planned today will spend most of their operating lives under the S02 allowance system.

10. If we examine the numbers used by different states for standard emissions we observe a very wide variation: for C02 the high and lowvalues varyby a factor oftwenty (there is also confusion between carbon and C02which have very different atomic weights); for S02 the high and low values vary by a factor ofmore than ten; and for NOx the high and low values vary by a factor ofroughly five. These huge variations alone suggest that the numbers being chosen are completely arbitrary.

11. This does not imply that the adder system should be expanded to the operation ofexisting generating plants. Extending a highly imperfect system to fix one set ofproblems willjust create other problems. We should internalize externalities right in the first place, and doing so should be a primary objective ofPUCs.

12. The only way to reduce aggregate S02 emissions in the long run is to withdraw allowances from the system.

13. The Clean Air Act Amendments provide for an Environmental Protection Agency study of trading between S02 and NOx.

14. This might suggest that negative adders should be applied to emissions that are subject to more than one-for-vne offset requirements. I do not recommend going down this path.

15. Justbecause PUCshave been able to achieve appropriate objectives onlyimperfectly does not logically lead to the conclusion that we might as well give them the wrong objectives to pursue.

16. Ofcourse in the context of a competitive bidding system for new generation, competing suppliers will have to take these expected costs into account when they make their bids unless there are "regulatoryout" provisions in power sales contracts that would be triggered by new environmental regulation. In this case, there would be no reason to impose additional adders since bidders should be expected to have incorporated expectations about future environmental costs into their bid prices.ISSUES AND TRENDS BRIEFING PAPERS

Issues and Trends Briefing Papers are concise and timely overviews of issues of strategic interest to electric utility executives and planners. They are published by EEI's Strategic Planning Department six times a year. If you would like to order past issues, please call or write us at the following address. Prior titles currently available are listed below. Single copies are $10.00 for EEI members and $12.50 for nonmembers; there is a discount for bulk orders. Requests may be made to:

Edison Electric Institute Attention: Order and Billing 701 Pennsylvania Avenue, N.W. Washington, D.C. 20004-2696 (202) 508-5425 (202) 508-5424

No. 54 Issues and Trends Briefing Papers in Print are:

Carbon Dioxide Reduction Through Electrification of the Industrial and Transportation Sectors: An Energy Research Group analysis of how existing electrotechnologies can be used in industry and transportation to reduce carbon dioxide emissions. The applications covered have the potential to reduce industrial CO2 emissions by over 17% and transportation CO2 emissions by over 8%. (August 1989, Item #01-89-02)
55 Principles and Guidelines of Effective Risk Communication: Risk communication is an important concept for electric utilities - the ability to listen to the public's concerns and respond effectively. The report describes the process of risk assessment, the public's perception of risks, the use of risk comparisons, and general risk communication skills. (October 1989, Item #01-89-04)

56 Staffing and Structure Changes in Electric Utilities: Today's utility environment is being greatly affected by deregulation and competition. As a result, many utilities are examining their staffing levels and other opportunities to streamline the organization. The report examines these trends and provides industry data for benchmarking staffing levels. (November 1989, Item #01-89-05)

57 Distribution Automation: The Window is Opening: Interest in distribution automation is growing

rapidly among electric utilities. Potential benefits include reduced costs and improved reliability and customer service. The report describes how distribution automation will change utility operations, and how utilities can estimate the costs and benefits. (December 1989, Item #01-89-06)

59 Update: Health Effects of Electric and Magnetic Fields - The Debate Intensifies: Provides an indepth review of recent developments in the debate over electric and magnetic fields. Coverage is provided of the growing interest among the media, Congress, the courts, federal agencies, and public interest groups. Recent scientific and engineering research is also examined, along with efforts by individual utilities to address the issue. (July 1991, Item #01-91-15)
60 The Use of Mobile Robots in the Electric Utility Industry: Mobile robot technologies have significant potential to address a range of utility issues, including operation and maintenance costs, worker safety regulations, and system reliability. The report describes current applications and the benefits of many different robotic technologies, and discusses how robots equipped with artificial intelligence may be integrated into future power plants. (October 1991, Item #01-91-14)
(Continued) ISSUESAND TRENDS BRIEFING PAPERS

Issues and Trends BriefingPapers are concise and timely overviews of issues ofstrategic interesttoelectric utility executives and planners. Theyare published by EEl's Strategic Planning Department sixtimes a year. If you would like to order past issues, please call orwrite us at the following address. Priortitles currently available are listed below. Single copies are $10.00 for EEl members and $12.50 for nonmembers; there is a discount for bulk orders. Requests may be made to:

No. Edison Electric Institute Attention: Order and Billing 701 Pennsylvania Avenue, N.W. Washington, D.C. 20004-2696 (202) 508-5425 (202) 508-5424

Issues and Trends Briefing Papers in Print are:

54 Carbon Dioxide Reduction Through Electrification ofthe Industrialand Transportation Sectors: An Energy Research Group analysis of how existing electrotechnologies can be used in industry and transportation to reduce carbon dioxide emissions. The applications covered have the potential to reduce industrial C02 emissions by over 17% and transportation C02 emissions by over 8%. (August 1989, Item #01-89-02)

55 Principles and Guidelines ofEffective Risk Communication: Risk communication is an important concept for electric utilities

- the ability to listen to the public's concerns and respond effectively. The report describesthe process of risk assessment, the public's perception of risks, the use of risk comparisons, and general risk communication skills. (October 1989, Item #01-89-04)

56 Staffing and Structure Changes in Electric Utilities: Today's utility environment is being greatly affected by deregulation and competition. As a result, many utilities are examining their staffing levels and other opportunitiestostreamlinethe organization. The report examinesthesetrends and provides industry data for benchmarking staffing levels. (November 1989, Item #01-89-05)

57 Distribution Automation: The Window is Opening: Interest in distribution automation is growing rapidly among electric utilities. Potential benefits include reduced costs and improved reliability and customer serVice. The report describes how distribution automation will change utility operations, and how utilities can estimate the costs and benefits. (December 1989, Item #01-89-06)

59 Update: Health Effects ofElectric andMagnetic Fields

- The Debate Intensifies: Provides an indepth review of recent developments in the debate over electric and magnetic fields. Coverage is provided of the growing interest among the media, Congress, the courts, federal agencies, and public interest groups. Recent scientific and engineering research is also examined, along with efforts by individual utilities to address the issue. (July 1991, Item #01-91-15)

60 The Use ofMobile Robots in the Electric UtilityIndustry: Mobile robottechnologies have significant potential to address a range of utility issues, including operation and maintenance costs, worker safety regulations, and system reliability. The report describes current applications and the benefits of manydifferent robotictechnologies, and discusses howrobots equipped with artificial intelligence may be integrated into future power plants. (October 1991, Item #01-91-14)
(Continued)(Continued)

61 Dealing With Environmental Externalities: Let's Do It Right!: A growing number of public utility commissions are using externality "adders" in the utility planning process to reflect "external" environmental costs

. These efforts are misguided
, however, and will lead to higher electricity prices and less environmental protection. MIT Professor Paul L

. Joskow clearly explains what externalities really are
, and why the current adder approach is unwise

. He then offers a more sensible approach to achieving cost-effective environmental improvement. (February 1992, Item #01-92-01)

# # #

For further information on Issues and Trends Briefing Papers, contact Howard Schwartz
, Staff Strategic Analyst, Edison Electric Institute, (202) 508-5521. Your comments and suggestions are greatly appreciated. (Continued)

61 Dealing With Environmental Externalities: Let's Do It Right!: A growing number of public utility commissions are using externality "adders" in the utility planning process to reflect "external" environmental costs. These efforts are misguided, however, andwill lead to higher electricity prices and less environmental protection. MIT Professor Paul L. Joskowclearly explainswhat externalities really are, and whythe current adderapproach is unwise. Hethen offers a more sensible approach to achieving cost-effective environmental improvement. (February 1992, Item #01-92-01)

# # #

For further information on Issues and Trends Briefing Papers, contact Howard Schwartz, Staff Strategic Analyst, Edison Electric Institute, (202) 508-5521. Your comments and suggestions are greatly appreciated.701 Pennsylvania Avenue, N.W. Washington D:C. 20004-2696

01-92-01 

# =-rJ

.....

# = EDISON ELECTRIC 

### _III!!....- INSTITUTE

701 Pennsylvania Avenue. NW. Washington D.C. 20004-2696

01-92-01 2-92