The Low Carbon Fuel Standard: An expensive option for increasing CO2 emissions

In April, California adopted a Low Carbon Fuel Standard (LCFS). Since then, Governor Schwarzenegger has been marketing the policy to other states and even Canada. (Both British Columbia and Ontario have agreed to adopt the standard). Until recently, a LCFS was an element of the American Clean Energy and Security Act of 2009 (H.R. 2454) but was dropped after it became clear that the standard would sink the bill. That’s good news – for now – since the policy will, at best, be much more expensive and less effective than a carbon tax or a cap-and-trade scheme, and, at worst, increase global CO2 emissions.

To see why, imagine you are a Canadian energy company that sells two types of automobile fuel – Dirty and Less-dirty. For simplicity, assume you sell 10 units of each fuel to California and to China. Dirty contains much more CO2 than Less-dirty – 19 lbs of CO2 per gallon versus 15. Nonetheless, you make more money selling dirty – $1 per gallon versus $0.5. Table 1 shows the situation for your sales to California: Your total profit is $15 and your fuel produces a total of 340 lbs CO2 or an average of 17 lbs per gallon (340 lbs /20 gallons).

Concerned about CO2 emissions, California adopts a Low Carbon Fuel Standard, which mandates that the average amount of CO2 contained in the portfolio of fuels you sell to the state must be no higher than 16.5 lbs. Thus, you need to decrease your average by 0.5 lbs. How will you do it?

The effectiveness of the LCFS depends on you responding passively: If, as shown in Table 2, you simply sell 3 more gallons of Less-dirty and 3 fewer of Dirty, you comply with the standard, and the Standard succeeds in lowering CO2 emissions. Unfortunately, your total profit will decline to $13.50. On the other hand, if you are not feeling so sheepish, you have two other, more appealing options. Since China hasn`t adopted the same standard, the most obvious thing to do is simply move two gallons of Dirty from California to China and two gallons of Less-dirty from China to California. In the industry jargon, this is called “shuffling”. Your profits stay the same and you comply with the standard. Unfortunately, total global CO2 emissions stay the same – the Low Carbon Fuel Standard has no effect.

Though, in reality, there would be an effect: Since the standard causes your company to change what was its optimal sales strategy, it now cost you more to deliver your fuel. If you are large enough or your competitors complied by doing a similar type of shuffling, then at least some of those increased costs will be passed onto consumers.

Suppose there were some other transaction costs or restrictions that prevented you from shuffling your fuels between California and China. You still have another option: you can keep your sales of Dirty to California constant while increasing your sales of Less-dirty to California. For instance, suppose you cut the price of Less-dirty in half in order to increase your sales to 17 gallons. As shown in Table 3, by inflating your sales of Less-dirty, you comply with the standard and your total profit, $14.25, is higher than it would be if you decreased your production of Dirty. Nonetheless, though your average emissions comply with the standard, your total CO2 emissions actually increase to 445 lbs. In other words, the LCFS causes a significant increase in CO2 emissions.

This example is intentionally designed to lead to the extreme result where emissions increase. Realistically, the LCFS will cause producers to do a combination of shuffling and price-cutting of relatively cleaner fuels to comply with the standard. The result will be that CO2 reductions will be much lower than policy makers claim and the costs will be much higher. In particular, Economists from UC Berkeley and Davis estimate it will cost between 5 and 10 times more for a LCFS to accomplish the same CO2 reduction as a carbon tax or cap-and-trade.

Though the California Air Resources Board claims that the LCFS is not a tax and that it will lower energy prices, the opposite must be true. In fact, the precise problem with the LCFS is that it subsidizes relatively cleaner fuels and over-taxes relatively dirtier ones. Hence, producers produce too much of some fuels and too little of others. Such market distortions impose large and real costs on an economy. The simple truth is that if you do not directly tax the consumption you want to discourage, then there will be efficiency losses - it will cost more to accomplish the same reduction – because the rational response of consumers and producers is always to try to maneuver around the policy’s objectives, and a direct tax gives the least maneuvering room. Which is why, if the policy is sufficiently indirect – and the LCFS may be – then you can actually make things worse.

I imagine many policy makers are aware of these flaws. However, since voters have signaled an unwillingness to accept higher energy prices to reduce CO2 emissions, the higher costs associated with a LCFS are likely considered a worthwhile tradeoff since the LCFS tax is hidden. This is not just bad policy, it is undemocratic.

Looking for competition in all the wrong places

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Looking for competition in all the wrong places

That increased competition will lower health care costs and increase accessibility seems widely accepted (at least publically) – even among those on the left. But the leading reform proposals do not address the barriers to competition and will accelerate cost growth, even if a “public option” isn’t adopted.

America’s health care market has a distinctive quality: over time, technology advances are associated with higher costs. This is unlike most markets. (Consider computers, high definition TVs, and digital cameras.) And the difference is not caused by something special about health care technology. For instance, the quality of cosmetic surgery has increased while its cost has decreased (see table): since 2003, the cost of each of the five most popular cosmetic surgeries has increased at about the rate of inflation, whereas health-care costs have climb at over twice that rate. What makes health care different?

The knee-jerk response is to say we need health care to survive and, thus, will pay anything for it. Yet Americans obviously have limits on what they are willing to pay for health care or health care cost would consume far more than 16% of GDP. And if increasing caused were due to the necessity of health care, then we should see the same pattern for food and clothing, but we don’t.

The difference between the food and health care markets can be explained by differences in the level of competition, but it is not a problem that can be solved by adding a government-owned health insurance provider to the hundreds of existing providers as many on the left are suggesting. Rather the solution is embodied in one of the most useful (and used) quotes from Milton Friedman: “Nobody spends somebody else’s money as carefully as he spends his own.” For 60 years, the government has been encouraging consumers to buy health care using as much of other peoples’ money as possible. Since most Americans aren’t paying for what they consume, they continuously demand more and better services with little consideration of the additional costs. And since, in the U.S., the supply of health care isn’t rationed – as it is in other countries with universal health care – the market has been unrestrained to provide incredible technology with little regard for cost.

Thus, unlike for food, clothing, and cosmetic surgery, health-care suppliers don’t compete to provide better value – more for less – but, instead, only better products. This tendency is clearly seen when you compare the growth of costs in the different health-care sectors to the amount of the percentage of the costs consumers pay out-of-pocket (see chart). The more consumers pay out-of-pocket, the slower costs grow. Consumers pay nearly nothing out-of-pocket for hospital care, and the cost in that sector have increased by over 7% per year. On the other hand, consumers pay nearly 84% out-of-pocket for durable medical supplies, and costs in that sector have increased by less than 2.5% a year, or around the rate of inflation.

On average, Americans pay about 20% of their health care costs out-of-pocket. This is too low: Americans are paying for nearly all their health care costs using insurance, which is not the purpose of insurance. We buy insurance to protect ourselves from rare, devastating events. Our fear of these events allows insurance providers to sell insurance at a cost that exceeds the expected payout by about 18%. That’s fine, but bad tax policy is encouraging Americans to buy too much coverage: both employer contributions and employees’ expenditures on health care insurance are tax deductable, which causes the real price of insurance to be negative. For example, if the value of an insurance policy – the consumer’s expected health care expenses during the year – is $100, the insurance company will sell the policy for around $118. But since the premium is tax deductable, the consumer – assuming a 25% tax rate – pays only $89 for $100 worth of coverage. At the same time, out-of-pocket health-care expenses are not tax deductable. This makes it rational to buy policies with very low deductibles, since the tax advantage makes it cheaper to use insurance – rather than money – to pay for, for example, a $200 visit to the doctor.

Since health-care consumers are not using their own money, they are not sensitive to price. Doctors use patients’ insensitivity to cost as an additional form of malpractice insurance: doctors prescribe precautionary services (an MRI, X-ray, a longer hospital stay…) that they wouldn’t otherwise prescribe if they had no chance of being sued and consumers cared about cost.

This suggests that 60 million uninsured and partially uninsured Americans may be one of the system’s most important sources of competition. For example, it is estimated that by 2012 Americans will spend $160 billion abroad on less expensive hospital services. You can be sure that American hospitals are competing to keep some of that money. Insuring those 60 million uninsured will greatly weaken their incentive to shop-around and hospitals’ incentive to control cost growth.

This is not to say, we shouldn’t create an environment where everyone has access to health care. But implementing any policy that increases the number of insured but does not address the source of rising costs will only lead to more rapid cost increases, since fewer people will care about cost. And the system cannot take even the current growth rate for much longer.

In their book Healthy, Wealthy and Wise, Glenn Hubbard and John Cogan propose a simple solution: make all health care expenditures, including out-of-pocket costs, tax deductible. This would not only make health care more affordable, but it would also increase consumers’ incentives to buy policies with higher deductibles. In turn, the higher deductibles would cause consumers to be more conscious about costs. The authors estimate that this change – along with some other modest policy changes like tax credits for the poor – would reduce costs by 9% and increase the number of insured by 20 million.

Regarding the current debate in congress, it would be appropriate if policy makers followed the same principle as doctors: first, do no harm. Rather than starting the reform process with major, risky structural changes to the current system, we should first implement less intrusive – but effective – policy changes that address the real barrier to competition – the “it’s not my money” effect.

James Eaves is an economist and Professor of Finance in Université Laval’s business School. His personal blog is practicalpolicy.com. He welcomes your comments at james.eaves@fsa.ulaval.ca.