March 9, 2017

Why California is the linchpin of fuel economy regulation

Don MacKenzie

Major automobile manufacturers have been lobbying the Trump administration to relax automotive fuel economy and greenhouse gas (GHG) standards that were established – with broad industry support – by the Obama administration in 2011. While the Trump administration may be able to rescind the federal standards (as long as such rescission is not arbitrary and capricious, per MVMA v. State Farm), the real crux of this issue will be whether California can retain its authority to set its own GHG standards. That authority is the linchpin that holds together a unified national policy on fuel economy; As long as that authority is upheld, the incentive for the auto industry to seek more lax federal standards is likely diminished, and possibly eliminated.

Section 209 of the Clean Air Act preempts individual states from setting their own emission standards for vehicles, but it allows a waiver for “any State which has adopted standards… prior to March 30, 1966.” Effectively, this exception means that California (and only California) can set its own vehicle emission standards that differ from federal standards. But, Section 177 allows for other states to opt into California’s standards instead of the corresponding federal standards. Prior to the Obama administration’s actions to develop a unified national program for fuel economy and GHG standards, states representing about 40% of new vehicle sales in the US were following California’s standards.

Other analysts have suggested that “no carmaker wants to build ‘California cars’ and ‘rest of the world cars.’ Result: ‘All cars meet the California standard.'” This is not quite incorrect, but it is incomplete, and doesn’t fully characterize the importance of California’s standard-setting authority. The New York Times has reported that “Automakers are also hopeful that the new E.P.A. administrator, Scott Pruitt, will begin legal action to revoke California’s ability to enforce its tailpipe standards,” while former Obama administration official Jody Freeman has noted that “if the Trump administration tries to significantly weaken the rules, California will withdraw its consent and enforce its own higher standards using its waiver, which is valid to 2025. Should the E.P.A. try to revoke the waiver prematurely, California will, without question, sue.”

I argue here that loosening federal standards without eliminating California’s waiver could be not just ineffective, but actually counterproductive, from the industry’s perspective.

Let’s start from three basic premises:

1. Meeting a stricter fuel economy or GHG standard imposes private costs on automobile suppliers and consumers, by increasing technology costs and/or forcing sacrifices in vehicle attributes valued by consumers, such as acceleration performance;
2. It costs an auto company a significant, but finite, amount of money to design and certify multiple variants of a product (i.e. a “California version” and a “rest of country” version);
3. The automobile market is (imperfectly) competitive, and carmakers whose products deviate from consumer preferences will lose market share to their competitors whose products better align with consumer preferences.

Given premise (1), automakers would prefer not to face any fuel economy or GHG standards at all. However, once it is a given that a subset of the market (e.g. California and other states opting into its standards) will be setting its own standard, a company must make a decision: does it sell the California version everywhere, or does it build a different variant for each sub-market? In making this decision, the company must trade off the costs of offering multiple variants (premise 2) against the costs of losing market share to competitors (premise 3).

I explored this question in chapter 6 of my doctoral dissertation, and what I found was surprising: under some conditions, auto manufacturers will actually prefer to to deal with a stricter fuel economy / GHG standard across the entire US, rather than in only some states.

I summarized the conditions leading to these different outcomes as:

1. When the states adopting a tighter fuel consumption or GHG standard constitute a large share of the overall market, when the cost of developing multiple variants is high, or when the nested standard is not too stringent, each manufacturer finds it most profitable to simply build to the tighter standard and sell those products everywhere, even if they are not required to do so.
2. When the adopting states represent a smaller share of the total market or the cost of developing a second variant is relatively low, the Nash equilibrium may have firms producing multiple variants. However, this may actually be less profitable than what firms could achieve if they (and their competitors) were all forced to build to the tighter standard nationwide.
3. When the cost of developing a second variant is not too high, and the adopting states’ standard is relatively strict, it may be most profitable for firms to accept the additional costs of building multiple variants. The savings from building a single variant are not worth the loss in revenue in non-adopting states, even if competitors are forced to build to the tighter standard as well. In this case, we end up with heterogeneous standards in the adopting and non-adopting states, and emissions leakage occurs.

In other words, they don’t just choose to build all their own cars to meet the California standard; they may actually prefer that the federal government require them to do so. The reason is that absent the federal requirement, firms can find themselves in a prisoners’ dilemma: each company can increase its own profits by offering both a California car and a rest-of-country car, but all companies would make more money if each one sold one version everywhere.

This helps to explain both why the auto industry supported the adoption of a national fuel economy program in 2009 and 2011, and why they are placing such a priority on repealing California’s waiver today: the industry could plausibly end up worse off if federal standards are weakened but California’s waiver remains in place.

Or, as Professor Freeman put it in an op-ed in yesterday’s New York Times,

Unraveling the agreement now will undo this alliance, plunging the companies back into regulatory chaos, with all its uncertainty, acrimony and cost.

Thus, maintaining California’s waiver authority under section 209 is the key to keeping fuel economy high throughout the country, and perhaps even attracting grudging support for federal standards from the automotive industry.