Commentary: Cap-and-Trade Helps Address ‘Knowledge Problem’

Published November 1, 2004

The success of cap-and-trade programs and other moves toward regulatory flexibility shows how little “experts” know about the best ways to control pollution.

As an example, consider the Clean Air Act’s Title IV sulfur dioxide (SO2) trading program.

Given the best available knowledge about pollution control options before the SO2 program was started, EPA estimated the new approach (that is, cap-and-trade) would reduce costs down to about $700 per ton.

No one knows what average costs were under the old “command-and-control” system, because they varied from facility to facility and project to project, but industry had estimated the Title IV program would cost $1,300/ton, so pre-cap-and-trade costs were almost certainly substantially higher than this.

From 1995 to 2000, under the SO2 program, the cost of reducing emissions was actually about $150/ton. More recently, under “phase 2” of the program, emission reduction costs are about $250/ton.

The cost turned out to be so much lower than anyone, including EPA and all other “experts,” had imagined, because no one knew what was possible until power plant operators were given a constant incentive to seek new ways to reduce emissions, rather than required simply to meet a technology requirement or emissions rate limit determined by regulators.

Until the power plant sulfur dioxide program was implemented in 1995, EPA and Congress were charging American coal-fired energy consumers perhaps $1,500 a ton or more for emission reductions they could have gotten for $150. That is, they were overcharging by at least a factor of 10. The fact that EPA overestimated the costs of cap-and-trade by nearly a factor of five shows how little EPA knew about how to control emissions from power plants. That’s not a slap at EPA–nobody knew what was possible until the regulatory system created an incentive to find out–an incentive to create new knowledge about pollution control.

The flexibility and incentive structure created by the cap-and-trade program unleashed a wave of innovations in power plant operation, rail transport and logistics to move low-sulfur coal from west to east, energy dispatch models that included the cost of emissions per kilowatt-hour from each boiler, financial instruments for selling coal with SO2 emission allowances included, and scrubber technology that drastically reduced the cost of reducing SO2 emissions from coal-fired power generation.

What EPA (and Congress, the President, and environmental activists) should be taken to task for is continuing to rely on the command-and-control approach for most regulatory programs given this “knowledge problem.” There’s no shame in regulators’ and politicians’ lack of knowledge about the best ways to control pollution. It’s their pretense of knowledge that’s so costly. Regulators and central planners can never know enough about the details of any activity, industry, or process to identify the least-cost (or even anywhere near the least-cost) approaches for achieving environmental protection.

Since almost all environmental regulation is based on prescriptive requirements by regulators, we’re likely getting much less pollution reduction per dollar than we ought to be; or, conversely, we’re spending far more than we need to for each increment of environmental improvement.

Joel Schwartz ([email protected]) is a visiting scholar at the American Enterprise Institute and author of the forthcoming AEI book, Air Quality in America: A Dose of Reality on Air Pollution Levels, Trends, and Health Risks.