Ted Gayer, co-director of the Economic Studies program and the Joseph A. Pechman Senior Fellow at the Brookings Institution, and W. Kip Viscusi, Vanderbilt University Distinguished Professor, with primary appointments in the Department of Economics and the Owen Graduate School of Management as well as in the Law School, set out to examine the economic justification for recent US energy regulations. The case studies include the proposed CAFE fuel economy requirements and US Environmental Protection Agency (EPA) greenhouse gas regulations for motor vehicles; and energy-efficiency standards for clothes dryers, room air conditioners, and light bulbs.

The efficiency rationale for any government regulation rests on the existence of some type of market failure. The ways markets may fail are quite diverse, ranging from characteristics of the market structure to various kinds of externalities; that is, adverse effects on parties other than the buyer and seller of a product. In the absence of some type of market failure there is no legitimate basis for regulation from the standpoint of enhancing economic efficiency.

This article examines a major class of recent government initiatives by the US Department of Energy (DOE), the US Environmental Protection Agency (EPA), and the US Department of Transportation (DOT) pertaining to energy efficiency (as distinct from economic efficiency). The regulations of interest all pertain to consumer products that are durable goods. There may be some kind of market failure with respect to the energy usage of these products, as energy use leads to environmental consequences. However, the existence of an imperfection alone cannot justify all regulations that take the form of government intrusion into the marketplace to override consumer choices.

We examine the justification for these energy regulations and show that demonstrable market failures are largely incidental to an assessment of the merits of these regulations. Rather, the preponderance of the assessed benefits is derived from an assumption of irrational consumer choice. The impetus for the new wave of energy-efficiency regulations has little to do with externalities. Instead, the regulations are based on an assumption that government choices better reflect the preferences of consumers and firms than the choices consumers and firms would make themselves. In the absence of these claimed private benefits of the regulation, the costs to society dwarf the estimated benefits.

—Gayer and Viscusi

Gayer and Viscusi start by advocating the mainstream approach of evaluating the merits of regulations based on their benefits and costs and whether, on balance, the regulations promote social welfare—an approach they say is consistent with the approach federal regulatory agencies followed since President Bill Clinton issued an Executive Order to that effect in 1993.

That approach, however, merely frames the issue, leaving open the determination of what is a cost or a benefit. Gayer and Viscusi suggest that government agencies are not properly assessing the beenfits from energy-efficiency standards.

The assumption that the world outside the agency is irrational is a direct consequence of the agencies’ view that energy efficiency is always the paramount product attribute and that choices made on any other basis must be fundamentally flawed.

The most prominent economic justification for environmental policies is to remedy a market failure due to externalities, which do represent actual potential benefits of energy-efficiency standards. The classic example of an externality is the release of air pollution as a byproduct of production of a marketable good. The air pollution harms human health, but abatement raises the firm’s production cost. If the government clearly establishes a property right for the clean air, then depending on who owns the property right, either polluters would need to purchase the use of the air or the victims of pollution would need to pay polluters to reduce pollution.

Either way, as Ronald Coase demonstrated, the social costs of air pollution are internalized into the market decision, resulting in an economically efficient outcome. However, high transaction costs frequently prevent the affected parties from reaching an efficient solution, especially in the case of air pollution in which large populations are exposed to pollution. As a result, abatement is not undertaken since the production decision is made without considering the external harm to human health. In these cases, more direct government intervention (whether through market-based instruments such as a pollution tax or through command-and-control regulations) can achieve the level of air-pollution reduction that increases net benefits to society.

Environmental policies can be most successful at maximizing net benefits—or at least improving net benefits relative to the nonintervention case—if they are designed after careful consideration of unbiased estimates of the costs and benefits of environmental quality. Benefit-cost analysis (BCA) provides the methodology for such an assessment and is the key component of effective regulatory policy.

—Gayer and Viscusi

Gayer and Viscusi argue that the analyses for the recent energy regulations make an increasingly important methodological challenge to BCA concerning the treatment of private benefits to individuals from government regulations.

In a post on the Brookings website, Gayer notes that cost-benefit analyses traditionally assume that informed citizens are best able to understand and choose among the available options for the one that best meets their own interests. A regulation that requires consumers to buy a more expensive, more energy-efficient product, for example, may produce social benefits from reduced pollution, will not otherwise make the consumer herself better off.

While some studies are questioning the assumption of consumer rationality underlying BCA, Gayer and Viscusi write, the existence of some systematic behavioral anomalies that do not accord with fully rational behavior does not imply that those anomalies are ubiquitous and consequential in all economic situations.

Just as one would want to assess whether a pollution externality is trivial or important, it is also essential to document both the existence and magnitude of behavioral anomalies if they are to be used as a justification for government intervention.

...If BCA abandoned the presumption of consumer sovereignty and replaced it with another assumption about the systematic behavior of consumers, it would lead to the normative implication that the analyst or policymaker decides what is best for each consumer. Given the informational and analytical challenges of finding behavioral failings among heterogeneous individuals, this is a tall order for any analyst or policymaker, especially given that they are also prone to information and behavioral failings.

...A shift away from the principle of consumer sovereignty will also lead to regulations focused more on correcting self harm than on internalizing environmental harm. For example, it would place greater weight on regulations that ban energy-inefficient products than on regulations that raise the price of pollution. Policies designed to focus on addressing the purported irrationality of the consumer rather than on the traditional goal of internalizing external costs of pollution will sacrifice some pollution reduction for more protection of the consumer from self harm. Therefore, the burden of proof for any BCA conducted as part of a review of regulatory proposals should be placed heavily on justifying any presumption of a deviation from consumer sovereignty. The agency preparing the BCA needs to demonstrate a systematic deviation from consumer rationality rather than just presuming that the regulator is better equipped to make decisions that protect individuals from themselves.

—Gayer and Viscusi

NHTSA CAFE and EPA greenhouse gas standards for vehicles. For the analysis of impact of the proposed joint national program of CAFE and greenhouse gas standards for passenger cars and light trucks (for 2017 and later model years), Gayer and Viscusi note, EPA and NHTSA needed to derive input values for such things as vehicle miles driven per year, the responsiveness of annual vehicle miles driven to changes in fuel cost, the magnitude of the rebound effect (which is the increase in driving that would occur with more fuel-efficient vehicles), projections of future fuel costs, the number of years the vehicle would be in service, the relationship between the measured fuel efficiency and the actual on-road efficiency, and the discount rate.

The analysis, the authors argue, presumes the regulator is better than the consumer at computing the various inputs to the net present value (the value today of a stream of future benefits, less costs) computation and the consideration of different vehicle classes controls for other features of the vehicles that might appeal to the consumer. This assumption, they note, effectively rules out consideration of motor-vehicle attributes other than fuel efficiency that will be affected by the regulation.

The dimensions of consequence in the EPA and NHTSA analyses essentially convert all motor vehicles into three-attribute products. Cars serve as a means of transportation whose only other dimensions of interest are mpg and cost. One does not have to be a reader of automobile reviews in Edmunds.com, Car and Driver, or Road and Track to realize that fuel efficiency is but one of many factors people use to assess the quality of an automobile. Acceleration, handling, braking ability, legroom, riding comfort, safety, reliability, styling, and trunk storage are among the many other dimensions of concern to automobile purchasers. Indeed, most automobile reviews note the tested vehicle price and the mpg but then focus on other vehicle characteristics of consequence to consumers but not as readily apparent. Econometric studies of the determinants of automobile prices likewise recognize the importance of product attributes in addition to fuel efficiency.

...The analyses by EPA and NHTSA ignore the loss in consumer welfare that would result if achieving higher fuel-economy standards means manufacturers have to sacrifice any of these other vehicle characteristics. The EPA and NHTSA analyses abstract from all these concerns and focus on several cost-related aspects. In addition to the calculation of lifetime fuel savings to the consumer, the regulators also compute the private consumer surplus from additional driving (that is, the private benefit to consumers net of driving costs that occurs because the amount of driving increases as fuel efficiency increases) and the private benefit of reduced fueling time (because consumers would have to refuel less often). The sum of these private net benefits to the consumer represents the bulk of the benefits of the fuel-efficiency mandate for both the NHTSA and EPA analyses.

—Gayer and Viscusi

Specifically, NHTSA estimates a total cost of $177 billion and a total benefit of $521 billion. Of the $521 billion in benefits, $440 billion (85%) stem from private savings to consumers, including $416 billion in lifetime fuel savings, $9 billion in consumer surplus from additional driving, and $15 billion in refueling time value.

EPA estimates for its regulations are similar: $192 billion in total costs and $613 billion in total benefits, 87% of which are private benefits to consumers: $444 billion in lifetime fuel savings, $71 billion in consumer surplus from additional driving, and $20 billion in refueling time value.

The environmental benefits play a largely incidental role in both analyses. In the NHTSA analysis, the estimated benefits from reducing the greenhouse-gas carbon dioxide accounts for only $46 billion, or 9 percent of total benefits. The greenhouse-gas carbon dioxide benefits in the EPA analysis are also $46 billion, or 8 percent of the benefits EPA estimates.

Even these comparatively modest benefits overstate the benefits to the US citizenry, since they also include the climate-change related benefits to other countries of reduced emissions within the United States. To the best of our knowledge, this is the first situation in which benefits to countries other than the United States have been included in a regulatory impact analysis.

If one counted only the domestic benefits, the social cost of carbon dioxide benefits would be just 7 to 23 percent of the estimated carbon dioxide benefits. Counting only domestic benefits would reduce the CAFE rule’s greenhouse benefits from $46.4 billion to a range of $3.2 billion to $10.7 billion. The domestic benefits of reducing greenhouse gas emissions therefore only account for 0.6 to 2.1 percent of total estimated benefits. The estimated costs of the regulation are 18 to 60 times greater than the domestic greenhouse-gas benefits. If the purpose of the standards is to reduce greenhouse-gas emissions, these regulations are very inefficient.

—Gayer and Viscusi

Moving forward. In their conclusion, Gayer and Viscusi pose the question as to how consumers could be as remiss as suggested by the regulations, in effect “leaving billions of potential economic gains on the table by not buying the most energy-efficient cars, clothes dryers, air conditioners, and light bulbs?”

It should be a red flag that something is amiss with an analysis that assumes such perplexing consumer and firm behavior that runs counter to the most rudimentary economic theory and our general sense that we do not live in a world in which people never make sound choices. It might be that there is something that is incorrect or perhaps even irrational in the assumptions being made in the regulatory impact analyses. Indeed, upon closer inspection it is apparent that there is no empirical evidence provided for the types of consumer failures alleged. Even if some consumers do sometimes fall short on certain dimensions of choice, the magnitude and prevalence of such a shortfall is important and is never addressed in the regulatory assessments. Nor is there adequate consideration of the actual and potential role of informational remedies that have already been adopted.

—Gayer and Viscusi

Gayer and Viscusi suggest directly that “Perhaps the main failure of rationality is that of the regulators themselves.” Agency officials given a specific mission tend to focus on those concerns, and assume others are either irrelevant or will be included at no additional cost in the post-regulation products, the authors posit. They suggest several possible courses of action:

• Noting that even though the legislation mandating these standards may not permit the Office of Management and Budget (OMB) to provide credible evidence of the market failures pivotal to justifying the regulations, the authors suggest that there could be changes to the analysis to show the true economic burdens of the regulations.

• OMB should also require agencies to prepare analyses in which the domestic greenhouse-gas benefits are included as benefits instead of the greenhouse-gas benefits to the world.

• Regulatory analyses for energy-efficiency regulations should have much firmer economic grounding than the current engineering approach.

Resources

• Ted Gayer and W. Kip Viscusi (2012) Overriding Consumer Preferences With Energy Regulations, Working Paper No. 12-21, Mercatus Center, George Mason University