FOUNDATIONS OF THE REGULATORY STATE

Prof. Jeffrey Gordon

Spring Semester, 2000

 To help you to understand the grading of your Reg State exam, I’ve prepared this packet, which includes "sample" answers. These are answers written during the exam that I thought well of, to give you an idea of what could be accomplished given actual exam constraints. (I have made minor editing changes and emendations.) These answers are not "model answers"; they miss some things and may even get some things wrong, although not very wrong. I have included more than one answer for each question.

I had mixed reactions to the overall class performance on the exam. Questions IA and IB were basic "entry level" questions, designed to explore how factual context matters in applying similar analytic tools and considerations. The questions were linked in the sense that

both raised standard insurance issues (adverse selection/moral hazard, including the ways that moral hazard problems can exacerbate adverse selection) and questions of redistribution. I was hoping more of you would draw attention to the similarities and differences in, for example, the moral hazard problems of a prescription drug program vs. flood insurance or the redistribution entailed by 50% coverage of program costs from general revenues for a drug prescription program for the elderly vs. flood insurance for homeowners in flood-prone areas.

Question II is based on a genuine New York statute (that Pataki signed even before getting your advice). I meant for you to focus on the lawyer’s work of seeing how particular policy ideas get expressed in statutory form, asking you to think about the incentives the statute creates and thus showing an understanding of its microstructure. The basic policy issue, which we discussed in class (using a Lilco example), is how cap and trade schemes work best if there are heterogeneity of abatement costs and homogeneity of abatement benefits, i.e., if plants incur different costs to reduce pollution but each unit of pollution reduction has the same benefit. The New York statute is based on the fact that this is not so for SO₂ emissions because of prevailing wind patterns, the "hot spots" problem. Notwithstanding the good intentions, will this scheme work? Most of you caught the basic statutory mechanism (with varying degrees of clarity and depth): the imposition of a tax ("air mitigation offset") equal to any profit made by a New York utility on the sale of emission allowances "vintaged" (meaning, accrued through allocation or created by emission reduction) after 2001 to utilities in "acid precipitation source states." Such a tax would eliminate the incentive for these sales and will stop them. Withdrawing New York allowances in this way is supposed to reduce the overall supply of allowances for upwind utilities and thus to raise the cost of such allowances. The upwind utilities would then have an incentive to reduce their SO₂ emissions, substituting, at the margin, some greater abatement for some amount of foregone allowances. Enforcement proceeds through a combination of self-reporting by New York utilities and tracing of allowance sales through the EPA allowance registry.

(Many of you were misled by New York’s statutory cloaking of a regulatory prohibition as a revenue-raising scheme to fund research and amelioration of acid rain problems. This disguise is presumably to avoid Supremacy Clause and Commerce Clause problems; assuming utilities were behaving rationally, they would sell no allowances and pay $0 tax, and there would be no fund.)

Would the scheme work as a technical matter? In particular, how would it work to stop the flow of permits directly and indirectly to upwind utilities? The tax applies to sales of allowances "for use in" complying with SO₂ emission requirements in upwind states. Why would this cover a New York sale of an allowance to an California utility, say, (or to an allowance broker) which immediately turned around and sold the allowance to an Indiana utility? The New York seller has no specific intention or knowledge at the time of sale that the allowance will end up in Indiana. Not enough of you focused on the lawyer’s point that the statute does not say "that were used in" upwind states in describing the allowances against which the tax would be assessed.

The statute, however, is structured on the assumption of a broader reach, hence the direction to the PUC to draft a restrictive covenant that if added to the allowance transfer will give the selling utility a safe harbor against tax assessment should the allowance ultimately be transferred for use in an upwind state. The restrictive covenant also gives enforcement power to New York state for wrongful transfer. And let’s assume that the EPA registry permits perfect tracking of allowances to their ultimate use.

Now will the scheme work? Some of you saw with varying degrees of clarity and depth that the almost certain answer is "no," and that in the worst case scenario New York is imposing costs on its citizens and its utilities with no benefit. This is because in a national trading market, all allowances are fungible; thus the New York restriction will not reduce the supply of allowances to upwind utilities; thus these utilities will not reduce their SO₂ emissions. Assume a New York utility sells an allowance to a California utility that is a net purchaser of allowances. This transaction frees up a Montana seller of allowances (say) to sell the allowance to an upwind utility instead. In other words, with modest transaction costs, an intermediary could direct New York allowances to non-upwind utilities and redirect the allowances that the non-upwind utility would have purchased to upwind utilities. The New York statute is complied with but the level of acid rain is unchanged. But it gets even better: assume the California utility is a net seller of allowances (because the proximity to low-sulphur coal makes it a low cost abater). It still needs some SO₂ allowances to cover its remaining emissions, but it can now buy a New York allowance and then sell its "own" allowance (that it would otherwise used itself) to an upwind utility. Once again, the statute is complied with, but the level of acid rain is unchanged. These results don’t depend on New York’s share of the overall national market in allowances.

Who bears the transaction costs of the redirection? New York utilities, of course, in the first instance, because the price of New York allowances is lower on account of the special tracking that is required. This presumably reduces the incentives at the margin for SO₂ abatement by New York utilities, meaning a higher level of SO₂ emission. Unless all New York power plants are located in the Hamptons, some of this emission will be dumped on New York state.

So why did the New York legislature enact this statute? (And why should Pataki sign it?) A few of you who got this far took a jaundiced (realistic?) view: the legislation is perfect politics in giving the environmentalists a symbolic victory but imposing almost no costs on the utilities (and only small costs on "we the People"). And who knows, maybe the point of the exercise is to give greater salience to the inter-regional acid rain problem and to promote the objective identified in the statement of legislative intent of getting Congress to enact a further 50% reduction of SO₂ emissions nationally.

Question III, based on a regulatory proposal for genetically modified food, was also drawn from the "real world" (and not the TV show). Many wrote good essays about regulation under certainty, how to think about the costs and benefits of genetically modified food, screening vs. standards and the new/old problem. The answers were often too general, however, not focusing on the specific regulatory measures that had been proposed. For example, the first measure called for biotech companies to provide the FDA with research results that "affirmed" the food’s safety 4 months prior to marketing. Is this screening or not? Does the FDA get to set the standards for safety? What counts as "safe": safe for human consumption (the usual FDA concern with food additives); or safe in light of potential biodiversity/longterm sustainable food chain concerns? Will the FDA determine whether the research results meet the safety standard or must it accept the "affirmation?" In other words, is the regulatory scheme a form of administrative ex ante protection (keeping unsafe products off the market through screening) or will it work through the fear of ex post tort liability (the risk of mass tort liability should harm arise from a product explicitly represented as safe). Or is it a form of mandatory disclosure, relying (like the Toxic Release Inventory program) on public reaction as a disciplinary force? (Is that an appropriate way to regulate this potential hazard in light of scientific uncertainty and heuristic issues?)

In addressing the second measure, the labeling proposal, many did not focus on the actual proposal, which called for a mechanism by which food "could be labeled as free of gene-altered ingredients." Instead, many assumed that the proposal would require labeling of the presence of gene-altered ingredients. It’s the difference between permitting speciality producers to identify their products as "all natural" vs. requiring general producers to identify their products as "containing possible frankenfoods." This reading influences arguments about the value of disclosure, heuristic bias, consumer choice, the market model, etc., that many of you pursued. It also influences the reading of the third proposal, for USDA validation of tests "that aim to detect the presence of gene altered ingredients." USDA standard setting imposes difference burdens in the case of qualification for a special designation vs. a universal and mandatory disclosure standard in the sale of food. Notice that what we think about the labeling program, a disclosure strategy that facilitates consumer choice, may depend on the nature of our safety concerns. Consumer choice on an issue bearing on individual health doesn’t address the collective choice problems associated with issues that may affect collective well-being.

I enjoyed the class and very much enjoyed getting to know many of you in class and outside of class. Good luck in your next two years of law school. I’m available for conversation and advice.

FOUNDATIONS OF THE REGULATORY STATE 

L 6110y 

Professor Gordon

  Final Examination -- Spring 2000

Time Allowed -- Four Hours 

This examination consists of 7 pages, including this one. Please check now to make sure you have all the pages.

 

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Question I

30%

(one hour)

A.  Senator Savvy of Florida has submitted legislation proposing a prescription drug plan for the elderly on these terms: Medicare recipients would have the opportunity to buy prescription drug insurance at a uniform premium set at a level designed to cover 50% of program costs. The remaining costs will be funded out of general revenues. The plan will pay 100% of the cost of prescription drugs for an insured up to a cap of $2000 annually (i.e., meaning drug expenditures above $2000 are borne by the insured). Your boss, director of domestic policy at the Office of Management and Budget, wants a memo from you analyzing this plan and any likely objections. She is open to hearing your suggestions for alternative approaches but she is most interested in a careful consideration of the insurance plan, including any modifications that might make it work better.

B. Representative Waters from Long Island, N.Y., has proposed renewal of the federal flood insurance program, which provides homeowner flood insurance (covering 100% of damage claims up to the assessed value of the house) where the private market will not. Homeowners pay an annual premium equal to 5% of the assessed valuation. Premiums once covered 75% of program costs; they now cover approximately 50%. General revenues cover the remainder. Your boss at OMB needs a memo analyzing this program including your recommendations for modifications.

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Question II

40%(One and � hours)

The following bill [1999 N.Y. SB 4917 (SN)] was recently passed by the New York State Legislature and sent to Governor Pataki for his signature. The Governor's counsel has some questions about the legislation and wants you to write a memo that will analyze the legislation and advise the Governor whether he should sign it. Your memo should explain the purpose of the legislation, its mechanisms (especially an analysis of sections 2 and 3 of proposed Section 66-k), whether you think these mechanisms will work, any modifications, and finally an overall recommendation and defense of your recommendation. Omit any possible discussion of federal constitutional questions.

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AN ACT to amend the Public Service Law, the Environmental Conservation Law, the State Finance Law and the Public Authorities Law, in relation to the control of acid deposition.

 

Section 1. Legislative findings and intent. The legislature finds that acid deposition, commonly referred to as acid rain, in sensitive resource area of the state degrades natural ecosystems, causes significant economic and environmental damage, including but not limited to declines in tourism,

reduction in the economic productivity of lands, and undermines the public health.

The legislature finds that proposed federal legislation before the Congress of the United States would require national sulfur dioxide emissions from electric generating sources to be reduced by an additional fifty percent from the amount allowed by title four of the Federal Clean Air Act when it is fully implemented and that such federal legislation is presumed adequate to

effectively control acid deposition in sensitive resource areas of the state.

The legislature finds that in the absence of federal action the state must act to safeguard public health and to protect its environment, economy and infrastructure from irreparable damage from acid deposition.

The legislature finds that a recent federal report to Congress stated that, without significant new reductions in acid deposition, the number of lakes without the ability to neutralize acid inputs may double within the next forty years in the Adirondack Park of New York.

The legislature finds that market-based pollution allowance trading programs can reduce the overall cost of making pollution reductions but such allowance trading programs must be structured to achieve necessary environmental and public health goals.

It is the intent of the legislature to ensure that utility corporations sited in New York State make prudent revenue decisions regarding their participation in the federal allowance credit trading programs established pursuant to the federal Clean Air Act.

It is the intent of the legislature to encourage sales and trades of pollution allowance credits that are beneficial to the sensitive resource areas of the state and thus, to the people of the State of New York.

 

Section 2. The Public Service Law is amended by adding a new section 66-k to read as follows:

section 66-k. Allowance credit trading or sales.

1. Definitions. For purpose of this section, the following terms shall have the following meanings:

(a) "SO₂" shall mean sulfur dioxide.

(b) "SO₂ allowance credit" shall mean any SO₂ credit issued to a generating source within the United States pursuant to the provisions of Title Four of the federal Clean Air Act Amendments of 1990.

 

(c) "select SO₂ allowance credits" shall mean any SO₂ allowance credit issued to generating sources located within the boundaries of the State of New York with a vintage year of 2001 or later.

(d) "acid precipitation source states" shall mean the following states: New Jersey, Pennsylvania, Maryland, Delaware, Virginia, North Carolina, Tennessee, West Virginia, Ohio, Michigan, Illinois, Kentucky, Indiana and Wisconsin.

2. Air pollution mitigation offset. (a) the [Public Utility Commission] shall assess an "air pollution mitigation offset" equal to any sum received by any utility corporation, person, or entity entering into contracts or engaging in the sale or trade of select SO₂ allowance credits for use in operations, permits or for maintaining compliance with SO₂ emission requirements in acid precipitation source states...

(b) any utility corporation, person, or entity entering into contracts or engaging in the sale or trade of any select SO₂ allowance credits shall provide the Commission with written notice of any select SO₂ allowance transaction with five business days of such transaction. Such notice shall include the purchase price, and shall provide the Commission a copy of the [relevant] allowance transfer form of the United States Environmental Protection Agency ["EPA"].

(c) the Commission will annually review information contained in the SO₂ allowance tracking database operated by the EPA for select SO₂ allowances as identified by their unique serial number.

(d) any moneys collected as an air pollution mitigation offset pursuant to this subdivision shall be deposited in the air pollution mitigation fund established pursuant to section 99-g of the State Finance Law and administered by the New York State Energy Research and Development Authority pursuant to section 1854(10-a) of the Public Authorities Law.

3. Exemptions. (a) the Commission, in consultation with the Department of Environmental Conservation, shall produce by rule or order a model restrictive covenant for use by any utility corporation, person or entity entering into contracts or engaging in the sale or trade of select SO₂ allowance credits. The model restrictive covenant will be a self-enforcing

contract that shall include at a minimum, the requirement to give notice to the Commission of any SO₂ allowance transaction covered by the restrictive covenant; the requirement that any subsequent holders of the SO₂ allowance covered by the restrictive covenant include an identical restrictive covenant in any document relating to the sale or purchase of the covered SO₂

allowances; provisions restricting usage in acid precipitation source states; and provisions for the enforcement of the terms of the restrictive covenant by the State of New York.

(b) any utility corporation, person or entity entering into contracts or engaging in the sale or trade of select SO₂ allowance credits may attach a restrictive covenant as a standard provision in any document relating to the sale or trade by the utility corporation, person or entity ... of select SO₂ allowance credits. Such restrictive covenant must conform with the required provisions of the model restrictive covenant produced by the Commission pursuant to this Subdivision.

(c) any utility corporation, person or entity acting in conformance with the provisions of this subdivision shall be exempt from the assessment of an air pollution mitigation offset.

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6. Nothing within this section will invalidate or subvert any prior contractual commitments and/or obligations made by a utility corporation, person or entity identified in subdivision two of this section prior to the effective date of this section.

 

Section 3. Section 19-0921 of the Environmental Conservation Law is amended by adding a new subdivision 3 to read as follows

3. The Commissioner shall make a written report to the Legislature upon his finding that a federal law has been enacted that will result in at least a 50% reduction in the emissions of SO₂ as defined in Section 66-k of the Public Service Law, by electric generating sources pursuant to Title Four of the federal Clean Air Act after full implementation.

 

Section 4. The State Finance Law is amended by adding a new section 99-g to read as follows:

Section 99-g. Air pollution mitigation fund. 1. There is hereby established in the joint custody of the comptroller and the New York State Energy Research and Development Authority a special fund to be known as the "Air pollution mitigation fund"

2. Such fund shall consist of all moneys collected by the Public Service Commission as an air pollution mitigation offset pursuant section 66-k(2) of the Public Service Law....

3. Moneys of such fund shall be available to the New York State Energy Research and Development Authority for the purposes of carrying out the provisions of section 1854(10-a) of the Public Authorities Law.

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Section 5. Section 1854 of the Public Authorities Law is amended by adding a new subdivision 10-a to read as follows:

10-a (a) to administer the air pollution mitigation fund established pursuant to section 99-g of the State Finance Law and consisting of moneys collected by the Public Service Commission as an air pollution mitigation offset pursuant to section 66-k(2) of the Public Service Law.

(b) to disburse moneys from such fund for the following purposes: (i) to reduce acid precipitation through energy efficiency, or through public benefit research and development, including, but not limited to, renewable energy; or (ii) the monitoring of, or research related to, the impact of acid precipitation deposition.

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Section 7. This act shall take effect immediately.  

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Question III

30%

(One hour)

In response to the intensifying objections from food safety activists and environmental groups about the health effects of genetically modified food and their potential to cause ecological damage, the Clinton administration has proposed several new regulatory measures.

These measures were described by the Washington Post (May 3, 2000), as follows:

"Among the more significant changes to be proposed, biotech companies would have to notify the Food and Drug Administration four months before marketing a new genetically modified food, providing the agency and the public with the research results that affirm the new food's safety. Until now, that process has been voluntary.

Moreover, the FDA intends to create a regulatory mechanism by which foods for the first time could be labeled as being free of gene_altered ingredients...

In a third change, the Agriculture Department would become directly involved in validating new scientific tests that aim to detect the presence of gene_altered ingredients. Ultimately, either the USDA or another group would certify such tests, to ensure all claims that a product is free of engineered ingredients meet the same standards."

Recently the Wall St. Journal (April 28, 2000) reported:

"Monsanto Co.'s genetically modified potato is falling victim to the consumer backlash over crop biotechnology.

Fast-food chains such as McDonald's are quietly telling their french-fry suppliers to stop using the potato from Monsanto, the only biotechnology firm to commercialize a genetically modified spud.

So many food concerns are shrinking from the Monsanto potato that J.R. Simplot Co., a major supplier of french fries to McDonald's, is instructing its farmers to stop growing it....

Critics have raised enough questions about the environmental and nutritional safety of crop biotechnology that surveys show that many U.S. consumers want labels on groceries containing genetically modified ingredients ....

American farmers, worried by the controversy, are retreating from the genetically modified seed they raced to embrace in the late 1990s. Such modified plants are easier to grow than their conventional cousins; they make their own insecticides and tolerate exposure to potent weedkillers. But government and industry surveys show that U.S. farmers plan to grow millions fewer acres of genetically modified corn, soybeans, and cotton than they did last year."

Pick a role as regulatory counsel for one of (i) New York Public Interest Research Group, (ii) Grocery Manufacturers Association, (iii) Greenpeace, or (iv) the Biotechnology Industry Organization and write a memo analyzing and critiquing the Clinton administration proposals. Explain why your organization should ultimately support or oppose the proposals.