Regulation vs. torts

Responding to libertarian commenters, Paul Krugman argues that torts are not nearly as effective as environmental regulations in practice.

Commenters say, but isn’t that an equally strong reason to believe that regulation won’t work either?

Well, here’s the thing: regulation demonstrably does work where tort law doesn’t. Consider the environmental issue: in reality, the perpetrators of oil spills never pay most of the cost; but in reality, environmental regulation has led to much cleaner air and water. (Look up the history of Los Angeles smog or the fate of Lake Erie if you don’t believe me.)

Tyler Cowen dissects Krugman's argument in his typical incisive and dispassionate style, scoring points (except I don't think he's keeping score) like:

There is in fact an agency regulating off-shore drilling and in the case under question it totally failed. How can Lake Erie, an orthogonally related success, be cited but this very directly relevant failure not be mentioned?

As usual, Cowen comes across as eminently sensible and I find it hard to disagree with much that he says. Am I just too rushed, and/or not trying hard enough?

WWID: Recognizing high dimensionality

In Chapter 6 of What Works in Development, Ricardo Hausmann makes, in commentator Ross Levine’s words, an “imaginative, provocative, and substantive” argument that much work on economic growth willfully ignores the complexity inherent in the classical development formula (“peace, easy taxes, and justice” in Adam Smith’s words, or trade openness, sound finances, and property rights, to paraphrase Larry Summers). Providing the right public inputs, particularly regulation, to enable a nation to develop new productive capabilities is a very “high dimensional” problem, which Hausmann compellingly illustrates with the myriad policy elements required to enable an efficient real estate market.

The necessary information to determine optimal policies is highly dispersed, Hausmann continues, and in such a context central planning is bound to fail. Unlike a product market, the market for public inputs lacks mechanisms to aggregate information (prices), incentivize action (profits), and allocate resources (capital markets). Hausmann then hypothesizes that in the United States, the open political architecture allows lobbyists may play a market-making role in the provision of public inputs. (Not without some rent-seeking, of course, but this is a necessary tension “in the absence of an omniscient and benevolent social planner.”)

How, then, to incorporate broad input into the provision of public inputs in developing countries? He doesn’t have all of the answers, and neither do commentators Nava Ashraf (who suggests looking to social enterprise for systems) and Levine (who uses the example of racism to argue that institutions themselves evolve in response to underlying incentives, and their change cannot be mandated independently of those incentives). But I find the question alone quite profound.

Very interesting stuff… I will have to let it marinate for a while, and hope to have further reflections at some point.

Speculation is not manipulation

In the fine tradition of Thomas Malthus, famous Stanford finance professor Darrell Duffie has penned an op ed entitled "In Defense of Financial Speculation: It is not the same thing as market manipulation." He has a sharp mind and makes the case well.

First, speculators perform valuable market functions by taking risk and disseminating information (remember Enron?).

Speculators earn a profit by absorbing risk that others don't want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.

Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment's value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country's default.

Is this sort of speculation wrong? I have not heard why.

The distinction between "speculation" and "manipulation" is important.

Those who call for stamping out speculation may be confused between speculation and market manipulation. Manipulation occurs when investors "attack'' a financial market in order to profit by changing the value of an investment. Profitable speculation occurs when investors accurately forecast an investment's fundamental strength or weakness.

Manipulation is much harder to pull off than making a simple directional bet.

Market manipulation for profit is not easily done... Simply driving up the price, as speculators are alleged to have done in the oil market in 2008, is not enough. To make a profit, a manipulator needs to obtain monopolistic control of the supply. Given the size of the oil market, that seems implausible, absent a major and sustained conspiracy.

As long as speculators do not crash and destabilize financial markets with them, they are not where regulatory attention should lie.

It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation.

Worth keeping in mind the next time someone starts ranting about "reckless speculation."

The regulatory revolving door

Much has been made of its contribution to the financial crisis, but the regulatory revolving door is alive and well in the resources sector as well:

Prosecutors are investigating whether Norton was discussing future employment with Shell before she stepped down as Interior secretary in March 2006, when she was in charge of a process that resulted in Shell winning three lucrative leases to research and develop oil shale projects on federal land in Colorado.

Nine months after resigning, Norton accepted a job in a Shell division that includes its oil shale efforts.

I'm not terribly interested in whether Norton acted improperly or not here; the bigger issue is that for all the incentive problems this revolving door creates, the alternative - an environmental regulator staffed with mediocre talent and completely lacking in any industry expertise - could be even worse. Simon Johnson, among others, has written extensively on regulatory capture in finance, but I haven't seen nearly the same degree of coverage in natural resources. I wonder if we will, given that many people have nothing to gain and a lot to lose by opening their mouths, and use of natural resources does not entail the same type of systemic risk that the financial system does (at least, not on the time-scale appreciated by politicians and voters).

Nuclear's long regulatory march

A U.S. nuclear renaissance faces many hurdles, not the least of which is the government:

On Wednesday, General Electric claimed a significant step toward getting one of its advanced reactor designs, the Economic Simplified Boiling Water Reactor, approved by the Nuclear Regulatory Commission — although the model has recently lost most of its customers.

G.E., along with its nuclear reactor partner, Hitachi, said on Wednesday that it was moving ahead. "Over the last five years, we have answered well over 6,000 questions from the N.R.C.," said Daniel L. Roderick, senior vice president of G.E.-Hitachi. "We have all of those answered; we have zero open right now."

But while Exelon, the Chicago-based utility, had planned to build two of G.E.’s new reactors in Victoria County, Tex., the utility dropped the idea last November, at least partly because of delays in design certification. It switched to an older Hitachi design.

Dominion, another large energy provider, still has plans on file for an E.S.B.W.R. in Virginia, but it says it is exploring alternatives.

Detroit Edison is the only company still on record as wanting to build an E.S.B.W.R.

Safety should be the top priority, of course, but bureaucratic inefficiency isn't doing the technology any favors in the race to reduce emissions from the nation's power generation.

The Waxman-Markey "windfalls" myth

In social conversations about climate legislation, one objection that often comes up to the Waxman-Markey bill that passed the House is that, contrary to Obama's campaign promise to auction 100% of the permits, 85% are "given away" in Waxman-Markey, representing a "windfall" to those companies that receive then. This is a perception issue, not a substance issue. As I showed before, ~80% of the free permits will be effectively rebated to consumers, and most of the balance going to clean tech, energy efficiency, international purposes (e.g. avoiding deforestation) and adaptation.

In a recent conversation, a good question came up - what about the 5% of the permits which are allocated to merchant power generators? Won't that constitute a windfall, as they are not required to pass on savings like a regulated utility?

My answer at the time was that merchant generators will have to use the permits for power they end up generating (except for renewable power, but they should receive cash value for renewable power they generate), so the only windfall would be if they do not generate enough to require their 5% allowance allocation and the rest can be sold on the open market.

Here is a related post on Climate Progress by two electricity market experts on why W-M doesn't create windfall profits for utilities. However, I didn't see any mention of the merchant (unregulated) generators in the post, so I'm not sure whether they are meant to be included in the argument, or were omitted. If the latter, and the authors are hiding behind "the bulk of free allowances", I'd like to hear their thoughts on whether the merchant generators could in fact capture a windfall from the current allowance allocation structure.

My provisional conclusion is that the upper bound on profit windfalls is quite low, but I'm not yet completely convinced that merchant generators can't benefit at all.

How environmental regulations work

Robert Stavins cites an older paper which makes an interesting point on the way in which environmental regulations affect markets (the example is the chlorine industry):

We found that the effects of the regulations on the likelihood of adopting membrane technology were not statistically significant. Mercury plants, which were subject to stringent regulation for water, air, and hazardous-waste removal, were no more likely to switch to the membrane technology than diaphragm plants. Similarly, TRI reporting appeared to have had no significant effect on adoption decisions.

We also examined what caused plants to exit the industry, with data on 55 facilities, 21 of which ceased operations between 1976 and 2001. Some interesting and quite striking patterns emerged. Regulations clearly explained some of the exit behavior. In particular, indirect regulations of the end-uses of chlorine accelerated shutdowns in some industries. Facilities affected by the pulp and paper cluster rule and the Montreal Protocol were substantially more likely to shut down than were other facilities.

The point is that, while regulators expected their actions to increase the number of plants using membrane technology, they ultimately did so via subtraction (of old plants), not addition (of new ones).

It is good to remember that the diffusion of new technology is the result of a combination of adoption at existing facilities and entry and exit of facilities with various technologies in place. In the case of chlorine manufacturing, our results indicated that regulatory factors did not have a significant effect on the decision to adopt the greener technology at existing plants. On the other hand, indirect regulation of the end-uses of chlorine accelerated facility closures significantly, and thereby increased the share of plants using the cleaner, membrane technology for chlorine production.

Environmental regulation did affect technological change, but not in the way many people assume it does. It did so not by encouraging the adoption of some technology by existing facilities, but by reducing the demand for a product and hence encouraging the shutdown of facilities using environmentally inferior options. This is a legitimate way for policies to operate, although it’s one most politicians would probably prefer not to recognize.

As Stavins implies, environmental regulations are not necessarily job creators, and the politically catchy myth of the green job revolution is not very helpful for the public dialogue on this contentious topic.

Ranchers key to phasing out corn ethanol subsidies?

Most everyone besides corn farmers think corn ethanol subsidies and protective tariffs in the U.S. are a bad idea, but with 21 farm states and 15 of those producing over >200m gallons of ethanol (couldn't find the link, sorry), it is tough to get anything done in the Senate without those farm senators on your side. (Not to mention the House). And with the Iowa primary looming large over any presidential election, it is equally dangerous to the executive branch (although John McCain commendably declared opposition to the subsidies late in his 2008 campaign). So most political observers think doing away with the ethanol subsidies and tariffs is unlikely to happen

Via Chris Clayton, two brave and progressive Congressional Representatives have introduced a bill to do just that. Chris asks a loaded question:

The question, though, is who would gain from such legislation, second-generation ethanol or imported sugar-based ethanol from Brazil?

Well, without U.S. subsidies and tariffs Brazil would become the lowest-cost ethanol provider overnight, so imports would gain (and second-gen ethanol remains a ways out). And corn farmers would obviously receive lower prices due to lower corn demand and a weakening of the food-energy link. What's new to me is the idea that there is another group who would also benefit tremendously:

“After 30 years of support, corn-based ethanol is still reliant on government support to be commercially viable," stated Gary Voogt, president of NCBA and a rancher from Marne, Mich. "It is time to allow it to compete on a level playing field, and to stop propping up one industry at the expense of another.

“Since January of 2008, cattle feeders have lost a record $5.2 billion in equity due to high feed costs and economic factors which have negatively affected beef demand...

“Soaring feed costs and government payments to the ethanol industry are hurting small businesses and family ranches. Cattle producers don’t ask for subsidies, just equal footing.

“The legislation introduced by Representatives Crowley and Mack allows for a market-based approach to our nation’s competing demands for corn, and helps us meet both our food and fuel needs,” NCBA stated.

Could ranchers counterbalance the farmers and underpin the success of this legislation? It seems like a long shot, but the mere idea makes me more optimistic than I have been for a while.

Oil speculator witch hunt goes global

Market speculation is a very convenient scapegoat. Having effectively blamed speculation for food volatility, U.S. regulators are moving on to oil:

The Commodities Futures Trading Commission (CFTC) is considering a plan, which already has widespread support in Congress, that would "impose limits as necessary to eliminate, diminish or prevent the undue burdens on interstate commerce that may result from excessive speculation."

To add international stature, none other than Gordon Brown and Nicholas Sarkozy penned a joint editorial in the WSJ calling on the International Organization of Securities Regulators to "reduce damaging speculation" in world oil markets.

Simon Johnson at the Baseline Scenario parses - he "welcomes" the CFTC's moves but calls the G8 rhetoric "disingenuous."

More generally, I question whether the actual rules which will be implemented to limit "damaging" speculation will actually reduce volatility overall - as someone else wrote recently (can't remember who but it stuck with me), one man's speculator is another man's welcome provider of market liquidity. Remember the onions...

Breaking news: Government intervention appears to end well

While its recent track record of intervention in the energy industry is not great, the U.S. government appears to have successfully shepherded both GM and Chrysler through bankruptcy at record speed:

In fewer than 45 days each, General Motors and Chrysler swept through government-sponsored sales in bankruptcy court — quick tours that most people in the legal community thought impossible not long ago.

Felix Salmon poses the million-dollar question - "How?":

But who or what should get the credit? Steve Rattner? The two judges involved? Section 363 of the federal bankruptcy code? And is this a heartening precedent for the wave of future bankruptcies which seems inevitable when all those leveraged loans mature over the next four or five years? Or is it a one-off, linked to extreme levels of government involvement, which is unlikely to be repeated?

Now, GM and Chrysler are hardly out of the woods; nevertheless, this impressively efficient performance (not to mention flashes of unquestionable brilliance like making the GM logo green) complicates the traditional free-market meme that government intervention always makes things worse. Diehard capitalists mustn't be too depressed, though - the House of Representatives is moving with equal speed to undo the White House's success.

Picking winners in nuclear

It's not what the U.S. government says they want to do, but after doing it in nuclear by doling out selective loan guarantees, it didn't take long for the effects to be felt:

Exelon Corp. has called off plans to build two new nuclear reactors in Victoria, Texas. The culprit, chairman and chief executive John Rowe, told the Associated Press was “worries over the economy and the limited availability of federal loan guarantees.”

Court rules against genetically modified alfalfa

I'm no lawyer, but the ruling that Monsanto's Roundup Ready Alfalfa "can cause potentially irreversible harm to organic and conventional crops" seems like a potentially monster precedent, given the current regulatory uncertainty around GM crops.

The cost of regulatory uncertainty

Futuregen loses two major power companies.