Air Quality Regulation in California

1. Air Quality Regulation in California Toxicity of Diesel Particulate Emissions as a Growing Area of Concern: The Potential for Alternative Fuels and Approaches January 12, 2007 Jeffrey Bossert Clark Kirkland & Ellis LLP

2. Alternative Fuels • Numerous fuel technologies to reduce PM are available: • Biodiesel (B20) • E-DieselTM • Diesel-Water Emulsions • Fischer-Tropsch Diesel (FTD) • Diesel-Electric Hybrids • Dimethyl Ether (DME)

3. Biodiesel (B20) • Oxygenated fuel made from vegetable or animal fats. • Commonly produced from oilseed plants such as soybeans or canola. • Has properties similar to petroleum diesel fuel and can be blended with such fuel at any ratio, theoretically. Most common type is 20% biodiesel -- B20. Pure biodiesel is referred to as “neat biodiesel” or B100. • Biodiesel is non-toxic and biodegradable. • CARB reports that B20 reduces PM emissions by 22%, and neat biodiesel by 30%. National Biodiesel Board, however, has found fewer PM benefits from B20. • EPA has found mild increases in NOx emissions. • Virtually eliminates sulfur emissions of any kind.

4. Biodiesel (B20) • Availability of this fuel exists with numerous companies producing in the US market. Capacity can readily be expanded. • There are some handling issues because biodiesel is a solvent that can damage rubber seals and hoses in vehicles. • Gets about 10% less fuel economy and delivers 10% less power than conventional diesel. • Most major engine manufacturers have stated that B20 use (but not higher than 20%) will not void their warranties. • Costs depend on the specific feedstock used.

5. E-DieselTM • Really a specific type of biodiesel • Adding in bioethanol to represent 5-15% of the mixture. • John Deere reports 27% less PM and 20% less carbon monoxide from using E-DieselTM, but reductions as high as 40% reported. • Need to develop general industry standard so that quality issues among different producers can be normalized. • Requires additional handling care to ensure water not added • Obviously, a ready-for-market technology

6. Diesel-Water Emulsions • Adding water into diesel fuel • Emulsion fuels are defined as emulsions of water in diesel fuel and are typically made of 10 to 20% mass/mass water mixed with very specific additives, including surfactants, and diesel fuels. • Lubrizol has estimated that its diesel-water emulsion would reduce PM in highway diesels by 51-58% and in non-highway applications by 1623% • Boosts engine hydrocarbon emissions by 30-12%, but such emissions low from diesel engines. • Stability issues in switching between emulsion and non-emulsion diesel fuels

7. Fischer-Tropsch Diesel (FTD) • The Fischer-Tropsch process is a catalyzed chemical reaction in which carbon monoxide and hydrogen are converted into liquid hydrocarbons of various forms. • Typical catalysts used are based on iron and cobalt. • Produced from various feedstocks • Current capacity largely outside the US • Sasol & Moss Gas - South Africa • Shell - Malaysia • Potentially less expensive than diesel • CARB has been pitched about a Wyoming-coal feedstock FTD plant

8. Diesel-Electric Hybrids NYC Buses Experienced PM Reductions of 60% • Emerges from older technology used in trains, submarines, and ships, though that technology has no gearbox. • New type of hybrid technology, similar in concept to passenger car hybrids we’re now familiar with. • Technology increasingly being used on urban transit bus fleets, but still cost perhaps $100K more than conventional alternative. • No new infrastructure needed. • On the passenger-car side, powertrain of choice for the Partnership for a New Generation of Vehicles (PNGV) Program Liebherr Diesel-Electric Dump Truck

9. Dimethyl Ether (DME) • Easily stored and shipped • can use LPG tankers • Physically similar to liquefied petroleum gas (LPG) • Non-toxic • Very energy efficient • Large-scale DME plants currently don’t exist in large quantities. • Primarily used now in smaller quantities as a propellant.

10. Dimethyl Ether (DME) • Market development would be needed. • Cost reductions will have to occur. • BP projects cost differential over methanol (another oxygenate) expected to be 40% by BP into the foreseeable future • Need to develop economies of scale and specific application technologies • China and Japan pioneering plants

11. Alternatives to Alternative Approaches • This conference well represents several disciplines: • engineers and other bearers of scientific and technical knowledge • lawyers • public officials steeped in praxis • NGOs, and • even a journalist • But one key perspective is missing -- what is it?

12. Economics • Economists are missing. • Economists can help all of these disciplines in the environmental area do several things: • place stopping points on goals that can be pursued to varying degrees of intensity; • achieve the same goals at lower cost; • preserve the American economy as the engine that is what in fact creates demand for greater environmental achievement. • I’m not an economist, so you’ll have to make do today with a devotee of law and economics. • But generalist lawyer that I am, I can’t predict for you which fuel technology will be best. • Should be left to the market

13. Pigovian Taxes • Here, many economists would be quick to suggest to the assembled disciplines here the benefits of Pigovian taxes. • Arthur Cecil Pigou (1877-1959) was a Cambridge University pioneer of welfare economics. • Pigou was a student of the great Alfred Marshall, one of the fathers of microeconomics.

14. Pigovian Taxes • A Pigovian tax is defined as a tax imposed to counteract a negative externality. • A negative externality is a cost that society bears, but which is not reflected in market transactions because all of the true social costs are not borne by the relevant market producers. • Pollution is the classic example of a negative externality because private firms must pay only for actual inputs and do not usually feel the full costs of pollution.

15. Pigovian Taxes

16. Environmental Pigovian Taxes • Pigovian taxes have long represented a kind of holy grail of economic policy in the environmental area. • The perennial objection to such taxes has always been that they are immoral --because they are equated by some environmentalists with selling the right to pollute. • But, there’s an important new convert to Pigovian taxes, however. • Who is it?

17. The New Convert to Green Pigovian Taxes • It’s Al Gore, the former “environmental” Vice President. Glad to have him aboard. • Pigovian taxes have surely come a long way from the dreary equation-filled textbooks of the Dismal Science, if Al Gore endorses them. • And, of course, he has, in connection with his call to tax carbon output for global warming purposes.

18. Al Gore, the Caveat • There’s a reason for Dismal Scientists not to fully rejoice at their latest convert, though. • At a major speech on global warming policy at the New York University Law School last year, Mr. Gore attacked the concept of negative externalities as a term economists use to ignore full social costs. • Needless to say, this gets the contribution of economics to pollution-control policy backwards.

19. Advantages of Pigovian Taxes • The advantages of Pigovian taxes are numerous: • superior static efficiency (avoids costs of guessing wrong about proper technology at time zero) • superior dynamic efficiency (avoids delta between the technology horse chosen by command and control vs. actual optimal new pollution technologies over time) • lower administrative costs • actually generate revenue, which can be spent on pro-environmental causes including further pollution reduction and/or new pollution abatement technology

20. Diesel PM Pigovian Taxes • Addresses lag issue of diesel trucks being longer-lived than passenger cars because if tax is set at proper level, retrofitting will occur at the optimal level or in the meantime private firms benefitting from imperfect market prices will lose that advantage. • Tax proceeds can then be invested in new technology programs, in fuel infrastructure build outs, in clean-diesel purchases, or in retrofit programs.

21. Hybrid Pigovian Taxes • One criticism of a Pigovian tax approach is that existing EPA standards for engines and fuels will incentivize future diesel PM emissions to move in a positive direction, but what to do about the older diesel vehicles on the road? • But Pigovian taxes can be used as even finer regulatory devices by building tax preferences into them. • For instance, engine manufacturers could be taxed based on PM emissions per past engine manufactured still in use, and tax credits could be given per dollar or per fraction of dollar invested in engine-retrofit programs.

22. Choice of Diesel PM Taxed Entity • Pigovian tax on Diesel PM could be placed on engine manufacturers or on diesel fuel manufacturers, or split between both. • Economists would argue we should think systematically about which of those options is superior. • Considerations include static and dynamic efficiency, and I would also include public choice considerations in the mix -- i.e., real-world analysis of how political actors behave.

23. Choice of Diesel PM Taxed Entity • Coase Theorem holds that in the presence of minimal transactions costs all government allocations of property rights are efficient because parties will bargain to eliminate externalities at lowest possible cost. • As applied to the question of choosing the target entity for a Pigovian Tax, the Coase Theorem suggests that policymakers should, all else being equal, be indifferent as to whether to place a Diesel PM tax on engine or equipment manufacturers or fuel producers. • High transactions costs prevent bargaining between generators of diesel PM pollution and those affected by it.

24. Choice of Diesel PM Taxed Entity • But engine manufacturers and fuel producers face much lower transactions costs. • Hence, if tax were placed on engine manufacturers, and the problem is optimally solved by reformulated fuel, then taxed manufacturers will demand new fuel compositions to minimize the burden of the tax. And vice versa. • Only consequence of the choice of taxed entity in Coasian terms is distributional -- in other words, the taxed entity will be less profitable.

25. Choice of Diesel PM Taxed Entity • With that distributional effect in mind, and other variables, which entity should be chosen to be taxed? • Given the relative health of the petroleum industry vs. the severe problems being experienced especially in American manufacturing industries, there is reason to place the tax on the petroleum industry and not on the engine manufacturers. • Additionally, taking public choice concerns to heart, if regulators overshoot the optimal tax level, setting a tax that is too high, the elasticity of demand for fuel is almost always lower than that for large pieces of capital equipment or consumer durables. Hence, efficiency losses of overshooting are lower if fuel producers are the taxed entity.

26. Diesel PM Taxation Realities • Environmentalists in some quarters continue to resist Pigovian taxes • In public choice terms, regulators resist the diminishment of their power where taxes are substituted for command-and control regulation • This leads to a potential problem of double-regulation -- command-and-control regulation + Pigovian taxes, which is in fact what Mr. Gore advocates for carbon. • Negative externalities tend to get double-counted • the lesson of NHTSA’s recent fuel economy regulations for light trucks.

27. Diesel PM Taxation Realities • Industry rightfully fears being whipsawed between taxes AND command-and-control regulation. • EPA standards for engines • EPA standards for fuels • Congress has adopted the Diesel Emissions Reduction Act (“DERA”) -- a voluntary program to provide national and state & local grants and loans to reduce diesel emissions through retrofits. • With all of these approaches on the books, industry would want to look for a comprehensive program that would not duplicate existing efforts or simply “pile on” existing programs. • DERA’s approach as a Spending Clause program paid for by general revenues raises the environmentalists’ question, though, of why the tax incidence shouldn’t placed closer to the source of pollution instead of on the population generally.

28. Avoiding Double Regulation and Double Counting • Since industry would favor taxes over regulation of the same stringency because it achieves the objectives of pollution abatement at lower cost and because it enhances flexibility, how can we design a stable policy that won’t lead to double regulation and double-counting of externalities? • Given the real-world politics and past track records, the answer cannot be for California regulators to merely issue promises of a stable state tax/regulatory policy. • The answer is a legal one -- federal preemption doctrine.

29. Preemption as the Best Guarantor of a Stable Political “Deal” for Pigovian Taxes • To work, Pigovian taxes cannot be taxes on top of regulation. They must be an exclusive mechanism for the relevant type of pollution control. • Creation of federal preemption doctrine would yield exclusivity in a way that should be capable of inducing practical and economic reliance. • Preemption is not the enemy of States, but collectively their friend. It’s simply a statutory counterpart to Dormant Commerce Clause theory, by which all States benefit as participants in a national common market. Cf. the European Union.

30. Threats to Preemption • The biggest question marks are the attitudes of local courts within and often including the Ninth Circuit, which have often shown themselves hostile to preemption, e.g.,: • Engine Mfrs. Ass’n v. South Coast Air Quality Management District, 541 U.S. 246 (2004) (reversing Ninth Circuit’s original anti-preemption ruling by 8-1 vote); • Air Conditioning and Refrigeration Institute v. Energy Resources Conservation and Development Commission, 410 F.3d 492 (9th Cir. 2005), cert. denied, 126 S. Ct. 2887 (2006) (Ninth Circuit’s anti-preemption ruling allowed to stand).

31. Questions Re Preemption • California’s special benefit under the Clean Air Act to regulate mobile sources. • Laws that privilege the regulation of commerce by one State over all others are and should be constitutionally suspect. Chafe against national markets. Export costs. • Assuming it was correct to confer such a benefit at the Act’s dawning, is it wise to maintain it? • Have, for instance, Houston’s air quality problems eclipsed those of Los Angeles, and shown them to no longer be (if they ever truly were) unique? • I simply pose the questions. I haven’t the answers.

32. Avoiding “Adding to Entropy” • Being a realist, neither EPA nor Congress is going to overturn EPA’s current diesel standards in favor of a Pigovian tax. Nor is industry likely to abandon the DERA general-revenues funding approach unless the advantages are clear. • The point of this presentation is to re-interject economic thinking back into this area so that policymakers can think about superior solutions the next time that diesel regulation (PM or otherwise) is up for major revision. • Or in the spirit of this presentation as one about alternatives, the alternative of Pigovian taxes can be considered as a solution for any environmental problem.

33. CONCLUSION • We have briefly examined several promising fuel technologies. Without doubt, these should be explored. I’d prefer the market to explore them rather than regulators. • If it’s innovation we seek, we should investigate more ambitious alternatives to bring regulation into the 21st century by looking at Pigovian tax alternatives. • Such alternatives can work at lower cost, while raising revenue, and achieving the same pollution-reduction goals. But to work at the state level, they likely need federal preemption. • Can California rise above its self-interest to proceed in the national interest? Can EPA abandon old ways? More command-and-control regulation for its own sake isn’t a solution. It’s an orthodoxy.

34. SOURCES • R. H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1 (1960). • Diesel Forum -- <<www.dieselforum.org>> • F.G. Jauss IV, A Bridge Too Far: The EPA’s Diesel Sulfur Rule and the Increasing Costs of Fuels Regulation Under the Clean Air Act, 53 Admin. L. Rev. 1021 (2001). • A.P. Morris, et al., Regulating by Litigation: The EPA’s Regulation of Heavy-Duty Diesel Engines, 56 Admin. L. Rev. 403 (2004). • A. C. Pigou, The Economics of Welfare (1st ed., Macmillan and Co. 1920). • A. C. Pigou, Wealth and Welfare (1st ed., Macmillan and Co. 1912). • The Passenger Cases, 48 U.S. (7 How.) 283 (1849). • R.A. Reiley, The Case for Regulating Ultrafine Particles under the Clean Air Act, 14 Penn. St. Envtl. L. Rev. 483 (2006). • Toyo Engineering Corp., Press Release, Toyo Engineering Awarded Large DME Plant for China (Jan. 4, 2006).