EPA’s Ethanol Regulation provides an informative case study for the water industry about regulation.  Defining tradable rights in regulatory targets provides flexibility in achieving regulatory goals.  Probably equally as important is that the prices established in those markets provide immediate feedback on the economic impact of regulation. 

Ethanol Regulation

Federal legislation passed in 2005 established the Renewal Fuel Standard.  Administered by the Environmental Protection Agency, the standard sets a schedule for increasing the minimum amount of renewable fuel used each year in transportation fuels.  EPA uses a market-based compliance system.  Refiners must submit credits to prove that they used the required amount of renewable fuel or paid for each year.  The credits are tradable.  A market has arisen for the purchase and sale of these credits.  Refiners and blenders of gasoline acquire the credits by either blending the renewable fuel or buying credits in lieu of blending.  Prices have historically traded around four cents per credit.

Now, the teachable moment about the information content of prices. 

EPA sets a schedule for renewable fuels regardless of demand.  The amount of ethanol used in gasoline has reached 10%.  EPA is now mandating a schedule that, based on demand, would increase ethanol’s share above 10%.  Using more than 10% ethanol is not technically feasible.  As one can imagine, EPA’s schedule is a controversial issue within the refining industry.

One imagines that the EPA standard has proven a boon to K Street and Beltway denizens.  Trade associations and firms generating studies on the economic costs of the regulation.  Environmental interests counter-punching with their own information and opinion.  Countless emails exchanged via Gmail.

Is this just another policy quagmire?  Who knows?

The credit market has spoken.  Credit prices have exploded from four cents to $1.45 per credit, a 3,525% increase!  This market feedback was immediate.  Like prediction markets, the credit market represents the “wisdom of crowds” about the impact of Ethanol regulation.  What the political process does with this information, of course, is another matter.

EPA announced last month that it would consider reducing the renewable fuel mandate next year.

What Does This Have to Do with the Water Industry?

A lot.  Water quality regulation is an important aspect of the water industry.  EPA has a tradition, dating back to the 1970s, of promoting market-based, or “cap and trade” (to use today’s jargon) systems to ease compliance.  The traditional case for market-based systems is flexibility in meeting defined standards.  The other case for them is that the prices provide information about the economic impact of regulation.  This price information can guide investments in and adoption of new technology.  Prices also provide important source of “feedback” to the politics of regulation.

As the scope of water quality regulation expands, look for market-based compliance to become more widespread.   Will regulators embrace credit markets as a valuable feedback tool, or will they view the market as “barbarians at the gate”.?

Political Postscripts

This post is inspired by an article “Bad Ethanol Policy is A Job Killer,” by Rep. Patrick Meehan, House Representative (R-PA) and Pat Eiding, president of the Philadelphia Council of the AFL-CIO, Wall Street Journal, September 3, 2013.  The authors call for more immediate EPA action.  They cite the case of a Pennsylvania refiner where, at current prices, the cost of their credit purchases will exceed twice the price paid for the refinery.  The article also cites concerns about the transparency in the credit market and the role of “Wall Street speculators”.  More on Wall Street speculators, transparency and markets in later posts.

Market-based approaches to environmental regulation, including water quality has bi-partisan roots.  See The Gore Report on Reinventing Government, 1993