How Regulatory Standards Can Affect a Cap-and-Trade Program for Greenhouse Gases

September 17, 2009

Some legislation considered by the current and previous Congresses has proposed combining cap-and-trade programs with various regulatory standards to reduce greenhouse-gas emissions. Yesterday CBO released anissue briefthat describes how regulatory standards can interact with a cap-and-trade program, using examples related to H.R. 2454, the American Clean Energy and Security Act of 2009, which passed the House of Representatives on June 26, 2009.

In some cases, regulatory standards would require producers of greenhouse gases to use specific technologies, such as renewable sources for generating electricity; in others, manufacturers would have to modify the performance of their products, such as commercial furnaces, to use energy more efficiently. Such regulatory standards have been used in the past to meet various environmental goals.

Over the past two decades, however, policymakers have established cap-and-trade and other market-based programs because such programs often provide a more efficient way to reduce pollution than is possible through the imposition of regulatory standards alone. Market-based approaches rely on the interaction between producers and consumers to determine how to meet specific targets for emissions. Because policymakers do not always have enough information to tailor national regulatory standards to local circumstances, for example, or to adjust standards rapidly as market conditions change, regulatory standards do not always ensure that the least expensive solution is brought to bear on an environmental problem. Market-based approaches, in contrast, allow flexibility in the approach to meeting an environmental goal and often can achieve the same result at a lower cost.

As a result, regulatory standards combined with market-based approaches often will increase the cost of meeting an environmental goal. In particular, if standards forced large reductions in emissions in a specific industry or for a particular product that would not result from a cap-and- trade program alone, the standards would reduce the demand for allowances and depress market prices for them. Some lower-cost strategies would then not be pursued because producers would have no incentive to adopt them. The target for emission reductions might be met, but the technology or performance standard might have substituted higher-cost for lower-cost reductions that would have occurred as a result of the cap-and-trade program without the additional standards.

Market-based approaches are effective only to the extent that markets deliver accurate and timely price information and only so long as producers and consumers respond to that information. When the price mechanism falls short and appropriate price signals are not sent or received, the imposition of regulatory standards can be a more cost-effective way than a cap-and-trade program or a tax to change behavior. For example, builders and owners of rental properties might see little need to insulate buildings or install energy-efficient appliances if utility bills are paid by tenants and if the differences in tenants costs are not reflected in the rent that could be charged. (Standards also might be desirable if they addressed other national priorities more effectively than market mechanisms could, even if their economic costs were higher.)

This issue brief was prepared by Rob Johansson of CBO's Microeconomic Analysis Unit.