Regulation by litigation: diesel engine emission control.

• Author: Yandle, Bruce

In the past few years, a form of federal regulation has emerged that makes the established rulemaking process look almost benign by comparison. Besides producing a steady flow of new rules to regulate the behavior of firms and industries through a process that follows due-process procedures and adds new pages to the Federal Register, the U.S. Environmental Protection Agency (EPA) has been filing lawsuits for the purpose of regulation. Thus, the EPA's enforcement division has added a second engine to the regulatory train. As Robert Reich, secretary of labor in the Clinton administration, has observed, "The era of big government may be over but the era of regulation through litigation has just begun" (1999). This new form of regulatory activity is called regulation by litigation (Viscuzi 2002; Yandle, Morriss, and Kosnik 2002).

When agency-sponsored suits are piled on top of agency rules, regulated firms and their customers get caught in a maze so filled with unexpected costs and outcomes that the motivating public-interest goals, if present at the outset, can get lost in a dizzying hurricane of briefs and penalties. After a while, for example, no one seems to be checking on air quality. Along the way, the incentive for regulated firms to settle and thus escape the costly maze becomes all the more attractive.

Reich's comment came after the attorneys general of forty-six states had signed a $246 billion settlement with the tobacco industry that specified, among other things, how the firms would market their products. In addition to providing much-welcomed revenues to hard-pressed states, the settlement leaves the industry regulated by litigation (Rhodes 2003).

As the tobacco suits were going forward, the EPA was suing and settling with the major producers of heavy-duty diesel engines. Under attack by the EPA's enforcement division, the engine producers were charged with using EPA-approved electronic controls--developed in large part in response to earlier regulation--to "defeat" EPA's mandated engine emissions tests. In a good example of the regulatory double-speak common at the EPA, the engine controllers were said to have "defeated" the emissions standards by ensuring that the engines met precisely the EPA standards using EPA's tests. Because the EPA's engine test focused only on simulating urban driving conditions, however, meeting the test standard allowed the engine controllers to focus on mileage rather than on emissions under highway driving conditions. In effect, the EPA sued the engine manufacturers because the engine makers had not designed their engines to meet a test procedure EPA had not created.

Despite the legal absurdity of the EPA's position, in 1998 the firms and the EPA signed a $1 billion settlement that tightens the previous regulatory standards and specifies how the industry will regulate emissions of nitrogen oxides (N[O.sub.x]). Other industries caught in the EPA's regulation-by-litigation maze include major refinery operators, electric utilities, and wood-product firms.

In this article, we examine regulation by litigation by focusing on the EPA's suit against diesel engine manufacturers, but we seek to do more than just examine and organize the details of a complex regulatory story. Our purpose is to explain why regulation by litigation emerged when it did and to identify the circumstances in which, given the choice, regulators will select this regulatory instrument when seeking to chasten an industry or to alter industry behavior. We begin with some theoretical background on regulation, showing how theories that claim to predict regulator behavior can be applied to regulation by litigation. Then we turn to the centerpiece of our report, an analysis of the diesel engine episode of regulation by litigation.

Litigation as Regulation

Theories of regulation may help us to understand the choices regulators make when they decide to take action. For example, public-interest theory (Bernstein 1955) holds that politicians and their appointees systematically seek to serve a broad public interest, always searching for lower-cost ways to provide public benefits. Dissatisfaction with this theory's inability to predict outcomes and a recognition of what in fact seemed to be going on led to the development of the capture theory (Kolko 1963), wherein the regulated end up "capturing" the regulators. Capture theory seemed to gain traction in predicting regulatory outcomes, but it failed to predict which of several competing special-interest groups would win the contest to capture the regulator. George Stigler (1974) and Sam Peltzman (1976) developed positive theories that now form the basis of a rich body of prediction-based empirical work explaining the details of regulation (see Yandle 2001). Fred McChesney (1991) added a refinement to these theories with his "extraction" theory. Instead of explaining the features of regulations added to the legal landscape, extraction theory explains political actions taken to postpone or end regulatory ventures. In these episodes, politicians in effect extract payments from threatened firms and industries in exchange for calling off the regulatory hounds. Finally, the "bootlegger and Baptist" theory (Yandle and Buck 2002) explains how regulation can occur as one supporting group (labeled Baptists) takes the moral high ground while another (labeled bootleggers, who are reinforced by the Baptists) simply seeks to gain competitive advantage.

No one theory of regulation can be viewed as sufficient to explain all regulatory actions. However, out of these theories comes a common notion that concentrated gains and diffuse costs can help explain the regulatory process. All else being equal, regulators will attempt to spread the cost of their action across a large number of relatively powerless consumers while facilitating a concentrated political gain. Firms that have the most to lose or gain will struggle longest and hardest to alter or deflect regulatory costs. Regulation by litigation fits this pattern.

Consider the tobacco episode. The gains from the tobacco settlement are concentrated in a relatively few hands--the attorneys who bring the suits, the tobacco companies that are cartelized by the action, and state politicians who have more money to allocate to favored projects. Meanwhile, the cost of the settlement is imposed on smokers worldwide. Outside the Western world, most smokers are unaware of the settlement and its costs, and in the United States smokers may not know that the higher prices of cigarettes incorporate in part the costs of the settlement.

In a similar way, the EPA's suit against diesel engine producers involved a small number of heavy-duty engine producers, firms such as Cummins, Caterpillar, Detroit Diesel, Navistar-International, and Volvo, as well as a massive number of users who purchase diesel engine-equipped trucks and other machinery. Together, these parties bore the costs. Who were the winners? We argue later that the EPA and the Clinton White House reaped political gains from a high-profile settlement accompanied by multi-million-dollar fines levied against these few large, well-known companies. In this sense, the executive branch of the federal government was the bootlegger who operated under the cover of environmental "Baptist." As a result, the costs of the EPA's action now are spread across a huge number of truck and equipment purchasers.

Were there other winners, in a relative sense? Perhaps. We can also examine the diesel episode in another light. Regulation by litigation also may be used to divide and conquer. Traditional regulation often requires all firms in an industry to adopt similar technologies or to meet similar standards. This coincidence of interest spurs them to create a cartel, enabling them to wrest some benefits from regulation, such as higher prices. Successful suits attacking one or two major firms in the industry will disrupt this regulation-based cartel, raising costs for the firms that are sued and keeping them from opposing regulatory actions that might be taken against other firms in the industry. Indeed, the bruised firms may become quiet supporters of action against their competitors, arguing for a level playing field. Competition in the struggle to develop a "winning" regulatory technology becomes more productive than competition to build more desirable consumer products.

During important political seasons, when symbols can be more important than substance, if not themselves the substance, regulation by litigation can be used to capture valuable political gains that old-fashioned regulation cannot. Regulation by litigation is quicker, requires no extended announcements and related hearings, is not subject to administrative safeguards, and, once in the courts, is more costly to alter through political action. Unlike regulations that may be in the pipeline and not yet final, which can be cancelled by mere notice in the Federal Register suits in progress tend to continue. Then, when settlements occur, the announcement of large civil penalties telegraphs to important constituents the message that enforcement actions are being taken. The size of the settlements can be esteemed as a trophy by those who favor regulation. Regulation-by-litigation trophies can then serve as glittering bookends for the boring pages of traditional regulation that rarely make headlines once the rules are in place and are operating.

The Regulatory Options

Like most regulatory agencies, the EPA has three options when initiating a new regulation.

First, the agency can engage in "regulation by rulemaking." This involves a notice of the proposed rule, a comment period for any and all parties to express their reactions to the agency, and a final notice of rulemaking, which responds to the comments received from interested parties. Once the regulation is final, affected parties bring suit against the agency if they have a basis for...