A PUBLICHIOI N OF

THE STRATEGIC PLANNING DEPARTMENT

IIJDl5®P1 T ETUDET, III3UIUUJUE

EE-RM-93-801 COMMENT OR11

ENDS 

PAPER: 

BY PAUL L. JOSKOW 

A PUBLICATION OF 

THE STRATEGIC PLANNING DEPARTMENT 

NUMBER 

EDISON ELECTRIC INSTITUTE 

• • 

, 

• 

APPENDIX A 
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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

EE-RM-93-801 COMMENT OR11

L 

GWITH 

RO TAL 

T R ALITIE 

DO IT RIGHT! 

By Paul L. Joskow 

Mitsui Professor of Economics 

and Professor of Economics and Management, 

Massachusetts Institute of Technology 

Copyright © 1992, Edison Electric Institute 
DEALING WITH

EXTERNALITIES,-

By Paul L. Joskow

Mitsui Professor of Economics

and Professor of Economics and Management,

Massachusetts Institute of Technology

Should we as a society adopt regulatory

policies 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' basic

obligation 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.

EE-RM-93-801 COMMENT OR11

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 of Technology 

Should we as a society adopt regulatory 

policies 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' basic 

obligation 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 Hmvard Northeast Electric Utility 

Executive Conference, Killington, Vennont, 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. 
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

t eh field of environmental economics, 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

(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.

EE-RM-93-801 COMMENT OR11

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 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 

the field of environmental economics, 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 

(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. 
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,

EE-RM-93-801 COMMENT OR11

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 

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 produ€tion 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. I 

This last point will 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 the

most 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

EE-RM-93-801 COMMENT OR11

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 

III 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 the 

most 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 
Dealing 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 EXTER NAL

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 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

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

EE-RM-93-801 COMMENT OR11

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 

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 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 

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 Me in Figure 1.4 
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 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

EE-RM-93-801 COMMENT OR11

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 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 (Me) 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 

Me 

,. 

t 

MB 

-

q ,. q 

Reduction in 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 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 and

demand 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 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 emissions

EE-RM-93-801 COMMENT OR11

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 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 and 

demand 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 (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 emissions 
8 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

EE-RM-93-801 COMMENT OR11

8 Issues and Trends 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.s 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 usmg 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 
Dealing 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 of both 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 an understanding of the principles

upon which the regulations are based and

how they work in practice.

OBSERVATIO N 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 significant

role 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

EE-RM-93-801 COMMENT OR11

Dealing With Environmental Externalities 9 

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 of both 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 

eXlstmg regulatory framework must 

embody an understanding 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 significant 

role 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 
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 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

EE-RM-93-801 COMMENT OR11

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 earlier for 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 already pay 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 

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 efficientlyalong 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 

an increasing role in future environmental 

regulation. 

The recent Clean Air Act Amendments 

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 attention from policymakers in the 
Dealing 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 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 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

EE-RM-93-801 COMMENT OR11

Dealing With Environmental Externalities 11 

United States and other countries. 

OBSERVATION No.5. Since there 

currently are no environmental regulations 

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 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 C02 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 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 

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 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. It focuses only on new 

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. Of most 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 of 
12 Issues and Trends Briefing Paper

global climate change. It is not.

ERRONEOUS ASSUM PTIONS

U ND ERLYING "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 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 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

EE-RM-93-801 COMMENT OR11

12 Issues and Trends Briefing Paper 

global climate change. It is not. 

ERRONEOUS ASSUMPTIONS 

UNDERLYING "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.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 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 "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 of whether an environmental or 

health impact is also an un priced 

externality, and the extent to which they 
Dealing 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 associated

with 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 must

account for both the residual environmental impacts and the effects of existing

regulations on the effective price for

emissions that private firms recognize in

EE-RM-93-801 COMMENT OR11

Dealing With Environmental Externalities 13 

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 

"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 associated 

with the impacts are not un priced 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 must 

account for both the residual environmental impacts and the effects of existing 

regulations on the effective price for 

emissions that private firms recognize in 
14 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 are

priced 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 and

control 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

EE-RM-93-801 COMMENT OR11

14 Issues and Trends Briefing Paper 

their production and pncmg decisions. 

The most obvious example of a failure 

to understand the difference between 

environmental impacts 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 of S02 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 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 

Massachusetts presently does) is inefficient 

double-counting. It confuses those 

impacts and damages that decisionmakers 

already take into account because they are 

priced 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 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 

with emission standards, residual emissions 

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 damage 
Dealing 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 the

adders. 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 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 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

EE-RM-93-801 COMMENT OR11

: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 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 

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 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 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 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 
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

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 have

absolutely no relationship to environmental damages. They measure nothing

but themselves. Every decent economist

EE-RM-93-801 COMMENT OR11

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 

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. 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 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 have 

absolutely no relationship to environmental damages. They measure nothing 

but themselves. Every decent economist 
Dealing 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 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 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."'

EE-RM-93-801 COMMENT OR11

Dealing With Environmental Externalities 17 

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 

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 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. 

N or 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.'" 
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 otherwise

optimal 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 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

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 environEE-RM-93-801 COMMENT OR11

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 otherwise 

optimal 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 

(Le., no adders at all) if one can 

demonstrate that placing 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 

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-
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

ENVIRONME NTAL 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 alone

will 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

EE-RM-93-801 COMMENT OR11

Dealing With Environmental Externalities 19 

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 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> 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 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 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. 

po 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 
20 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

EE-RM-93-801 COMMENT OR11

20 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. 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 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 
Dealing 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 complex since even those regulatory

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 better

ways 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 environmental

externality adders appears to be a conseEE-RM-93-801 COMMENT OR11

Dealing 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 complex since even those regulatory 

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 better 

ways 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 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.

EE-RM-93-801 COMMENT OR11

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.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 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. 
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 and

incentives for utilities to meet environmental constraints at the lowest possible

cost.

For example, the S02 emission trading

EE-RM-93-801 COMMENT OR11

Dealing With Environmental Externalities 23 

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 

rate making 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 

adverse impacts on local and regional 

economies, and reduce the effectiveness of 

environmental policies. 

Further, there is no reason for pues to 

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, 

and provide oversight of the local impacts 

of electricity facilities, with their concerns 

about regional and global environmental 

impacts? The answer is quite simple. 

pues 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. 

pues have it in their power to create 

a regulatory environment that will 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. 

For example, the S02 emission trading 
24 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 future

environmental 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 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 emissions 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 outside the utility sector. By

encouraging utilities to experiment with

EE-RM-93-801 COMMENT OR11

24 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. 

II> PUCs should require utilities to 

account for the costs of likely future 

environmental 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 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, 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 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 outside the utility sector. By 

encouraging utilities to experiment with 
Dealing 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 inappropriate

externality 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 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

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 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

25

"Utilities should be encoura ged

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 the federal 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 of real concern to real people. These

people expect PUCs and other responsible

state agencies to pay special attention to

their local concerns.

EE-RM-93-801 COMMENT OR11

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 

economical methods to reduce greenhouse 

gas emissions and the precursors of ozone. 

~ 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 

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 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 

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 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 the federal 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 of real concern to real people. These 

people expect PUCs and other responsible 

state agencies to pay special attention to 

their local concerns. 
26 Issues and Trends Briefing Paper

I N 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 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 with

uncertain cost and environmental consequences, and adopt policies that will

achieve identifiable environmental improvements at the lowest cost to society.

EE-RM-93-801 COMMENT OR11

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 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 with 

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 clearly

presented 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.

EE-RM-93-801 COMMENT OR11

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 clearly 

presented 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 fmal 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 (NAP AP) 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. 
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 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.

EE-RM-93-801 COMMENT OR11

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 low values vary by a factor of twenty (there is also confusion between 

carbon and C02 which have very different atomic weights); for S02 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 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. 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 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)

EE-RM-93-801 COMMENT OR11

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 EEl'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 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 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 C02 emissions by over 17% and transportation C02 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) 
(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.

EE-RM-93-801 COMMENT OR11

(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. 
701 Pennsylvania Avenue, N.W.

Washington D:C. 20004-2696

01-92-01

EE-RM-93-801 COMMENT OR11

=-

rJ ..... = EDISON ELECTRIC _III!!....- INSTITUTE 

701 Pennsylvania Avenue. NW. 

Washington D.C. 20004-2696 

01-92-01 

2-92