Avoiding Regulatory Gridlock in the Acid Rain Program

Abstract

One must be careful what one wishes, lest it come true. For over two decades economists have extolled incentive-based regulation as the way to achieve environmental and other social goals at less cost than traditional commandand-control approaches. Title IV of the Clean Air Act Amendments of 1990 finally conforms to these economic prescriptions. The so-called acid rain initiates the largest experiment in history in the use of incentivebased environmental regulation, namely marketable discharge permits. In one important respect this experiment deviates significantly from the assumptions of most economic analysis. Incentive-based regulation of sulfur dioxide (SO2) at the national level will overlay a well-established system of electric utility regulation at the state level. However, economic analysis has usually been limited to the role of incentive-based environmental regulation, in a competitive market, or occasionally, to the role of market power on behalf of producers in an unregulated market, while excursions into the realm of a regulated industry have been few.1 This paper examines how the SO2 trading program will be affected by electric utility regulation. We find that the success of the program will depend on the practice of public utility at the state level (state regulators hereafter): The program could be a ringing success, or it could perform worse than traditional command-and-control regulation. We believe that the federal government has a role to play in affecting the outcome. In accord with the decentralized nature of incentive-based regulation, success will require innovative and flexible leadership by the federal government rather than preemptive policymaking.