Regulation and markets are often compared as if they were incompatible. Yet among the greatest contributions of the economic profession to the world is market-based regulatory policymaking. Where laws of yesteryear relied heavily on bans and mandates with minimal regard for compliance costs, regulatory policy today is far more likely to rely on markets for compliance. Early experiments in the 1980s validated the theory underlying compliance markets, and their use ballooned thereafter.
Market-based regulatory designs help minimize the costs of regulation while enjoying just as much of its benefits, whatever those may be. Compliance markets now play a role in U.S. policies regulating numerous air pollutants, vehicle fuel economy, and fisheries, greenhouse gas mitigation efforts of the European Union, California, and the multistate Regional Greenhouse Gas Initiative in the U.S. Northeast, and numerous other policies throughout the world. Among these policies is the Renewable Fuel Standard, which mandates the use of renewable fuel sources in U.S. transportation fuels.
Regulatory compliance markets are products of government policy, however, and their efficacy depends heavily on how they are governed. When an underlying regulatory policy constantly shifts, or when there is room to lobby your way to an exemption, market mechanisms won’t provide all the benefits that basic economic models predict. Policies that require frequent, subjective bureaucratic decisions invite these problems. Recognizing this issue reveals simple fixes that would provide better information about future compliance costs to market actors and better secure whatever benefits a regulation seeks to provide. The Renewable Fuel Standard’s compliance credit market serves as an unfortunate example of how these markets can fall short, but first we need to understand how market-based regulation is supposed to work.
The Basics of Tradeable Compliance Credits
As an introductory example, consider proposals for combating climate change. A government interested in regulating carbon emissions might compare a market-based system like cap and trade to a command and control system. Under command and control, the government might set specific technology standards for different industries or mandate specific volumes of carbon that they must reduce. The targeted industry then must comply or die; regardless of the cost of compliance, their continued existence relies on their ability to meet the new standard, even if there’s a much cheaper way to reduce carbon emissions in a different industry right next door.
Under a cap and trade system, the government instead sets a total carbon emissions cap and somehow allots permits to emit that carbon. A market emerges for these permits; if I can reduce one ton of carbon emissions more cheaply than you can, I’ll simply sell you one of my permits at a slight markup and reduce my own emissions. You avoid paying your own, higher mitigation cost, I make a small profit by selling my permit, and we can both satisfy the carbon regulation. In theory, compliance costs across the entire economy are minimized; low-cost industries sell credits and reduce emissions, high-cost industries buy the credits and continue operating without prohibitively expensive adjustments.
Of course, real-world market-based regulation is more complex, but the basic formula described above is already operating in numerous regulations. On top of limited global adoption of carbon markets, tradable permits are used to help minimize compliance costs in regulating atmospheric sulfur dioxide, chlorofluorocarbon, and nitrogen oxide emissions, waterway nitrogen emissions, vehicle fuel efficiency, and wetland development.
Compliance Credits Under the Renewable Fuel Standard
Compliance credit markets are also built into the Renewable Fuel Standard (RFS), which requires U.S. fuel blenders to mix biofuels, primarily corn-based ethanol, into domestic fuel supplies. Under the RFS, the Environmental Protection Agency (EPA) sets yearly biofuel volume targets, which measure in the billions of gallons. Fuel blenders across the country are liable to meet some allotted portion of that target.
When a blender purchases biofuel and blends it into gasoline or diesel, they receive a Renewable Identification Number (RIN), which is what they ultimately submit to the EPA to prove compliance. That RIN can be traded, allowing blenders with cheap and easy access to ethanol to blend more than their allotted share and sell the excess RINs to blenders without such easy access to ethanol.
The RFS falls short of the idealized market-based regulation in a number of ways. For one, market participants often do not even know the mandate they need to meet. While the EPA is supposed to release the year’s volumetric mandates on November 30 of the preceding year, they routinely miss this deadline. The Trump administration recently missed it for 2021, electing to punt the decision to Biden’s incoming team (there is still not even a proposed rule for 2021). This sounds bad, but it’s been far worse; 2014’s mandate wasn’t finalized until November 30, 2015, almost a year after the compliance period had already ended! These mid-year compliance announcements cause dramatic swings in the prices for RINs, as documented in my recent CGO working paper.
Another perennial RFS issue is Small Refinery Exemptions (SREs). The RFS allows refiners whose daily crude throughput is less than 75,000 barrels to petition for exemption if complying would cause them a “disproportionate economic hardship.” Who receives SREs is not public information, but the number issued swung from only 7 in 2015 to a whopping 35 in 2017 (accounting for 9.4% of the total mandate volume). It’s hard to imagine what “disproportionate economic hardships’’ could have befallen so many refiners in 2017. Some SRE recipients have been made public, and since exemption decisions are made at the refinery (rather than the company) level, multinational corporations like Chevron and Exxon Mobil are among the beneficiaries. In early 2020, the 10th Circuit Court of Appeals ultimately agreed that the EPA had been excessively issuing SREs, and that decision again sent shocks through RIN markets.
The RFS is filled with bureaucratic touchpoints: the EPA has to propose a new mandate every year, field public comments, and release a finalized regulation. They have to consider dozens of applications for SREs and decide who to give them to. They play a number of other administrative roles in RIN markets. Each of these touchpoints introduces scope for lobbying and rent-seeking to infect the market; biofuel firms, refiners, and consumer advocacy groups initiate new campaigns and submit lengthy regulatory comments every year when mandates are proposed. Refiners fight for exemptions and biofuel groups fight the EPA to withhold them.
I’ve so far held aside whether incentivizing biofuel usage makes sense as federal policy — to be clear, I have made arguments in many other writings that the mandate is bad policy and damages the environment. But taking the policy’s goals as given and assessing how well the market helps advance those goals is a separate analysis. With all its shortcomings, the RIN system is still superior to a would-be command and control system with similar objectives. Yet, the excessive volatility induced by the constant opportunities for bureaucrats to muck with the fundamentals of the market reveals obvious room for improvement.
How to Make Better Market-based Policy
Fortunately, there are plenty of ways for lawmakers to “bind themselves to the mast.” Policies requiring frequent bureaucratic updates could often be replaced by formulaic rules. Flexibility intended to limit the potential of catastrophically high compliance prices can be replaced by simple price collars. Even limiting the frequency of subjective bureaucratic decision making could make a difference.
Many of the bureaucratic touchpoints sprinkled throughout the RFS are simply not necessary. Why are we still having the EPA make annual mandate adjustments, when they’ve missed their annual deadline by over a month for more than half of the last decade? Simply limiting these adjustments to occur every three or every five years would limit touchpoints, and grouping multiple years into single rulemakings already happens out of the necessity of making up for delays. Even better would be setting up a clear and formulaic rule that determines the mandate’s level. Requiring every regulated party to buy renewable fuels equal to a defined percentage of their sales would eliminate most of the modeling and guesswork that goes into the EPA’s current volume-based rulemakings. Both lengthening timelines between adjustments and making policy more formulaic would narrow the scope for rent-seeking, slow the onslaught of market swings, and provide some much-needed certainty to market participants. Consumers and industry both benefit from greater clarity.
Policymakers developing the Renewable Fuel Standard probably thought they were helping control compliance costs by designing the policy as they did. What if the mandates are too high? — let the EPA revise them downward every year. What if there’s a particularly vulnerable refiner that may go out of business? — let the EPA exempt small refineries. The net effect of these “pressure valves”, however, is to turn up the political heat and reduce the policy’s effectiveness. Rather than effectively minimizing compliance costs, keeping open frequent opportunities for rent-seeking undermines the operation of the compliance credit market in the first place. If lawmakers really feel the need to include pressure valves, they can do so without adding bureaucratic touchpoints by including a formal price cap — a trigger price where the regulator sells additional permits to prevent further price hikes. It’s better for both refiners and biorefiners to know the compliance cost maximum ahead of time, rather than guessing at when the EPA will intervene (and pushing to influence that decision).
Future policymakers should avoid introducing bureaucratic touchpoints to compliance markets when using predictable rules can work. Giving clarity to market participants makes compliance markets work better; and when those compliance markets are geared towards important environmental objectives, that helps us all live in a greener world at lower cost.