In the essay below, I explore the consequences of current energy and environmental policy and suggest an alternative set of solutions based on private property rights to resolve cost externalities and foster innovation.  The essay is a little longer than I hoped.  It is in two parts, the first identifies the failures in current policy, and the second part identifies how we can implement a more enlightened environmental policy.

How Did We Get Here?

Our energy policy is perhaps best described as going nowhere fast. Many, myself included, see climate change as one of the most pressing issues we face. We need to take action.  But what action do we take?  Most advocates support increased centralization where government directs the action and picks which technologies to research and implement. Advocates of this approach state that only government has the ability and resources to make such drastic changes.  This line of reasoning is fundamentally flawed for one simple reason. It presumes knowledge that, not only we do not have, but is entirely unknowable. Mark Twain said it best, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”  Assuming any single answer limits the available choices.  We close the policy door on any option that is not compatible with our assumptions.

We make assumptions every day. So, what’s the big deal when we make an assumption about what sort of national or international energy policy to take?  We have to make those assumptions to do anything, right? While this is true for an individual, assumption of knowledge leads oftentimes to disastrous outcomes.  The scale of these unintended outcomes is only magnified when we apply it to the states/nations/world.  Our goal should be to create policy that meets our needs with few if any unintended consequences.  How do we do this, and where do we begin?

First, we need to understand how we coordinate our action with incomplete information.  Fredrick Hayek was one of the first people to identify how individuals coordinate action through   prices. He refers to the price system as the miracle that enabled our society to specialize. Prices allow us to communicate a great deal of information and then make decisions based off of the resources that we have at our disposal. “The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all.” (Hayek 1945)  This is the market to which those of us who advocate free markets refer.  Prices are how we communicate this data. When we purchase anything the relevant information of present scarcity, future scarcity, cost of production, restrictions in distribution, legal settlements, and regulations are all rolled up into one convenient number, the price.  Mike Munger at Learn Liberty does an wonderful job conveying how prices convey information.

Any distortion in the price signal, through subsidy, mandate, or price control causes our behavioral patterns to shift.  This leads to shortage, surplus, and invariably some special interest is served by such measures. In fact, special interests are often times behind such well intentioned and high minded policy. This is the unfortunate reality of presuming to know what the price “should” be. Price has nothing to do with “willingness to pay.” It has everything to do with “actually paying.”  Want to find the price of something you own? Sell it. Want to find the price of something you want? Buy it.

We often assume that things have an intrinsic value.  Typically, intrinsic value is attributed to things in the environment and is used as a valuation in environmental and policy to estimate social costs.  Value is dependent on several factors, time, location, availability of alternatives, scarcity, and practical knowledge of the individual using the item.  The practical knowledge of the individual governs how they use what is at their disposal. Practical knowledge establishes value.  The action of the individual in relation to others provides context and value to their actions.  Value is the information communicated by the price signal.

Practical information performs “eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.” (Hayek 1945) This information is dispersed and possessed only by specific individuals and is only communicated through the actions of others. It is not knowable or capable of being collected and used by a group of individuals. When we want to place a price on carbon, we want to collect this information about carbon’s social cost. This information is unknowable, except through a process of the market. Here a solution could be to create a property right of atmospheric carbon, vice trying to implement a Pigovian tax to account for the externality.  The problem with a Pigovian tax is that it is impossible to know the appropriate price of the tax.

Prior to 1970, United States environmental policy was a patchwork of many different and competing policies.  There were a great deal of variance in the standards, as some states saw that being more lax on pollution was a way of improving their overall standard of living through increased industrialization and economic activity. This is the “race to the bottom” given as justification for the EPA. However, if a state caused a harm to another state, the wronged state could file a nuisance suit against the offender.  This common law constraint resolved any specific and measurable harm. The problem was not about the pollution.  I think the real reason behind the push for the EPA was some states had more effective regulation.  These states were rapidly industrializing creating an incentive to relocate from states with less effective regulation.  By creating a “level playing field” to the standards a state with stringent regulations the relative difference between the states would be lost.  As Always always, Nixon, after electoral votes, would have an incentive to force California’s regulations on the rest of the country, while appearing to care about the environment.  The level playing field allowed a cartel of already industrialized states to maintain their industry by removing differentials in policy.  This is an extension of Bruce Yandle’s Bootlegger and Baptist theory to the interactions between states.  Politics makes strange bedfellows.

The level playing field prevents individuals or groups of individuals to use their practical knowledge to find the solution that works best for them. In The Constitution of Liberty, Hayek notes, “The existence of individuals and groups simultaneously observing partially different rules provides the opportunity for the selection of the more effective ones.”  The act of competing regulations lets us find the regulations that work best for us. It provides a better aggregation of the practical knowledge in society.  Small scale changes have smaller impacts. If a state enacts a policy that makes it’s citizens worse off, they move. They take their industry and move to a more favorable locale. The threat of the loss of citizenry induces the offending state to adjust their regulations or decline. Now less important, that state has less impact further minimizing the impact of the bad policy on the larger whole.

An effective energy policy would first seek to allow solutions to develop. If we want to shut down coal plants, don’t make it difficult to replace them.  Such a simple statement, however, one that is oddly prohibited by current policy.  Regulation makes it difficult to obtain permitting for new facilities, as an example water permitting can takes about five years before a construction permit can even be issued.  Want to build a nuke, better start permitting 10-years in advance.  Want to replace old reactors with new reactors, getting a design license through the Nuclear Regulatory Commission takes upwards of 15-years.  Want to build a new combined cycle plant, but you don’t have pipeline access.  Good luck getting the right-of-way for the new pipeline.  Our solution to this is to mandate clean energy, give subsidies, loan guarantees, fund extra research, create dedicated national laboratories, etc. None of these solutions address the fundamental problem, i.e. we presume to know what is best and prohibit meaningful action.  The climate crisis, the energy crisis, the anything crisis are a result of our continued interference and meddling presuming knowledge we don’t have.

We decry the market as being ineffective, but fail to understand why the market is not responding. The market does not respond because policy prevents the appropriate market response. The Bootlegger and Baptist theory provides an explanation, where policy/regulation acts to serve an established interest by preventing market forces (competition) form affecting them.  If we want to resolve climate change as quickly and effectively as possible, then we need to make it easier to replace existing technology.

Using Our Understanding

How do we allow the greatest use of all practical knowledge within a society? Can we enact policy that presumes nothing that we do not know?  If we can do such a thing what would the policy look like?  Some recommend letting the markets decide these questions. However, “the market” is a concept that means different things to different people and needs clarification.

Aside
I use the word market to describe a process of price discovery, where individuals act based on their practical knowledge. Markets are controlled through policy (the use of government’s gravitas to restrict/enable certain action). Markets can also be created. In fact, an auction is a process where a market is created to sell a specific item that does not normally benefit from price discovery.  End Aside

We have two real problems that restrict our ability to act regarding climate change. The first is the process of price discovery in existing markets leading to outcomes where preference is shifted toward preserving the status quo (the bootlegger and the Baptist problem). The second problem is that we may need to create new markets to resolve the most important “tragedy of the commons”, climate change.

Normalizing Markets

The first positive action we can take is to understand that our current policy framework inhibits action and we need to adjust existing policy to allow action. Existing policy presumes to know the appropriate outcome, even to presume knowing what specific technology solutions will work best.  Much of our environmental policy originates from the EPA, which creates a “level playing field”. This process inhibits price discovery. If we want a solution, the first thing we cannot do is to presume knowledge we do not possess. Here, I refer to knowing which technology is best (technology standard), what is a fair level of pollution applied evenly to everyone (performance standard), which generation source is preferable (mandate), or what the price of an externality is (Pigovian Tax). A level playing field, such as these, presumes uniformity, and ignores the distribution of value for each individual. These solutions presume to know what is best.  This presumption of knowledge distorts the outcome of the market and skews price discovery in favor of a certain set of results that reduce the overall welfare in our society through a misallocation of capital.

Let’s take for an experiment a uniform price on carbon in the United States, and for the purpose of argument assume that it represents the theoretical externality cost.  The regions that are primarily coal free, New England, New York, and Pacific Contiguous states (including Illinois >50% carbon free) would benefit from this policy by having a lower cost of energy relative to the other states which are seeing industrial growth and rely heavily on coal to produce electricity, Texas, Rust Belt, Georgia, South Carolina, Virginia, and Tennessee.  In a very broad sense, the states are competing against each other for industry and any relative difference is significant.

Figure 1: Electricity produced by generation source for various regions and states taken from the Energy Information Agency Electricity Data Browser.

I routinely talk with the CEO of an Georgian industrial construction company and the chamber of commerce about why we are seeing companies relocate to the Southeast. The main reason why companies come here is the  low and stable energy price, $58/MW-hr. These companies are relocating from Germany, Japan, California, Washington, and Illinois, and not only do they come, so do the entire supply chain ecosystems that support their operations.  What we have here is a set up for the Bootleggers and the Baptists.  In this case, the Bootleggers are the states that have a low marginal cost of carbon, the same states that are seeing industry and tax revenue move away.  Many of these states are facing extended budget shortfalls, anemic growth and collapsing tax revenue. It is in the interest of these states to force level the playing field for everyone.  By holding everyone to a uniform standard they come out ahead.  However, the sates that have policy in place that is more conducive for business are seeing economic growth.  Many of these states were late in scaling electricity production and rely on a non trivial portion of coal generation built before 1980.  As a result of the past path to industrialization, they would be disproportionately penalized.  Bruce Yandle identified a similar set of circumstances surrounding the creation of the EPA.(Yandle 1989)

Similar to beginning the EPA, the regions targeted by the proposed regulation are in the process of decarbonizing (5 new reactors under construction in the Southeast) as they were in implementing stronger state environmental policy in the 1960’s. South Carolina will be 70% carbon free by 2018 when VC Summer 3 comes online.  The purpose of the carbon tax has nothing to do with reducing carbon. If it did, the bootleggers would not support it. It has everything to do with eliminating marginal differences between the states. What it does is to preserve a certain social order (IMHO distribution of electoral votes) by minimizing incentives for people to move.

The reason why I say this is, industry is decarbonizing for other reasons, the chief one being high and volatile fuel costs.  However the pace of decarbonization has been slowed by making it very difficult to build new electricity generation, e.g. recent EPA rules on GHG’s heavily favor General Electric’s combustion turbines at the expense of everything else.  Some will argue that wind and solar can fill the gap, but where these sources fail is dispatachability. Reliability carries a significant premium in the consumption of electricity.  Thus, there is a social cost incurred by forcing consumption of an inferior good as being equivalent to the premium, i.e. selling hamburger as if it were equivalent to prime rib.  You can’t taste the difference, really.

Why does every state have to be doing the same thing?  Why do we presume to know what is best for everyone? When clearly some will come out ahead and others behind.  I don’t know what the best policy is. Here, I think a great deal of experimentation, especially at the state level will prove most enlightening.  It will also limit the overall macroeconomic impacts by limiting the damage to a few unwise and recalcitrant states with poor policy.  In this regard, addressing existing Federal policy that restricts new construction of any power source would prove fruitful. This is not deleting existing policy.  If we were, we would have problems, e.g. NEPA superseded a significant amount of common law that cannot be replaced overnight.  Existing policy needs to be tailored to create markets and allow market discovery.

Creating Property Rights

We can create more effective policy. Effective is a loaded word and needs clarification. We need policy that achieves the stated policy goal, reducing carbon emissions, and fosters competition between states, companies, and individuals.  Unfortunately, we seem to think that competition is bad, we ignore the consequence of seeking to be better and do more for less.  Competition makes us all better off.

We need to create markets to allow price discovery.  A recent example of such environmental policy was the program to reduce SOx emissions in the 1990’s. This was done through the EPA creating a market where individuals could exchange allowances to emit SOx, with an overall declining cap.  This created a property right that the EPA held in monopoly and distributed through a market.

The idea of creating a property right from the commons is not new. Coase (1960) suggested such an approach for regulating EM spectrum.  Hazlett (1989) expanded Coase’s ideas.  And for environmental regulations, Yandle discussed this in great length.(Yandle 1989) Yandle noted that the creation of property rights through policy carries the consequence of not being politically favorable, and that political markets tend to push regulation toward command and control structures in order to maximize their monopoly authority (p. 103).

When an individual owns the soil, they own it form heaven to hell, cuius est solum, eius est usque ad coelum et ad inferos, is a very old idea of property rights. One possible solution to climate change is to create a property right for the disposal of pollutants into the atmosphere.  Each land owner would own a number of rights based on the amount of air above their land. These rights can be leased just as any other mineral right can be leased, even by the federal government. Because air moves easily between properties, we need some level of a common framework.  We could for each criteria pollutant, specify a maximum limit.  One might argue that renters have no say in the right to pollute.  Here there will be rental properties and land holders who will refuse to sell rights to pollute in exchange for rent premiums.  A large land holder could even sell shares to not pollute for a defined period.  In this way every individual’s actions would impact the availability of allowed pollution permits.

Such a policy course is not without difficulty–there is the rest of the world.  The limits would have to be set (by Congress). One method is based on the land area of the United States and water inside our Exclusive Economic Zone (EEZ) and some multiple of current pollution levels. This defines a concentration cap of criteria pollutants.  An acre at sea level (reference air mass) would be allowed a certain number of shares each year for pollution. This quantity would scale with elevation.  Because of the size of land held by the federal government (1.1 million km2) and the area of the EEZ (11.4 million km2), the federal government would control the bulk of allowed permits, falling under the Department of the Interior to administer.

This is a very specific example of how to create a decentralized solution solution for establishing a price on carbon that suits every individual without presuming their needs or desires.  We can even extend this concept to water pollution, by selling pollution rights for a number of major river basins, based upon the land area in those river basins.  Taking this further, events such as a radiological release or a refinery fire, would have to purchase a sufficient quantity of permits based upon the one time event.  Here utilities or other such company would be allowed to create pools outside of state jurisdiction, and could exercise those pools as needed based upon a set of covenants of the pool members.

By creating a property right, we eliminate arbitrary policy barriers to market entry. This will free up innovation by reducing regulatory uncertainty. The innovator would base their decisions on what they perceived the cost of their solution would be. If they underestimated the social tolerance to environmental risk they would be forced to adapt or go out of business, reducing the scope and impact of their actions.  If they overestimated the risk, then their design would respond accordingly. There is no grandfathering clause as the rule of law applies uniformly to everyone.  Our old coal plants would be comparatively more expensive based on the actual social cost of pollution.

There would be opportunity for arbitrage in assembling quantities of property rights and predicting future values based on current events and scientific understanding.  The ability to adjust for changes in situ and without cumbersome hearing processes would greatly improve the pricing and allocation of pollution rights. This is fundamentally Coase’s theorem for how we resolve economic allocation in the presence of externalities.

Why Property Rights, and What Can Go Wrong?

Why do we need to create property rights?  Here the answer is straightforward.  Property rights are a way of preserving the commons by assigning individual responsibility. There are other methods of preserving the commons and have evolved in parallel with the idea of property tights over the past several millennia.  One of the most profound tools to regulate the commons was through evolved common law. However, with the creation of the EPA we abandoned our entire common law structure of environmental regulation, e.g. the failure of North Carolina’s nuisance suit against the Tennessee Valley Authority.  Because of the time and history that took to establish that common law, there is no way to bring it back.  This is the fundamental problem with deregulation.  By creating a property right we borrow from the common law that exists surrounding the concept of private property.  Private property is the cornerstone of our society.

A fundamental idea is that society evolves structure in the absence of regulation and that this organic construction is common law.(Hayek 1960 and Hayek 1983)  We need to appreciate the importance of evolved social structure without it we run into problems.  When we legislate and regulate structure, it paves over the organic structure–obliterating much of the richness that previously existed.  When we deregulate, which is what I propose in this paper, we must replace the structure that we tear down with a different structure.  I propose replacing many existing regulations with property rights to resolve the tragedy of the commons in a manner that allows complexity.

The approach I advocate rests on the premise of not presuming to know the values (practical knowledge used in economic calculation) of my fellow humans.  I have no right to presume such knowledge and by presuming such knowledge I infringe on other individual’s inalienable rights.  This requires a measure of trust in other people.  Unfortunately, based on the current trend in policy and political discourse, such a liberal principle is an anathema.  My approach guts the power of the EPA–destroying the political rents that can be paid through environmental regulation, both in the executive and legislative. Because of this, the likelihood of it seeing the light of being brought to the floor of the House or Senate is nil.  It removes too much authority from the government restoring it to the individual with whom it rightfully belongs.

I write this to present you with a logically consistent alternative to our current discourse on resolving climate change. I only sought logical consistency.  I do not presume to know that this is the “best course” of action just that it is “a course”.  I welcome your thoughts and feedback. Thank you for bearing with me on this complex and lengthy subject.