Friday, May 29, 2009

Incentive distortions in fuel economy regulations

Over the past week, both China and the US have adopted stronger automotive fuel economy standards in an effort to increase fuel economy and thereby reduce greenhouse gas pollution from burning gasoline. The Obama administration has announced more stringent Corporate Average Fuel Economy (CAFE) standard - a single standard nationwide, rather than two fuel efficiency standards, one for California and the 13 other states that chose to follow its more stringent Pavley standards, and another standard for the rest of the country under the existing CAFE program.

Harvard Professor Robert Stavins however feels that CAFE is a less effective instrument in addressing the global warming challenge than gasoline taxes or cap-and-trade approach. The former is an one-time levy on new vehicle purchases and thereby affects which cars are purchased, whereas the latter affects both vehicle purchases and the driving preferences. He also sees two other distortions in the CAFE standards approach

1. CAFE standards increase the price of new cars, and thereby have the "unintentional effect of keeping older — dirtier and less fuel-efficient — cars on the road longer". In other words, the CAFE standards increase becomes an example of vintage-differentiated-regulation.

2. CAFE standards decrease the cost per mile of driving and thus exhibits a "rebound effect". "People have an incentive to drive more, not less, thereby lessening the anticipated reduction in gasoline usage".

An interesting research paper by Lawrence Goulder, Mark Jacobsen, and Arthur van Benthem find similar incentive distortions arising from the dual fuel efficiency standards (California and 13 states and the rest) and other state specific initiatives.

1. The interaction between these state-level limits and the federal CAFE standard, gives automakers incentives to offset emissions reductions in the Pavley states with increased emissions in other states.

2. It induces substitutions of used cars for new cars and leads to reduced scrapping of used cars and thereby counteracts the initiative’s GHG emissions reduction goals.

James Kwak has this detailed post about the impact of CAFE standards on manufacturers, car buyers and the economy (jobs etc).

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