California’s auto-emissions policy hits a Tesla pothole — Christopher Knittel

MIT Sloan Prof. Christopher Knittel

From The Wall Street Journal

It is a basic tenet of economics that regulations almost always have unintended consequences. While Adam Smith may have been one of the first to understand this, he could not have possibly foreseen the morass of expensive and unwanted consequences that could come from conflicting emission and fuel standards enacted by the state of California and federal programs, such as for greenhouse gases and Corporate Average Fuel Economy.

Both the state and federal regulations have worthy goals: to decrease greenhouse-gas emissions and lower petroleum consumption. Yet taken together, the federal standards effectively cancel out the California standard. Instead of promoting fuel reduction as intended, the California standard allows for the production of less-efficient vehicles, while facilitating a massive transfer of cash via credit trading. It also forms a de facto industrial policy that sends us down a path toward electric vehicles that may or may not be the best technological or environmental choice for the future.

These are complicated regulations, so let me explain:

The State of California Zero Emission Vehicle (ZEV) standard requires a certain percentage of an auto maker’s California sales to be zero-tailpipe-emission vehicles. For 2014 this requirement is about 1% of sales; the percentage is expected to ramp up to 16% in 2015. In principle, these sales can be either electric vehicles or some other technology such as hydrogen fuel-cell vehicles, but currently electric vehicles are the only real option.

If a manufacturer doesn’t meet this standard, it must buy zero-emission-vehicle credits from a manufacturer that has a surplus of credits. Tesla, for example, makes only electric vehicles and therefore has a surplus of credits. General MotorsGM +0.47% was a major buyer of credits in 2013, purchasing over 300 zero-emission credits and over 500 “partial” credits. These numbers will continue to increase as the zero-emission mandate becomes more stringent.

The zero-emission mandate thus creates large transfers of wealth across automobile manufacturers. The beneficiaries of these transfers are companies selling more than their “fair share” of electric cars. For example, each Model S that Tesla sells generates seven zero-emission-vehicle credits that Tesla can sell to auto makers that are not selling their fair share. Recently, these credits sold for $5,000 each, bringing Tesla $35,000 in extra revenue for each Model S sold. Nissan 7201.TO -2.57% (the Leaf) and Toyota7203.TO -0.85% (plug-in Prius) have also generated credits. On the other side of the ledger, companies selling few electric vehicles must raise the prices of their vehicles to pay for the zero-emission mandate.

The California policy is then superimposed on the federal standards, which require that the average fuel economy across a manufacturer’s entire fleet of U.S. vehicles exceeds federally mandated standards for greenhouse-gas emissions and fuel economy. For example, the 2016 target requires that the average fuel-economy rating per vehicle across all manufacturers be 35.5 miles per gallon.

There are, however, a number of features that complicate this rule. For example, federal standards give special double credits for each electric vehicle a manufacturer produces. Given this feature, the end result of adding California’s zero-emission-vehicle program to the federal standards is to reduce overall fuel economy—precisely the opposite of what was intended.

Here’s how this works: Ignoring all other special credits under the federal program, if no electric vehicles were sold, average fuel economy in 2016 would be exactly equal to 35.5 mpg. However, each time an electric car is sold, the average fuel economy of all regular vehicles sold is allowed to decrease by more than the reduction that could be credited to an extra electric vehicle on the road. Why? Because electric cars garner double credits. Admittedly, the reduction in fuel economy is likely to be small, but what is important is that fuel economy moves in the wrong direction.

To be sure, supporters of the zero-emission-vehicle mandate may contend that there is another, more advantageous unintended consequence. They argue that these rules are promoting innovation in new technologies and new types of cars. Yet even if that were true, I would argue that there are better ways to promote innovation in the auto industry. The current process is flawed because it forces investment in a technology that may not end up being the ultimate winner.

Focusing on zero tailpipe-emitting vehicles overlooks an excellent alternative because policy makers are suffering from something that many in the industry believe consumers suffer from: Miles Per Gallon Illusion. MPG Illusion is when consumers do not realize that increasing fuel economy from 15 mpg to 20 mpg saves much more gasoline than going from 45 mpg to 50 mpg, because the former increase represents much a larger percentage. In other words, for someone driving 15,000 miles a year, the 45-to-50 mpg jump saves only 33 gallons a year, while the 15-to-20 rise saves 250 gallons. While the zero-emissions mandate may shift some Prius buyers to an electric car, the best option for reducing petroleum consumption and greenhouse-gas emission is shifting a large SUV buyer into a less-large SUV.

The government needs to be in the business of setting overall environmental goals and standards on both the state and federal levels that make sense both separately and together, not a confusing, conflicting set of rules. And it needs to get out of the business of picking market winners and losers.

See the full post in The Wall Street Journal.

Christopher Knittel is the William Barton Rogers Professor of Energy and a Professor of Applied Economics at the MIT Sloan School of Management.

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