In July, Carol Browner, chief of the Environmental Protection Agency, issued new regulations reducing permissible levels of smog and particulate (fine soot) pollution. The political battle leading up to the decision was fierce, even within the administration. One staff member on the Council of Economic Advisors maintained that the regulations would cost a whopping $60 billion—a figure quickly seized upon by industry opposition. The EPA's own cost estimate was much more modest, between $6 billion and $8 billion. In making her case for the new regulations, however, Browner publicly disavowed even her own agency's cost estimates. She argued that industry would find a way to do it cheaper.
Whom to believe? Confronted with conflicting estimates, most lay people either throw up their hands or choose sides ideologically. But history provides a basis for evaluating these estimates. Not only do industry lobbyists wildly overestimate the costs of proposed environmental regulations. More surprisingly, academic and government economists consistently do too—and for an equally surprising reason. When forecasting the costs of new environmental regulations, economic analysts routinely ignore a primary economic lesson: Markets cut costs through innovation. And innovation can be promoted through regulation. This history is worth bearing in mind as we approach the most important environmental controversy to date—how to deal with the crisis of global warming.
THE ABCS OF OVERESTIMATION
In every case we have found where researchers have calculated actual regulatory costs and then compared them to ex ante estimates, the estimate exceeded the actual cost. We have uncovered a dozen such efforts, ranging from A (asbestos) to V (vinyl chloride). In all cases but one, the initial estimates were at least double the actual costs.
Asbestos. When the Occupational Safety and Health Administration (OSHA) instituted regulations covering exposure to asbestos in the early 1970s, they hired a consulting firm to estimate the cost of compliance. Two later studies found that the original prediction for the cost of compliance was more than double the actual cost, because of overly static assumptions.
Benzene. In the late 1970s, the chemical industry predicted that controlling benzene emissions would cost $350,000 per plant. Shortly after these predictions were made, however, the plants developed a process that substituted other chemicals for benzene and virtually eliminated control costs.
Chlorofluorocarbons (CFCs). In 1988, reducing CFC production by 50 percent within 10 years was estimated by the EPA to cost $3.55 per kilogram. By 1993, the goal had become much more ambitious: complete elimination of CFC production, with the deadline moved up two years, to 1996. Nevertheless, the estimated cost of compliance fell more than 30 percent, to $2.45 per kilogram. And where substitutes for certain CFCs had not been expected to be available for eight or nine years, industry was able to identify and adopt substitutes in as little as two years.
CFCs in automobile air conditioners. In 1993 car manufacturers estimated that the price of a new car would increase by $650 to $1,200 due to new regulations limiting the use of CFCs. In 1997 the actual cost was estimated to be $40 to $400 per car.
Coke ovens. The original OSHA estimate for the cost of complying with the 1976 coke oven standard was more than five times higher than estimates of actual costs. OSHA's contractor suggested that complying with the standard would cost from $200 million to more than $1 billion. However, a Council on Wage-Price Stability study later estimated the actual cost of the standard to be $160 million.
The OSHA consultant estimated that three steel firms in their sample would spend $93 million on capital equipment and $34 million in annual operating costs to comply with the regulations. A later study by Arthur Andersen determined that the three firms actually spent between $5 million and $7 million in 1977 to comply with the standard, and only $1 million to $2 million on capital expenditures. Ultimately, firms were able to meet the standard without incurring all of the capital costs in the first year, and actual compliance costs were dramatically lower than originally predicted.
In the late 1980s, coke production again came under regulatory scrutiny, this time by the EPA. In 1987, the agency estimated that the cost of controlling hazardous air pollution from coke ovens would be roughly $4 billion. By 1991 that estimate fell to between $250 million and $400 million.
Cotton dust. In 1976, OSHA proposed a maximum permissible exposure limit of 0.2 milligrams per cubic meter for cotton dust, and its consultant estimated that compliance costs would be approximately $700 million per year. The standard promulgated in 1978 actually allowed for higher exposure levels in some sectors of the textile industry, but the small changes in the standard do not fully explain the decrease in estimated compliance costs; in 1978 the estimate fell to $205 million per year. Moreover, a new study conducted in 1982, after the Reagan administration called for a review of the standard, concluded that compliance costs were $83 million per year.
Halons. In 1989 members of the United Nations Environment Program's Halons Technical Options Committee disagreed on whether direct halon replacements could be found and whether a phase-out was possible. However, in 1993 the committee concluded that a phase-out of halons, a substance found in fire extinguishers that destroys the ozone layer faster than chlorofluorocarbons, would be both technologically and economically feasible by 1994.
Strip mining. Prior to the passage of the 1978 Surface Mining Control and Reclamation Act, estimates for compliance costs ranged from $6 to $12 per ton of coal. Actual costs for eastern coal operations have been in the range of 50 cents to $1 per ton. After the regulations were adopted, the market switched away from coal deposits with high reclamation costs. Ready substitutes included surface-minable coal in flatter areas (with lower reclamation costs), and underground deposits.
Vinyl chloride. OSHA's vinyl chloride standard, set in 1974, provides a final example of wildly excessive cost projections. The agency's consultant estimated that it would cost $22 million per year to meet the permissible exposure limit of 2 to 5 parts per million (ppm) in the vinyl chloride monomer sector, and $87 million per year to meet the 10 to 15 ppm exposure limit in the polyvinyl chloride sector. In addition, the consultant argued that the 1 ppm permissible exposure limit simply could not be attained. The president of Firestone's plastics division said that a standard of 1 ppm "puts the vinyl plastics industry on a collision course with economic disaster."
In spite of these protests, OSHA did adopt the strict permissible exposure limit of 1 ppm. A study conducted several years later by researchers from the Wharton School of Business estimated that the total cost of compliance for both sectors had been about $20 million per year. A 1976 congressional research paper also indicated that the actual cost of compliance was dramatically less than the original prediction. The early claims that the 1 ppm standard could not be met evaporated; instead, the regulatory action led to about a 6 percent rise in polyvinyl chloride prices.
While costs have been consistently overestimated for emission reduction, they have been underestimated for environmental cleanup. For example, when the Clean Water Act was enacted in 1972, the EPA estimated that $12.6 billion was needed to provide secondary sewage treatment systems. According to the American Enterprise Institute, actual spending for sewage treatment between 1972 and 1981 exceeded $160 billion.
Costs for the Superfund program have also mushroomed. When first launched, people expected the mandated cleanups to apply to a small handful of Love Canals. However, the program has expanded dramatically, now covering far more than a thousand sites. In addition, cleanup has proved far more costly than predicted: The average cost overrun on cleanup expenditures at Superfund sites has been 44 percent.
The message from these cases is clear. On the one hand, treating already polluted water, cleaning dirty soil, and scrubbing oily rocks costs a lot of money, (much) more than expected. On the other, when it comes to reducing pollution emissions at the source, it is almost certain to be (substantially) cheaper than we think it will be. Updating Poor Richard's Almanack, an ounce of prevention is clearly worth a pound of cleanup.
Why were the estimated costs of reducing emissions at the source so inflated? The reason, of course, is "technology-forcing." When industry is required to lower pollution output, it usually doesn't just slap a new filter on an existing process; it often invents new technology. Frequently the new technology turns out to have higher productivity benefits, which help to offset the cost of the regulation. To see this, it is worth looking in detail at two high-profile cases where markets have responded to regulation by cutting costs.
Robert Hahn, a well-known environmental economist, is currently a resident scholar at the American Enterprise Institute and an adjunct research fellow at Harvard's Kennedy School of Government, and is a former senior staff member of Bush's Council of Economic Advisors. In 1990 he and a co-author wrote a report for the U.S. Business Roundtable predicting the impact of the proposed Clean Air Act amendments on employment. These amendments had the dual purpose of cleaning up both acid rain and so-called "air toxics" from industrial plants.
The executive summary of Hahn's report leaves "no doubt that, across the Clean Air Act Amendments studied, there are a minimum of several hundred thousand jobs at various levels of severity of risk—even with the more moderate [Bush] Administration proposals." Hahn's absolute minimum prediction was 20,000 jobs directly lost, mostly from the closing of coke ovens in the steel industry. Hahn and his co-author viewed this as "truly a limiting, rock-bottom estimate" for several reasons. Important among them was that it considered only job losses arising from one portion of the bill—control of air toxics.
The amendments did pass later in 1990. The bill was in most respects more restrictive on air toxics than the one on which Hahn's study based its minimum job loss estimates. The legislation also authorized retraining funds of $50 million per year for displaced workers, which gives a nice way to track job impacts.
In the almost seven years since passage of the legislation, fewer than 7,000 workers have received aid because their jobs were affected by the Clean Air Act amendments. And the vast majority of these have been eastern, high-sulfur-coal miners, who have been laid off due not to the air toxics provision, but to the acid rain amendment. (The same legislation has in fact led to a boom in the western, low-sulfur-coal industry.) No workers from shut-down coke oven plants have received adjustment assistance. And between 1992 and 1995, production in the coke and (closely related) blast furnace industries actually increased, from $1.74 billion to $1.95 billion.
Hahn was consulting for industry here, so it is not surprising that his numbers were a bit on the high side. Corporate America, when faced with new regulations, has never been shy about claiming that the sky is falling. But Hahn is not a hired gun; he has very solid academic credentials. How could he have gotten it so wrong?
It turns out that Hahn's overestimation of regulatory impacts, while extreme, is not unusual. In fact, as we have seen in every case for which we have been able to track down data, academic and government economists have routinely overestimated the costs of reducing pollution emissions—by at least 30 percent, and generally by more than 100 percent.
THE ACID TEST
The EPA's acid rain program is another dramatic case in point. Since 1995, electrical utilities have been required to hold permits for each ton of sulfur dioxide they emit. These permits, in limited supply, are distributed to firms each year by the government. The innovative feature of the program is that the permits can then be bought and sold. Given this, permit prices roughly reflect per ton pollution control costs. This is true because a firm generally wouldn't buy an extra permit if the cost of doing so exceeded the cost of reducing sulfur emissions by a ton.
When the tradable permits market was being designed in the early 1990s, credible industry estimates of permit prices (and thus control costs) were $1,500 per ton; the EPA was predicting $750. In 1997, permits were in fact selling for around $100 a piece.
Part of the current low permit price is due to a higher than expected initial supply of permits, but real compliance costs have in fact been two to four times lower than the EPA expected, and four to eight times below industry estimates.
THE VIRTUE OF MARKETS
When environmental economists figure their cost estimates, one particular lapse is quite startling. Economists have tended to grossly underestimate a virtue of markets they readily preach elsewhere: flexibility. When pollution regulation makes a certain type of production more expensive, markets adjust—in fairly rapid order, uncovering substitute methods of production, and developing cheaper cleanup technologies. This fact, while not completely ignored by economists, is seldom factored into their cost estimates. Instead analysts tend to predict future costs statically, as if firms would continue to use existing practices and technologies.
So, for example, the much lower than expected costs for the acid rain program can be explained in retrospect by the increased flexibility that firms were given to achieve their mandated reductions in sulfur dioxide emissions. Rather than install expensive scrubbers (or buy extra permits), many more firms than expected have met their sulfur dioxide targets by switching to low-sulfur coal, or developing new fuel-blending techniques. Railroad deregulation, along with economies of scale, led to an unexpected decline in low-sulfur-coal prices. And with the increased competition from coal, scrubber prices fell by half from 1990 to 1995.
All this is easy to see after the fact, but would have been very hard to predict. Hahn got his 20,000 lost jobs from air toxics regulation following this same practice—ignoring innovative market responses. While parenthetically noting that "technological improvements could reduce the direct economic impacts," the study explicitly ignores the possibility "because of the difficulties in predicting how technology will evolve." Because in the mid- to late 1980s, available control technologies for coke ovens seemed to be quite expensive, Hahn assumed that regulating air toxics would simply shut down much of the industry.
However, as we saw above, the EPA's own estimates of control costs for coke ovens were plummeting even as Hahn was writing his report. By 1991, they were down by a factor of ten or more from the 1987 forecasts. Hahn may not have been aware of the EPA's work; instead he cites an industry source to justify his claim that "there is widespread agreement that coke ovens will be required to close down, with an estimated loss of 15,000 jobs."
A secondary reason for the overestimates is that in implementation, legislation is never as draconian as it appears on paper. In practice, timetables get stretched out, compliance dates get extended, and waivers are granted. Eventually the regulations begin to bite, but industry is usually given a fair amount of time to adjust. Most cost estimates assume high degrees of near-term compliance.
Peering into the future is hard work. It is, in fact, close to impossible for economists to predict the specifics of how technology will evolve. This is especially true since much of the information about potential innovations consists of closely held trade secrets, which industry has little incentive to reveal. But basing cost predictions on scenarios that assume no technical evolution is guaranteed to produce gross overestimates. Innovation is indeed something at which markets are very good. When given a narrowly defined task—to produce commodity x emitting less of pollutant y—short-term substitutions and long-term shifts in technology guarantee large cost reductions over current practice.
INFLATING COSTS, IGNORING BENEFITS
In the late 1980s, when the international phase-out of ozone-destroying CFCs got underway, a company called Nortel began looking for substitutes. The company, which had used the chemicals as a cleaning agent, invested $1 million to purchase and employ new hardware. Once the redesigned system was in place, however, Nortel found that it actually saved $4 million in chemical waste-disposal costs and CFC purchases.
The CFC regulatory compliance costs for Nortel clearly were $1 million. But how do we figure in the $4 million savings? Economists have long recognized that a dollar spent on environmental pollution control is not the "true" cost to society. Some have argued that the cost is in fact much higher, because environmental spending "diverts" capital investment from more productive uses.
In recent years, by contrast, Michael Porter of the Harvard Business School has been pointing to examples like Nortel to argue that environmental regulations, by forcing firms to rethink their production processes, can often lead to lower production costs and lend a competitive advantage.
More generally, much of the reported costs of environmental regulation occurs when firms invest in new capital equipment, thoroughly redesigned to be both cleaner and more productive. Many of these investments would have happened sooner or later anyway. So a primary effect of regulation is to speed up the investment process. This is costly to firms, since they must scrap old machinery that is not necessarily worn out. When this happens, however, much of measured compliance cost is in fact just early capital investments. This in turn implies that the compliance figures are much higher than the real costs.
Researchers at Resources for the Future recently conducted a study asking how much $1 spent on environmental protection really costs an industry. For some industries, specifically steel, the answer was little more than $1, due to the diversion effect. For others, notably plastics, the industry actually saved money as productivity was boosted. On average, the study concluded, $1 spent on environmental pollution control reflected a real expense of 13 cents. In general then, even when cost estimates are "correct," this new research suggest that the reported values often overstate the true costs to the firm, on average by a factor of seven.
THE ROAD TO KYOTO
The debate over compliance costs is now heating up for the mother of all pollution issues—global warming. International negotiators are at work on what are supposed to be binding carbon emission reduction requirements, to be announced in Kyoto in December. The European Union is pushing for a 15 percent cut below 1990 levels to be achieved by 2010; the members of the Alliance of Small Island States—whose very existence is at stake due to anticipated flooding—want a 20 percent cutback by 2005.
The United States, by far the world's biggest greenhouse polluter, is dragging its heels. President Clinton, when pressed to commit the U.S. to specifics, has promised only to convene a conference in the fall to try to achieve a consensus among American industry, labor, and other groups on the need for action. And Clinton will clearly face a tough sales job for ratification in the Republican-controlled Senate.
Academic economists have lined up behind a strong U.S. leadership role in Kyoto. Greenhouse "moderates" like Yale's William Nordhaus and Harvard's Dale Jorgenson headed up a list of more than 2,000 economists who signed a letter arguing that a first round of carbon emission reductions could be achieved at relatively low cost. And in late July, to the dismay of U.S. industry, the Clinton economic team published its official cost estimates, confirming this general view.
There is a minority opinion among economists that reducing greenhouse gas emissions will be very, very cheap, and in the long run, even profitable. The reasons? Already existing energy efficiency technologies can help the United States break its addiction to cheap oil without too much pain. And within a decade or two, renewable fuel sources—coupled with efficiently redesigned technologies—will be cheaper than oil or coal are today. In this view, the sooner we redirect the market into a serious search for alternatives to fossil fuels, the richer we will be in the future.
There are, however, likely to be transitional costs, both for workers, particularly in fossil fuel industries, and for Third World countries. In the past, government has not done a very good job in equitably sharing the burdens of such transitions. This is no reason to reject a global warming accord, but it is a strong reason to be alert to the allocation of costs and benefits.
In the global warming debate, as when past environmental regulations have been proposed, there are the three compliance cost scenarios: apocalyptic (industry), doable but costly (academic and government), and profitable (a few visionaries). Our guess, based on the record of previous academic and government cost forecasts, is somewhere between doable and profitable.