Thursday, October 27, 2011

Prospective Economic Analysis of New California Regulations

The Economics of new goods literature has tried to estimate how much our well being is improved by when for profit companies design and sell new cereals or new mini-vans or new drugs.  An analogous question can be asked about "new regulations".  Whether it is Bernanke's QE2 or California's anti-carbon AB32, how much will  these new regulations improve our quality of life?  As you can imagine, this is a tough question.

A new study by the California Little Hoover commission tries to tackle this broad issue of how economic analysis should be incorporated into such prospective decision making.   A group of CGE modelers have earned good consulting gigs supplying such estimates but I have questioned their work's plausibility.  When you know that you do not know what will be the consequences of a new policy but your hunch is that it will work, how do you design it so that as you learn you can incorporate the new lessons into refining the regulation to make sure that it is cost effective and avoids unintended consequences.  Regulator learning and experimentation is an under-researched topic.

 Here I report the parts of the study's EXECUTIVE SUMMARY.  Take a look at page 25 of the study to see the discussion of my work with J.R DeShazo.

"California’s regulatory agencies are known nationwide as  trailblazers that set benchmarks that the nation as a whole often  follows.  Over the years, such regulations have produced huge  benefits for Californians in consumer safety, food security, worker protection, energy efficiency and air and water quality.
The state’s large population and its dynamic and complex economy  require a sophisticated, coordinated and thoughtful approach to  developing the regulations our society needs to ensure fairness and
protect California’s quality of life.

It is unfortunate on several levels then, that California’s approach to  developing regulations is uneven, lacks coordination and, despite an  independent agency to enforce the Administrative Procedure Act, lacks
the kind of thorough oversight that ensures efficiency and accountability.   The way California state departments develop regulations varies widely,  particularly in their use of economic analysis to determine what burden a  proposed regulation will have on a person or business affected by it.  California has been reluctant to adopt and use analytical tools employed  in other states and at the federal level.  This has produced a regulatory  approach that can focus intensely on solving problems in a single arena
without taking into consideration the broader context or consequences of  the solution it imposes or developing regulations that maximize benefits  in a systematic way.  In the course of the Commission’s study, it saw examples of where these  shortcomings either resulted in failed rulemaking efforts, the potential
imposition of costly conditions that could force painful tradeoffs, or  regulations undermined by an economic analysis that did not account for  real-time changes in the economy.  

An oversight system put in place to ensure that agencies weighed
alternatives to solving a problem and used an economic impact
assessment to choose the least burdensome solution simply does not
work.  The department checks a box on a form.  The box is examined to
see that it is checked.  But no one checks to see if the department did its
homework in assessing the impact or choosing the least burdensome

These shortcomings have costs to the state, in time and money, as well
as in the state’s reputation for fairness and the legitimacy of the
regulatory process.  These shortcomings also have costs to the state’s

One area critical to this goal is greater use of economic analysis in the
development of regulations – already required by the state’s
Administrative Procedure Act – and greater oversight of the process to
ensure adequate assessments and consistency across agencies.  Though
economic analysis should not be the determining factor in developing
regulations, the work of building the analysis should force state agencies
to engage with all interested parties early in the rulemaking process,
develop and assess alternatives, and create a richer body of information
to put before the board members and department directors who
ultimately make the decision.  Such analysis also can articulate and
measure the benefits of a proposed regulation, providing greater context
for the public as well as decision makers.

In recommending greater use of economic analysis, the Commission
encourages a focus on prioritizing alternatives by their cost-effectiveness.
This would tend to result in the selection of the alternative that best
provides the benefit intended in the legislation but is least burdensome
to regulated stakeholders and to the people of California.  The emphasis
on cost-effectiveness assessments is not to short shrift discussion, or
assessment, of benefits.  In most cases, however, the benefit, often with
specific targets, is laid out in the legislation that the proposed
regulations are to implement.  All regulations should be required to show
how a preferred approach would produce the desired benefits.  

Non-regulated stakeholders, particularly environmental groups and labor
advocates, have expressed concern about the potential abuse of
economic analysis to undermine the goals of regulation, and its ability to
create “analysis paralysis.”  In interviews and during a Commission
advisory committee meeting, they reserved a specific wariness for costbenefit analysis, which they said  can understate the value of such
benefits as clean water and air and human health, while allowing
industry to overstate its costs.
The Commission recognizes that some parties within an industry have an
incentive to game the process by withholding information or inflating
estimates of the cost of compliance.  It recognizes, too, the view that not
all benefits, or costs, can be assigned an accurate dollar value and neatly
fit into a cost-benefit model.  It recommends the state focus more on
cost-effectiveness assessments of alternatives that meet the goals of the
legislation the regulation is trying to implement.  A formal cost-benefit
analysis is time-consuming and expensive and should be reserved for
special cases or where required by legislation.  For regulatory packages
that have a significant impact on the economy, the state should have its
economic impact assessments peer-reviewed by a panel of anonymous
outside experts.  

The Commission recommends that the state start the process of
strengthening its rulemaking process by establishing a small Office of
Economic and Regulatory Analysis, that would reestablish the regulatory
analysis function which once existed in the now-defunct Trade and
Commerce Agency.   The primary duty of this small group would be the
review of economic impact assessments for proposed regulations.  This
function could be assigned to the Department of Finance, which already
has the task of assessing the fiscal impact of new regulations, or to the
Office of the Governor or the Bureau of State Audits, which would
provide independence from the executive branch entities overseen.  In reestablishing this function, the state can learn from the example of the
U.S. Office of Information and Regulatory Affairs, which is located in the
White House’s Office of Management and Budget.  The small cost
associated with re-establishing this function would be more than offset
by reducing the costs of failed regulatory processes, by reducing lengthy
challenges on methodology and the potential to improve confidence in the
rulemaking process.

One of the first tasks of California’s Office of Economic and Regulatory
Analysis would be to set guidelines for economic impact assessments
that would be used across departments to ensure consistency and
fairness.  The guidelines should be designed to accommodate a range of
scales for regulatory involvement, with the most rigorous reserved for the
most significant proposed regulations.  The state should recruit an
advisory body of economists and experts from other disciplines with
regulatory experience to help draft the guidelines.  The guidelines should
build on, but not be restricted by, work already done in California by the
California Energy Commission and the California Air Resources Board,
as well as the U.S. Office of Management and Budget’s Circular A-4.
Separate from the Form 399 filing
process, staff performing the
regulatory review function should
have the authority to check in with
departments as they are drafting
regulations to ensure that the
agencies are following the
appropriate guidelines for the level of
economic impact analysis required,
and that they are making every effort
to engage with all interested parties
inside and out of government before
the rules are put out for public
comment. As part of the review
function, this staff should determine
what level of economic impact
assessment is needed on the front
end.  When the economic impact
assessment is complete, as part of
the Form 399 process, the regulatory
review staff should make a
determination whether the
assessment is adequate.
The Office of Administrative Law,
which ensures that agencies follow
the Administrative Procedure Act
through the rulemaking process,
should be required to send back final
versions of proposed
recommendations that have not done
the necessary economic impact
assessment as determined by the
Office of Economic and Regulatory

A cost-effectiveness test approach to evaluating alternatives should be
emphasized especially where the desired social benefit and targeted goal
is spelled out in statute.  The guidelines also should include proper
methodologies for a more formal cost-benefit analysis in the event such
an analysis is required by legislation.

To the extent regulatory reform can build confidence and enhance
communication, transparency and  accountability, such reform can
improve the foundation for economic growth and bolster the legitimacy of
the state’s regulatory structure, protecting public health, consumers,
workers and the environment.  Done well, regulatory review should result
in fewer failed rulemaking processes, saving state agencies and
stakeholders alike time and money as departments implement the goals
of the Legislature.

The Commission’s goal is not to create less or more regulation, but
rather better regulation – rules developed through a transparent and
interactive process that meet the statutory purpose and that place the
least burden necessary on Californians and the California economy.

Recommendation 1: The state should require  departments promulgating regulations or
rules that impose costs on individuals, businesses or government entities to perform an
economic assessment that takes into account costs that will be incurred and benefits that
will result.
‰ The economic assessment must be completed well before the
proposed regulation is released for public comment.  
‰ Departments must demonstrate  how the proposed regulatory
action will meet the statutory purpose of the regulation.
‰ Departments promulgating the regulation should be required to
reach out to regulated and interested parties in the development
of the economic assessment prior to the regulation’s release for
public comment.

Recommendation 2: The state should require departments proposing a major regulation
to perform a high-quality, rigorous economic analysis.

‰ A major regulation is a regulation that would impose an annual
cost of $25 million or more.  
‰ At the minimum, the economic analysis should be a costeffectiveness assessment of alternatives that meet the statutory
purpose of the regulation to determine the lowest cost alternative
to meeting this goal, prior to the release of the regulation for
public comment (possibly the alternative that maximizes net
social benefits).
‰ Proposed regulations that impose a substantially higher burden
on  an  affected  industry  or  industries, or have the potential to
materially reshape the state’s economy, should be subject to a
cost-benefit analysis that includes an assessment of costs as well
as social benefits.

‰ The department promulgating a  major regulation should be
required to make a substantial effort to engage all regulated and
interested parties in the development of alternatives that would
satisfy the statutory purpose of the proposed major regulation
prior to its release for public comment.  This should not prevent
the department from developing additional alternatives, or
refining its economic analysis, on the basis of information
provided through the public comment process.

‰ The state should require a department that is promulgating a
major regulation to demonstrate that its preferred alternative is
the most cost-effective approach to meeting the major regulation’s
statutory purpose or explain why another alternative was chosen,
or, in the case of a more substantial regulation that calls for a
cost-benefit analysis, demonstrate that the chosen regulatory
approach maximizes net social benefits.
‰ The department must respond to comments about its analysis of
the alternatives, including the selected alternative, made during
the public comment period.