Tailored regulation: will voluntary site-specific environmental performance standards improve welfare?

• Author: Blackman, Allen

1. Introduction

   There is a growing consensus among policymakers that command-and-control environmental regulation stifles efficiency and innovation by requiring heterogeneous plants to adopt similar abatement strategies. While market-based instruments such as tradable permits and emissions fees address this problem, there are a variety of political and economic barriers to their immediate and widespread application. As a result, the last decade has witnessed a number of efforts to modify existing regulations to give individual plants more control over pollution abatement. Chief among these efforts at limited reform is Project XL, the flagship of the Environmental Protection Agency's (EPA) regulatory reinvention initiative. Participating plants are allowed to develop pollution control strategies that "replace or modify specific regulatory requirements" on the condition that these strategies improve their environmental performance (Federal Register 1995). In essence, Project XL defines voluntary site-specific performance stand ards that are more stringent than the de facto standards implied by current regulation and gives plants "regulatory flexibility" to meet these standards in unconventional ways.

   Blackman and Mazurek (2001) provide detailed descriptions of the first eight XL projects to be implemented. Half of these projects involve replacing complex technology standards that require a plant to obtain new air permits whenever its production process changes with a single plantwide emissions cap that leaves the plant free to reconfigure its production and abatement process as long as total emissions do not exceed a predetermined limit. The plants implementing these four XL projects are in sectors where production processes change continuously and existing technology standards and permit requirements are particularly costly. (1)

   Project XL has had a troubled history, in large part because of administrative problems at the EPA (Caballero 1998). Nevertheless, it will almost certainly emerge as a prototype for similar efforts. President Clinton touted it as a "regulatory blueprint for the future," a characterization that has pervaded analysis of the project (Phillips 1995). (2) Such characterizations appear increasingly credible. In the last several years, a number of influential policy reports have called upon Congress to replace command-and-control regulation with a performance-based system (National Academy of Public Administration 1997, 2000; Enterprise for the Environment 1998). Toward that end, the Second Generation of Environmental Improvement Act has been introduced in Congress to provide the legislative underpinnings for a broad-based Project XL-like program (Inside EPA Weekly Report 1999; Inside EPA 's Environmental Policy Alert 2001b). Recent pronouncements by Bush administration environmental officials affirm the continued i mportance of Project XL and similar regulatory initiatives (Inside EPA's Environmental Policy Alert 2001a; Whitman 2001). (3) A number of such programs have already been adopted at the state level (Larsen 1998; Inside EPA's Environmental Policy Alert 2000).

   All of these programs-which we refer to as tailored regulation (TR) programs-have common characteristics that we have alluded to above: They are voluntary (i.e., plants choose whether or not to participate), they entail a shift away from technology and process standards and toward more flexible performance standards, and they require participating plants to demonstrate "superior environmental performance." (4) In addition, TR programs have two characteristics we have not yet touched upon. First, they require firms to pay a fixed cost to participate. This cost is for negotiating a performance standard with regulators, developing monitoring procedures, and (in some cases) investing in new types of pollution control equipment. For example, Blackman and Mazurek (2001) found that the average fixed cost of putting Project XL agreements in place is approximately $325,000 per firm, not counting the costs of new pollution control equipment. Second, TR programs emphasize the diffusion of "regulatory innovations" develo ped at participating plants to nonparticipating plants. The EPA claims that diffusion is the principal aim of Project XL. The Second Generation legislation also stresses transfer of the benefits of plant-specific agreements. (5)

   From the point of view of firms, the main attraction of TR is the significant cost savings that can arise from being allowed to circumvent "one size fits all" command-and-control regulations. While TR requires an improvement in environmental performance that would raise costs, all other things being equal, and that could theoretically completely offset cost savings from regulatory flexibility, the net impact of TR is always to reduce a participant's marginal production costs, that is, to shift the participant's marginal cost curve down. The reason for this is simply that TR is voluntary, and a plant will choose to pay a fixed participation cost only if marginal costs fall. The experience of Project XL participants confirms this logic. For example, a pulp-manufacturing plant that was allowed to substitute plantwide caps on air, water, and hazardous waste emissions for conventional technology and effluent standards reported savings of $200,000 in materials costs in the first year of the project and predicted ov er $10 million in savings during the 15-year term of the agreement. Several other XL participants have reported cost savings of similar magnitudes (U.S. Environmental Protection Agency 1999b). (6) It is important to note that TR participants do not necessarily achieve cost savings because they adopt innovations that enable them to produce both "cheaper and cleaner." Rather, their costs fall because they are able to circumvent inefficient command-and-control regulations.

   There are at least two reasons to believe that TR will enhance welfare. First, as just noted, TR can generate significant cost savings for industry. In addition, the superior-environmental-performance rule ensures that environmental quality will not deteriorate. Notwithstanding these benefits, one troubling feature of TR is that it enables participating firms to operate under a different set of guidelines than their competitors. Therefore, TR could have detrimental welfare impacts by providing cost savings--and hence a competitive advantage--to selected firms. Stakeholders increasingly recognize that site-specific regulatory flexibility can have competitive impacts (Inside EPA 2001a).

   In this paper, we analyze whether and how TR, compared with a command-and-control regime, can reduce social welfare, and we develop policy prescriptions aimed at avoiding undesirable outcomes. Using a simple model of competitive interaction, we find that TR can reduce welfare in oligo-polistic markets. Although TR always has a positive impact on consumers' surplus (because output prices fall) and on environmental quality (because of the superior-environmental-performance rule), it can reduce producers' surplus by lowering the production costs of relatively inefficient firms, thereby helping these firms "steal" market share from more efficient firms. We also find that regulators' efforts to diffuse the benefits of TR agreements among nonparticipating firms dampen incentives for firms to participate for the same reason that incentives to invest in conventional research and development are dampened when firms are able to free-ride on their competitors' investments.

   A brief survey of the relevant literature is presented in section 2. In section 3, a generic modeling framework is developed. Using this framework, the properties of TR assuming monopoly and duopoly are examined in sections 4 and 5, respectively. A summary and conclusions are presented in section 6.

2. Literature

   To our knowledge, this is the first economic analysis of voluntary site-specific performance standards. However, it contributes to a growing literature on the economics of voluntary regulation.

   The literature has focused on three types of explanations for firms' willingness to enter into voluntary regulatory agreements. The first explanation is that in undertaking voluntary agreements, firms seek either to preempt future regulation and enforcement or to encourage more stringent de facto regulation in order to raise rivals' costs. For example, Segerson and Miceli (1998) suggest that a "background legislative threat" motivates participation in a voluntary agreement (along with government abatement cost subsidies and the promise of lower compliance and transaction costs).

   A second explanation for participation in voluntary agreements is that firms seek to capture consumers willingness to pay for goods produced in an environmentally friendly manner. For example, using a vertical product quality model, Arora and Gangopadhyay (1995) show that firms may voluntarily overcomply with regulatory standards in order to attract high-income green consumers.

   A third explanation is that firms enter into voluntary agreements to reduce their production costs. This is the motivation for firms to participate in TR in our model: The regulatory flexibility TR confers lowers firms' production costs. By contrast, almost all existing analyses concern voluntary agreements that raise production costs (Brau and Carraro 1999).

   Our model is also distinguished from the bulk of the literature on voluntary regulation by its focus on competition. We adopt this focus because as a firm-specific cost-saving regulatory option, TR clearly can have competitive impacts. Few other papers have focused explicitly on the link between voluntary regulation and competition. However, Brau and Carraro (1999) survey related literature to draw some preliminary conclusions. Like us, Brau and Carraro find that there may be a tradeoff between the environmental benefits of voluntary regulation and the economic costs...