July 24, 2020

Recommendations to Improve Consistency and Transparency in the EPA’s Clean Air Act Benefit-Cost Analyses

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The Environmental Protection Agency (EPA) is seeking comments on its proposed rule, “Increasing Consistency and Transparency in Considering Benefits and Costs in the Clean Air Act Rulemaking Process” (hereafter referred to as the EPA benefit-cost rule). If implemented, this proposed procedural regulation would commit the EPA to adhering to certain analytical practices when establishing regulations under the Clean Air Act. In general, the EPA should be applauded for embracing economic analysis in its rulemaking process and attempting to commit to some best practices, and many features of the EPA’s proposal are praiseworthy. However, the regulation in its present form also has some shortcomings. To improve the regulation, this comment makes three broad recommendations:

  1. The EPA should more clearly define any vague terminology in its proposed regulation, particularly terms such as “benefit-cost analysis,” “social benefits,” and “society.”
  2. The EPA should commit to presenting disaggregated benefits and costs in its analysis, specifically categorizing impacts in terms of whether they pertain to investment, mortality, and people in other countries.
  3. The EPA should not adjust its $100 million threshold for economically significant regulations for inflation. Nor should it not commit to monetizing all costs and benefits in its regulatory analysis.

Definitions

The EPA consistently uses vague terminology throughout its rulemaking, especially with respect to terms such as “well-being,” “society,” “social welfare,” “benefit-cost analysis,” “social benefits,” and “social costs.” If such terms are not clearly defined, the EPA’s analysis could suffer and may not measure anything particularly meaningful. In general, the EPA should be clear that it intends its analysis to measure efficiency, specifically Kaldor-Hicks efficiency (since there are two types of efficiency—Pareto efficiency is the other).

The EPA should also clarify its definitions of benefits and costs. According to the Office of Management and Budget, “‘Opportunity cost’ is the appropriate concept for valuing both benefits and costs.” However, the EPA’s proposed regulation seems to suggest that only costs are measured in terms of their opportunity cost (while benefits are measured in terms of changes in “societal well-being”). Moreover, it is the opportunity cost to society that is the relevant metric here, where “society” refers to all individuals with standing in the analysis, now and in the future. The EPA should clearly define “society” to make clear exactly who gets standing in its regulatory analysis.

Finally, the EPA pays little attention to the “opportunity cost of capital” in its proposed regulation; i.e., the returns to invested capital created or displaced by its regulations. The EPA’s proposed rulemaking should define the “opportunity cost of capital” and commit to measuring it, since this is a critical input in any benefit-cost analysis.

The following definitions would constitute substantial improvements if added or substituted in place of those definitions currently in the EPA’s proposed rulemaking:

  1. “Benefit-cost analysis” (BCA) means an evaluation of the positive and negative changes associated with the action. The normative foundation of BCA is the potential compensation test of Kaldor and Hicks. BCA answers the question of whether the benefits for those who gain from the action are sufficient to, in principle, compensate those burdened, such that everyone would be at least as well off as before the policy. The calculation of net benefits (benefits minus costs) measures the economic efficiency of a regulation, where economic efficiency refers to Kaldor-Hicks efficiency, a situation whereby the dollar value of aggregate wealth in society is maximized.
  2. “Social benefits,” or “benefits,” means the positive incremental changes accrued as a result of the regulation or policy action. Benefits are measured in terms of their social opportunity cost, which in practice usually refers to the maximum amount society is willing to pay for the benefit.
  3. “Social costs,” or “costs,” means the negative incremental changes incurred as a result of the regulation or policy action. Costs are measured in terms of their social opportunity cost, which in practice usually refers to the minimum amount society is willing to accept as compensation for a loss.
  4. “Society” refers to all individuals with standing in the analysis, now and in the future. By default, those with standing are typically citizens and residents within the United States. Standing can be granted to other individuals when impacts on other individuals are of concern.
  5. “Opportunity cost” means the value of the next best alternative to a particular activity or resource. Willingness to pay captures the notion of opportunity cost by measuring what individuals are willing to forgo to enjoy a particular benefit.
  6. “Social opportunity cost” is the value society is willing to forego to enjoy a particular benefit. It refers to what the market price of a resource would be in a perfectly competitive market, free of distortions such as externalities. If the market for a resource does not exist or substantial market failures are present in a market for a good, then the social opportunity cost of the resource is the price that would emerge if the market did exist and if affected third parties (including those in the future) could trade in the market at zero transaction costs.
  7. “Opportunity cost of capital” means the returns to invested capital that are not reflected in a capital asset’s price. It can be expressed as the marginal before-tax rate of return to private capital in the US economy. A base-case rate of 7 percent shall be used to account for the opportunity cost of capital in the EPA’s regulatory analysis.

Disaggregating Benefits for Summary Tables

The EPA is requesting comment on whether and how it should present disaggregated benefits and costs within a table that summarizes conclusions of its BCAs. In general, it would be helpful if the EPA would commit to doing this. Moreover, the following are examples of types of benefits and costs the EPA should take care to single out in such a table:

  • The EPA should delineate between benefits and costs that are consumed and those that come in the form of investment.

In general, the proper way to conduct BCA is to separate consumption and investment, since these different benefits and costs have different rates of return associated with them. If an analyst doesn’t discern which benefits and costs are invested and which are consumed, he or she can have little confidence that the opportunity cost of capital has been accounted for in analysis.

  • The EPA should distinguish domestic benefits and costs from international benefits and costs, and it should use an international measure of willingness to pay when presenting benefits and costs from an international perspective.

At the outset of an analysis, an analyst must decide who gets counted in the analysis (this is the issue of standing mentioned earlier). This can be determined by several factors. One is democracy. For example, US regulatory agencies might be responsible for considering the effects only on people within the borders of the United States, since these are the people within the agencies’ jurisdiction. Or, standing might be determined by the distribution of policy impacts. For example, when individuals in other countries are affected, impacts on them might be included as well, but should be presented in a disaggregated manner such that it is clear which benefits accrue to people in the United States and which accrue to people in other countries. Moreover, when the scope of analysis extends to individuals in other countries, the social opportunity cost of resources should be valued from an international perspective as well. For example, the EPA often uses a population average value of a statistical life to monetize mortality benefits in its analysis. When analysis is conducted from an international perspective, the relevant average would be the global average value.

  • The EPA should present mortality benefits separately, including countervailing changes in mortality.

The agency should clearly break down how many lives are expected to be saved from its rules and present this number unconcealed by factors such as discounting. It should also present the “gross” and “net” mortality reduction, where the net mortality reduction accounts for countervailing risk increases (or decreases) owing to income losses (or gains) induced by the regulation.

$100 Million Designation: The EPA Should Not Adjust This Threshold for Inflation

The EPA is seeking comment as to whether it should adjust for inflation the $100 million “economically significant” designation for its rules, resulting in a higher threshold to qualify for mandatory scrutiny. It should not. The $100 million threshold was always an arbitrary cutoff. All else equal, it is better for more regulations to be analyzed than fewer, unless the EPA can demonstrate that the burden imposed on the agency by doing so outweighs the benefits. At this point, so few regulations are analyzed, let alone analyzed credibly, that it is hard to imagine why analyzing fewer regulations would be sensible.

The EPA Should Drop Its Commitment to “Monetize All the Benefits”

The EPA is proposing to commit to “monetize all the benefits” to the extent practicable. However, monetizing all benefits in a BCA is not necessary, realistic, or even desirable in most cases. This commitment may open up EPA rules unnecessarily to challenges. The EPA should drop this commitment.

Conclusion

This comment has made a number of recommendations to the EPA about ways to improve its proposed benefit-cost rule. While the nominal commitment of the agency to adhering to sound benefit-cost practices is noteworthy, there remain problems with the EPA’s proposed rule as it now stands. However, a few simple but important changes could go a long way toward improving this rulemaking and improving future EPA regulatory analysis.