Labor and capital productivity may decrease under new regulations. For example, the administrative costs of monitoring emissions and filing reports with regulatory agencies may require firms to hire more workers whose labor does not increase productivity ( as measured by labor employed relative to produced output). Pollution control devices or restrictions on the use of products may cause lower levels of output relative to unconstrained production processes. For example, placing restrictions on pesticide use may reduce the yield of crops susceptible to pest damage, holding other factors of production ( e. g., labor, fertilizer) constant. In each case, however, private costs are captured by changes in the supply and demand curves of the product, and therefore care should be taken to insure that social costs associated with productivity losses are not double counted with other social cost estimates.

Discouraged investment may occur if research and development funds are reallocated to meet additional compliance costs. This may result in decreases in technological innovation and product quality. The latter can be modeled as the reduced amount consumers are willing to pay for the low quality good, relative to what they were willing to pay for the original, higher quality good. In practice, changes in technological innovations are not commonly analyzed in most economic models used in benefit cost analyses of individual regulations and policies.

8.3.3 Other Issues Arising in Presentation of Social Costs Four additional issues to note arise in the organization and presentation of social costs, several of which have also been raised earlier in this document in connection with the measurement of social benefits. These issues discussed here on social costs include: ( 1) discounting, ( 2) difficulties valuing some social cost categories, ( 3) conducting sensitivity analyses, and ( 4) simplifying market effects.

Discounting: Social discounting procedures for economic analyses are reviewed in considerable detail in Chapter 6. For purposes of computing the social costs of environmental policies, costs should be discounted using the methods and social discount rates discussed in that chapter. This is the case regardless of the methods used to estimate social costs. Social costs can be estimated in detail year byyear or estimated using growth rates, or merely assumed to be constant. These streams of social costs can then be adjusted to yield: ( 1) discounted present value, ( 2) future value, or ( 3) the annualized cost of the policy. All three approaches are different ways to express the same concept and choosing which method to present the results will depend on the method that most effectively allows comparisons among the options and the measurement of net benefits. 11 Difficulties of valuing social costs: Some consequences of environmental policies are difficult to represent in the definitive, quantitative terms of conventional social cost analysis. Irreversible environmental impacts, substantial changes in economic opportunities for certain segments of the population, social costs that span very long time horizons, socioeconomic effects on communities, and poorly understood effects on large scale ecosystems are difficult to summarize in a quantitative benefitcost analysis. Some alternative techniques for measuring and presenting these effects to policy makers are reviewed in section 7.6.3 of the benefits chapter that discusses measuring ecological benefits. The relative significance of social cost categories that are not quantified   or are quantified but not valued   should be described in the analysis.

Sensitivity analysis: The estimates in the social cost analysis will not be known with certainty. In fact, some data and models will likely introduce substantial uncertainties into the estimations of social costs. Numerous assumptions are made in regard to 123 Chapter 8: Social Costs 11 Many EPA analyses typically prepare an annualized cost estimate, since this measure is one of several used to determine whether rules require additional review and oversight, and is used to help establish the scope of the economic analysis to be conducted ( e. g., the social cost threshold of $ 100 million in annual costs is used to identify rules that require a benefit cost analysis under the provisions of EO 12866). the baseline, predicting responses to policy, and the number of affected markets. Therefore, the conclusions drawn in the benefit cost analysis will be sensitive to the degree of uncertainty present and the assumptions that were made. Reporting the uncertainty of the data, the assumptions used, and how the uncertainty and assumptions affect the results are important components of the presentation of social cost. Section 5.5 outlines the process of analyzing and presenting uncertainty.

Simplifying market effects: Given the complexity of modern economies, measuring and predicting all of the consequences of a particular action would involve a significant effort. The central question explored in this section is whether some or all markets indirectly affected by a policy must be analyzed to obtain a measure of social costs suitable for a benefit cost analysis, or whether the calculation of social costs can be limited to an assessment of the directly affected markets without introducing unacceptable biases and errors into the analysis.

In general, the social cost of a policy can be measured exclusively by changes that occur in the markets directly targeted by a policy, as long as significant net changes in social welfare are not generated in indirectly affected markets If price changes in other markets generate both gainers and losers among the producers and consumers, then they may offset each other in a social cost analysis as transfers. 12 However, if there are strong reasons to believe that conditions in other related markets might generate important net social welfare consequences, these should be examined. If a policy indirectly increases or decreases the quantity of a good that is consumed, whose production or consumption involves an externality, then this results in net social welfare effects that may be worth considering when calculating total social costs ( and benefits).

8.4 Modeling Tools The following section first focuses on the basic framework common to all models used to estimate social costs, while the remaining sections examine the models commonly used: ( 1) direct compliance cost methods, ( 2) partial equilibrium models, ( 3) multi market models, and ( 4) computable general equilibrium models.

8.4.1 The Basic Framework Benefit cost models must predict what actions firms are likely to choose when attempting to comply with a new policy and what the compliance costs of those actions will be. Normally, these are based on engineering or process cost models that examine firms' alternative compliance methods. Engineering cost estimates typically specify the capital, operating, and maintenance costs that are likely to occur in adopting different pollution control strategies. When possible, these initial engineering cost estimates should include the expected level of compliance costs, as well as reasonable lower and upper bounds for purposes of sensitivity analysis.

In addition to the preliminary engineering or other estimates of the social costs of various compliance strategies, other costs may be significant. As noted earlier, for some market based approaches, transaction costs can often be substantial. For example, when setting up the market for a permit trading system, determining how many permits to purchase or sell can involve detailed cost modeling and forecasting, in addition to the social costs associated with operating the trading system. When these costs are likely to be significant, they should be estimated in addition to the basic private real resource costs of capital and the operating costs of alternative compliance methods.

8.4.2 The Direct Compliance Cost Method In some cases, social costs are estimated using the direct compliance cost method. This is the simplest approach used in estimating social costs. Under this approach, the social cost for a policy is simply set equal to the initial engineering or other compliance cost estimates for the compliance options the firms are likely to adopt; no additional modeling is undertaken. If only compliance costs are calculated, the private ( compliance) costs are likely to 124 Chapter 8: Social Costs 12 This conclusion regarding the net social welfare implications of price changes in related markets requires some qualification. Even when non zero welfare effects are produced by price changes in related markets, they are likely to be small relative to the estimated producer and consumer welfare effects in the directly affected markets. See Arnold ( 1995) for more discussion of related markets and welfare measurement. be overestimated. This is because private costs are computed for the pre policy level of output under the implicit assumption that there is no substitution away from the affected products or activities into other relatively less expensive ones. That is, firms do not make any capital or labor adjustments in their production processes. In addition when the resulting changes in consumer surplus are calculated at the new higher prices, consumer welfare losses are also likely to be overestimated since changes in consumer behavior will not be taken into account.

Nevertheless, using direct compliance costs as an approximation of actual social costs may be reasonable for a policy when price and quantity changes are small, and there are few indirect effects. However, if consumers can easily switch to substitute goods, this adjustment will make the actual social cost of the policy significantly less than indicated by the direct compliance cost estimates. Likewise, if firms can find less costly substitutes for their inputs or production processes, which have been made more expensive by the new regulations, then compliance costs will be an overestimate of the actual social costs.

8.4.3 Partial Equilibrium Analysis Because of the limitations of using direct compliance costs as a measure of social costs, an alternative approach is to model the economic effects of these compliance costs on producers and consumers using a partial equilibrium supply and demand model of the affected markets. This allows for a more complete analysis of social costs and their incidence. " Partial" equilibrium refers to the fact that the supply and demand functions are modeled for just one or a few isolated markets and that conditions in other markets are assumed either to be unaffected by a policy or unimportant for social cost estimation.

For example, if using a partial equilibrium supply and demand framework, a new environmental policy that increases production costs will cause a change in the supply function. The demand function, the old and new supply functions, prices, and quantities can then be used to compute changes in producer and consumer surpluses. If the relevant markets are evolving over time, this technique can be applied in each future time period using new supply and demand functions. This makes it possible to estimate the changing distribution of social costs over time.

The practical difference between the results of the partial equilibrium supply and demand based modeling and the direct compliance costs approach depends on the nature of the policy and the magnitude of its effects. For small compliance costs, price and quantity movements are likely to be minimal, so the social cost estimates derived from the partial equilibrium model framework will not be significantly different from the results obtained from the direct compliance cost method.

For policies with larger compliance costs, price and quantity movements could be more substantial. The estimated social costs using the supply and demand framework in these cases may be considerably less than those suggested by the simpler direct compliance cost approach. Moreover, policies that effectively ban products or activities cause the loss of all producer and consumer surpluses in these markets. Therefore, it is difficult to calculate social costs of these policies without an explicit supply and demand framework.

Analyzing the effects of a policy using a partial equilibrium model of the directly affected markets is appropriate when the ramifications in indirectly affected markets do not generate net social costs. It is also a reasonable framework as long as the social costs imposed by a policy are small and do not significantly alter other markets or produce measurable macroeconomic effects ( e. g., changes in national unemployment levels).

In most cases, a conventional partial equilibrium framework comparing the pre policy baseline with the expected results of a new environmental policy will suffice for an economic analysis. For analyzing environmental policies that pose very large consequences for the economy, computable general equilibrium modeling is an alternative technique that is particularly useful and is discussed later in this chapter. 13 The partial equilibrium framework is a commonly used theoretical tool for modeling and measuring the social costs of environmental policies. In theory, a variety of 125 Chapter 8: Social Costs 13 Useful recent illustrations of partial equilibrium analyses prepared in support of environmental policies include EPA ( 1998) Economic Analysis of Effluent Guidelines and Standards for the Centralized Waste Treatment Industry, and EPA ( 1996) Economic Impact Analysis of Proposed NESHAP for Flexible Polyurethane Foam. social costs can be observed and calculated using this technique. Even transitional effects that result in shortrun social costs, such as premature capital equipment retirement and relatively brief spells of involuntary unemployment can be modeled and estimated using this framework. Thus, the approach offers a theoretically sound, if limited, method for conceptualizing the consequences of an environmental policy and measuring their social costs.

Deriving the supply and demand functions is the foundation of benefit cost analysis and is necessary in all economic models used to analyze social costs and benefits. However, because of its importance and the uncertainties associated with estimating supply and demand functions, it may be useful to evaluate key assumptions with sensitivity analyses and develop a range of estimated social costs.

The typical analysis is performed assuming a competitive market, although unusual circumstances may require relaxing this assumption. Even should competitive market conditions fail to hold, partial equilibrium analysis can be adapted to analyze varying market conditions that may more closely reflect real world conditions. It is useful to indicate when social benefits or social costs have been overestimated or underestimated because of biases caused by market distortions. However, the principles underlying partial equilibrium analysis can serve as a useful model to evaluate the real resource costs of many of EPA's regulations and policies.

As previously discussed in Section 5.6, " Emerging Cross Cutting Issues," environmental policies usually can be analyzed assuming a first best regulatory setting, although actual conditions reflect a second best world in light of taxes placed on a variety of goods and services. Therefore, it is conceivable that a regulatory policy in one sector may have effects in labor markets and other sectors of the economy. Thus, examining costs in only the final goods market may cause costs ( or even benefits) to be underestimated.

The scope of the regulatory program is likely to be proportional to the effects experienced in other sectors of the economy. Therefore, the larger the program, the more important it is to examine several markets to accurately estimate costs and determine ( 1) tax interaction effects, ( 2) changes in technology, and ( 3) the effects on firms' research and development decisions. Thus, multi market models are needed for regulatory policies that may have large economic effects on several sectors of the economy.

8.4.4 Multi Market Models Multi market models go beyond partial equilibrium analysis by extending the inquiry to more than just a single market. Multi market analysis attempts to capture at least some of the interactions between markets. However, unlike the general equilibrium models discussed in the next section, multi market models do not attempt to incorporate a representation of the entire economy.

An example of the use of a multi market model for environmental policy analysis is contained in a report prepared for EPA on the regulatory impact of controls on asbestos and asbestos products ( EPA 1989). The model developed for the study describes the interactions between the asbestos fiber market and markets for the goods that use the fiber as an intermediate input. The collective demands for final goods that use asbestos create a derived demand for asbestos fiber. The price of the fiber is determined through the interaction between the demand and supply schedules for asbestos. Changes in this price in turn influence the prices and demands for the downstream goods. The specification of the links between the input and output markets is especially important for simulating alternative regulatory policies, including interventions in both the input market ( caps on the usage of asbestos fiber) and in the output market ( bans on some of the goods that use asbestos as an input), as well as combinations of the two. The model was then used to compare the efficiency losses under various regulatory scenarios.

8.4.5 General Equilibrium Analysis Although the use of a partial equilibrium or multi market model may be appropriate when policies are likely to affect a limited number of markets, they are not able to capture interactions between a large number of sectors. Many environmental policies, such as energy taxes, can be expected to impact a large number of sectors both directly where the policy is applied, and indirectly through spillover and feedback effects on those and other sectors. A strength of general equilibrium models is their ability to 126 Chapter 8: Social Costs account consistently for the linkages between all sectors of the economy. Three types of general equilibrium models that have been used for the analysis of social costs are input output models, linear programming models, and computable general equilibrium ( CGE) models.

<IP_ADDRESS> Input Output ( I/ O) Models The central idea underlying I/ O analysis is that in modern economies, production activities are closely interrelated. An input output table represents the flow of goods and services through the economy, usually measured as transactions occurring over the course of a year. In addition to the primary factors of capital, labor, and land, most productive sectors use many different intermediate inputs. In an I/ O table, the column associated with a particular sector lists the value of the individual intermediate and primary inputs consumed by that sector. The row associated with an individual sector lists the value of that sector's output purchased as both intermediate inputs and final demand. For each sector in a table, the column sum represents the total costs of production and the row sum represents total expenditure on that sector's output. A key feature of I/ O tables is that, by definition, for every sector, total costs must equal total expenditures during the year. 14 An I/ O table can be turned into a simple linear model through a series of matrix operations. The intermediate inputs matrix defines a matrix of technical coefficients, based on the assumption that inputs to production are consumed in fixed proportions to output and that there are constant returns to scale. The model is manipulated by making exogenous changes to the vector of final demands. The model will then calculate how much of each of the intermediate goods is required to produce the new final demand vector. The sum of the intermediate inputs required plus final demand is equal to total output for the year.

I/ O models have a long history in environmental policy analysis. Leontief ( 1970) showed how it was possible to augment the basic I/ O model with an additional set of coefficients for pollution generation and/ or abatement. When a set of pollution coefficients has been defined, an I/ O model can then produce an estimate of the quantity of pollution that would be generated along with a given amount of final demand or total output. The quantity of pollution generated may be specified in either monetary terms ( as damages) or in physical units.

Some economic research firms use I/ O models to provide upper bound estimates on price effects. Others use I/ O models to look at the related markets and their potential significance prior to adopting a partial or general equilibrium model. The I/ O approach has also been extended further to include non market, ecological commodities such as ecosystem services. 15 Although I/ O models can be a useful as a consistency check or a first order approximation, they have a number of shortcomings that limit their applicability as a predictive tool:

Given that prices are normally assumed to be fixed and do not adjust to indicate scarcity, there is nothing to ensure that the total demands generated by manipulation of the model are consistent with the actual productive capacity of the economy.

The fixed coefficients assumption leaves no scope for substitution of inputs in production.

Since there is no producer or consumer behavior built into I/ O models, simulation of policy interventions that would affect those agents is of limited value.

Because the construction of an input output table is a costly and time consuming process, usually requiring a specialized survey, the application of input output analysis to environmental policy making will normally only be possible when an appropriate table already exists. More importantly, since input output tables are used in linear programming and computable general equilibrium models, this last shortcoming is shared by these models as well.

127 Chapter 8: Social Costs 14 A general reference on input output models is Miller and Blair ( 1985).

15 A discussion of the application of input output models to environmental policy analysis, with a number of examples, is provided in Chapter 7 of Miller and Blair ( 1985). Another example applied to the environmental protection industry is EPA ( 1995b), The U. S. Environmental Protection Industry: A Proposed Framework for Assessment. <IP_ADDRESS> Linear Programming ( LP) Models I/ O models are driven by exogenous changes in final demand. Since they do not contain an objective function, I/ O models are difficult to use for decision making among multiple alternatives. However, it is possible to extend the basic I/ O model into a LP model by incorporating an explicit objective function and a set of inequality constraints 16 In addition to the usual economic variables, the objective function may be specified to include a number of environmental variables, such as the discharge of air or water pollutants The specification of multiple inequality constraints allows for a great deal of flexibility in the application of LP model ( because of this flexibility, EPA's Office of Air and Radiation has used linear programming models for many years). Shadow prices generated in the dual form of LP models have a limited relationship to market prices and may sometimes be useful as indicators of the importance of the individual constraints. Sensitivity analysis can be conducted by varying key parameters in the model. 17 The flexibility in the specification of LP models is also something of a liability of the approach. The problem is that the selection of the constraints used is often ad hoc and may influence the model solution. As with many linear models, there is often a tendency towards unrealistic solutions, such as excessive specialization in production or trade. Finally, the lack of realistic consumer and producer behavior is carried over from I/ O models.

<IP_ADDRESS> Computable General Equilibrium ( CGE) Models As discussed in the previous sections on I/ O and LP models these approaches have shortcomings that make them less than ideal tools for policy analysis in modern market economies. In particular, in both I/ O and LP models, the behavior of producers and consumers does not reflect the independent optimizing behavior that is usually assumed to be a characteristic of agents in a market economy. Without the specification of realistic producer and consumer behavior, model based policy simulations will be unable to correctly account for the reactions agents may have to policies that impact them. Computable general equilibrium ( CGE) models incorporate more realistic behavioral specifications of the agents into the model and are thus able to provide a better laboratory for many types of policy analysis. CGE models have been used to analyze a wide variety of policy interventions, including issues in public finance, international trade, development, and increasingly, the environment. 18 Most policies meant to protect the environment, ranging from those relying on market based instruments, such as effluent taxes, to command and control regulations, induce changes in the behavior of consumers and producers These changes may occur directly where the intervention takes place or indirectly as the effects of the intervention are passed through the economy. Because they focus on both trying to model more accurately the expected reactions of consumers and producers to policy interventions and on the interactions between various actors in the economy, for some problems CGE models may be the most appropriate tool for the analysis of social costs. CGE models are particularly good at examining questions of static resource allocation, such as the effects the imposition of a tax may have on sectoral output, income, and employment. Under certain specifications, CGE models may also be useful for assessing impacts on overall measures of economic performance, such as aggregate output, employment, and various measures of welfare.

In almost all cases, CGE models start from the framework and data of an input output table, which provides a basic set of accounting identities for the production sectors. Producers are assumed to maximize their profits through their choice of productive inputs, typically labor, capital, and intermediate goods, and sometimes land. Consumers,

128 Chapter 8: Social Costs 16 The term linear programming actually refers to any applied mathematical programming exercise where an objective function is either maximized or minimized subject to a set of inequality constraints and where all of the equations are linear. In this section, only general equilibrium applications ( i. e., those based on an input output table) are discussed.

17 Linear programming models are discussed in Dervis et al. ( 1982). A number of examples of the application of linear programming models to environmental problems are given in Hufschmidt et al. ( 1983).

18 General references on CGE models include Dervis et al. ( 1982) and Ginsburgh and Keyser ( 1997). Applications to environmental policy are discussed in Wajsman ( 1995). or in many cases a representative consumer, are assumed to maximize their utility by choosing their consumption bundles, subject to a budget constraint. Although not usually specified as an optimizing agent, most CGE models also include a government sector that collects a variety of taxes to pay for its purchases of goods and services. The domestic demand for imports and the supply of exports are determined based on the relative prices of domestic and foreign goods.

CGE models may be categorized across a number of dimensions. These can include ( 1) the method by which the parameters of the model are specified ( through calibration or econometric estimation), ( 2) the time horizon of the model ( static or dynamic), and ( 3) the scope of the model ( single or multi country). Most CGE models are calibrated to a single base year, which is assumed to be in equilibrium. After the specification of a subset of elasticities and other data obtained through a literature search ( or using informed judgments) the rest of the parameters can be determined by working backward from a social accounting matrix ( SAM) for the base year. 19 An alternative to the calibration approach is econometric estimation. 20 General equilibrium econometric estimation allows models to incorporate the representation of more sophisticated producer and consumer behavior than would normally be possible through calibration. However, econometric estimation requires a consistent set of multi sector timeseries data and this data is usually not available for developing countries.

CGE models can also be differentiated by the time horizon of the analysis. The majority of CGE models are " static," meaning that no explicit dynamics are incorporated and the time frame for the attainment of a new equilibrium following a policy or external shock is indeterminate. In conducting simulations, an exogenous shock is introduced or a variable, such as a tax rate, is altered. The model is then allowed to search for a solution until a new set of prices is found which again equilibrates the system. The new prices in turn determine a new set of factor demands, outputs, and incomes. The values from this new solution are then compared with the values from the original equilibrium Dynamic models, on the other hand, incorporate an explicit updating of time dependent variables, such as the labor supply, capital stock, technology, and demand patterns. In conducting a simulation, a baseline case is first run with a given set of assumptions about the timedependent variables. Next, an alternative or counterfactual simulation is run with the same set of assumptions, but with a policy or external shock. The values resulting from the alternative solution are then compared with the original baseline. These values may be compared at different points in time or discounted to estimate present values, or to evaluate changes in welfare.

Another dimension along which CGE models may be classified is by scope: ( 1) single country or single region models ( 2) multi country or multi region models, and ( 3) global models encompassing all countries and regions. Although models representing a single country or region are the most common, multi country or multi region models are being developed in increasing numbers. Because trade is inherently a multi country phenomenon, multi country models are generally the best suited for examining issues that involve the flow of goods, services, and capital across national boundaries.

CGE models have been applied to an expanding array of environmental policy issues. Most recently, they have been used for the analysis of policies designed to avert or slow global climate change, such as those proposed in the Kyoto Protocol. Both single country and multi country CGE models have been used for these simulations, with multicountry models able to assess policies like global emissions trading. Because they are able to incorporate taxes and other existing distortions, CGE models have been used to explore the potential for a " double dividend"   a reduction in pollution plus a reduction in the inefficiencies of the tax system   from substituting taxes on pollutants for pre existing taxes on output, income, or wages. In addition CGE models have been used to perform retrospective analyses of the economic costs of a number of environmental regulations. 21 129 Chapter 8: Social Costs 19 References on social accounting matrices include Pyatt and Round ( 1985) and Chapter 10 of Sadoulet and de Janvry ( 1995).

20 This approach has been pioneered by Dale Jorgenson and a number of his collaborators. See in particular the papers collected in Jorgenson ( 1998a, 1998b). Another example of the use of the econometric approach is Hazilla and Kopp ( 1990).

21 For example, the Jorgenson Wilcoxen dynamic CGE model of the U. S. was used to estimate compliance costs between 1970 and 1990 for EPA's retrospective study of the benefits and costs of the Clean Air Act ( EPA, 1997b). A previous CGE based study by Hazilla and Kopp ( 1990) looked at the costs of both the Clean Air and Clean Water Acts. While CGE models have a number of advantages as tools for policy analysis, they also have serious drawbacks:

Although the costs have been reduced in recent years, the construction of a CGE model can be still be time consuming and expensive.

In addition to an appropriate input output table, a considerable amount of data on national accounts, trade, elasticities, and environmental externalities must be collected and made consistent with the sectors chosen to be part of the analysis.

Dynamic models also require that forecasts be made for many exogenous variables.

Many environmental policies only affect a small part of what may be a highly aggregated sector in an inputoutput table. Sometimes it will be possible to separate these smaller sectors out, but sufficient data is often not available at that level of detail.

8.5 Estimating the Social Costs of Alternative Policy Approaches This section discusses the methods of estimating the social costs for several alternative regulatory and nonregulatory policy approaches, which are divided into three categories: ( 1) direct controls, ( 2) incentive based controls, and ( 3) voluntary actions taken to reduce environmental risks. The discussion focuses on the significant features of each regulatory approach that must be examined in either partial equilibrium, multi market, or CGE models. In addition to the private compliance costs, transactions costs may be significant. Therefore, the associated changes in the prices of goods and services will alter producer and consumer surplus and must be calculated to estimate the total social costs.

Independent of the method used, the social cost analysis should explain how the uncertainties and assumptions in the data and models affect the results. Since much of the data used is not known with certainty and many assumptions must be made to develop the necessary analytical models, social cost estimates can never be known with total certainty. Another difficulty is that private ( compliance cost bounds in one project may be based on the intuition of a single engineer, but the private cost bounds in another sector may be developed based on adequate data permitting the estimation of confidence intervals. Aggregating these into a single study may conceal important uncertainties rather than enlightening the decision making process. 22 8.5.1 Direct ( or Standards Based) Controls In general, direct or standards based controls rely on different types of standards that mandate a level of performance intended to acheive an environmental objective.

<IP_ADDRESS> Technology Standards Estimating the private compliance costs of standards based regulations is relatively straightforward compared to incentive based approaches. Technology standards often require Best Available Technology ( BAT) or Best Practicable Technology ( BPT). Since these technologies already exist, their costs and the number of firms required to use them are often well documented. Additional compliance costs include expenditures on maintenance and training costs associated with installing and operating the equipment. However, estimating the private compliance costs is not always simple, especially for proposed regulations. For example, unanticipated scaling effects, as well as unforeseen bottlenecks in construction and implementation may occur, resulting in differences between the anticipated bids for a project, the bids received, and the actual construction cost.

The private real resource costs, when discounted over time, correspond to the sum of investment costs and discounted annual costs ( operating and maintenance and other annual regulatory costs) that will be incurred by firms to comply with the regulation. Thus, the realresource costs of regulation can be approximated, in most instances, by methodologies routinely used by other EPA 130 Chapter 8: Social Costs 22 Another reason for variability of the compliance cost estimates for pollution control may be due to the way emission rates are characterized their method of transport, and chemical transformation rather than variations in the price of pollution control equipment and labor costs. program offices to evaluate compliance costs. Furthermore, the supply and demand curves that implicitly lie behind such calculations need not be formally estimated unless the effects of the regulation on price and output are expected to be significant.

<IP_ADDRESS> Emission Standards Regulations that limit emissions are usually targeted at particular point sources or geographic regions, but there also exist national standards such as ambient air and water quality standards. For point sources, private compliance cost estimates are usually based on the cost to purchase and operate regulatory equipment needed to comply with the regulations. This equipment will be similar to that needed to meet technology standards. Since it may be prohibitive to examine in detail each area and all its pollution sources, private social and compliance cost estimates can be based upon random samples of representative areas and industries. The survey should accurately reflect the expected compliance costs for different categories and sizes of industries in each area. In each of the three cases, additional social costs are involved with monitoring and enforcement of the regulations.

<IP_ADDRESS> Production Bans The prohibition of a product or service results in shutdowns causing short and, sometimes, long term unemployment as well as the loss or premature retirement of capital equipment. Therefore, adjustment costs should include: ( 1) the value of wages temporarily or permanently foregone because of reductions in production levels in the directly affected markets23 and ( 2) the social cost of reemploying displaced workers ( including the administrative cost for transfer payment programs, but excluding the payment itself). Moreover, policies that effectively ban products or activities cause the loss of all producer and consumer surpluses in these markets. Regulations also may substantially affect secondary or linked markets. CGE and multi market models will account for these effects, but partial equilibrium models will not do so unless a separate model is used.

Some policies, although not explicitly banning production, may be so stringent that the effect on production is the same. In this case, the concept of compliance cost is less applicable. For example, if the mandated environmental protection controls would be so costly that the new equilibrium level of output is zero ( because the consumers of the good shift completely to substitutes and producers of the good exit this market to produce other outputs), then it is not possible to use compliance costs as an estimate of social costs. A ban on producing this good would produce a similar result.

In the case of an effective ban on production, the social cost of the new policy is measured by the complete loss of all producer and consumer surpluses in this market. The real resource cost in this case might be conceptualized as the welfare change associated with the additional expense and lower quality of the other goods that consumers purchase as substitutes for their previous use of the product.

8.5.2 Incentive Based Controls The appeal of incentive based approaches is their potential ability to achieve environmental improvement goals more cost effectively than traditional standards based methods. The approaches examined here include: marketable permits emission taxes, bubbles and offsets, user charges, product charges, subsidies for pollution reduction, government cost sharing, refundable deposits, pollution indemnity and information and labeling rules. In many cases, significant transfers will occur between private parties and the government, but in most cases, these policies achieve their greater economic efficiency through mechanisms that encourage private parties to use information known to them but not to the environmental authorities. Such information may include differences in emission control costs among different firms. Analyses of the social costs of incentive based approaches may require different information and tools than those used to analyze more traditional 131 Chapter 8: Social Costs 23 Lost wages, rather than lost production, is suggested as a proxy for the value of displaced resources. In most cases, lost wages will capture most of the value of displaced resources because it is likely that inputs other than labor will be reallocated to other sectors of the economy fairly quickly and at little cost. policies. The task of calculating the exact compliance costs of these policies is therefore more difficult. 24 <IP_ADDRESS> Marketable Permits Permits are usually denominated in the amount of emissions allowed and the number and denomination of permits issued determines the aggregate amount of emissions 25 Marketable permits establish the aggregate quantity of pollution allowed and allow the price of those entitlements to vary. Since different polluters incur different private costs to control emissions, they will be willing to pay different amounts for permits. The price of permits, in theory, will be established by the unit cost of control of the marginal polluter. Marketable permits are traded between emission sources, giving rise to a transfer among private parties but not social costs.

In contrast to technology standards, incentive based approaches ( taxes or permits) do not require any particular firm to install particular pollution control devices. Therefore, it is usually necessary to predict what technology will be used by the firms to meet the new regulations to estimate costs. Under a marketable permit system, the private costs of pollution control are estimated following a three step process:

Calculate the demand and supply functions for the permits ( these demand and supply functions are based on the costs of different sources' pollution control options). Polluters will be willing to pay prices for the permits up to the unit cost of reducing emissions.

Estimate the equilibrium price for permits. This price will determine which firms will install pollution control measures and those which will purchase additional permits.

Calculate the real resource cost of the regulation by summing the investment costs and the present value of operating and maintenance costs incurred to reduce emissions. ( The cost of the permits purchased by firms is classified as an income transfer between firms, not a social cost.)

Marketable permits may be sold at auction initially, in which case the prices bid for the newly issued permits again represent income transfers to the government. Alternatively, permits may be allocated to sources by some rule, in which case no private costs are imposed at the outset. In neither case is the private cost of a permit counted as part of the social cost, since it is not a realresource cost, but rather a transfer from one firm to another or a transfer from a firm to the government. The act of establishing the permit system and assigning property rights to the distributed permits may result in some type of " wealth transfer" taking place, which should be accounted for in the equity assessment of the benefit cost analysis.

As described earlier, the marketable permit systems requires the creation of a functioning market. This results in administrative costs and also additional enforcement costs since it is necessary to ensure that emissions do not exceed the levels for which permits are held. Both need to be added to the social cost estimate.

<IP_ADDRESS> Emission Taxes Estimates of the social costs of pollution control under emissions taxes are virtually the same as those under marketable permits. Here however, the unit price of pollution will be known ( since it is set by the regulation) and does not have to be calculated. Because the private cost of pollution control varies among firms, firms with the highest private costs of pollution control are expected to cut back production and pay the tax on the remaining emissions, rather than install required pollution control equipment. Most often, firms will choose some combination of cutbacks in production, installation of pollution control equipment, and payment of the tax. However, as in the case of most regulations, real world limitations may reduce the possible selection of cost minimizing alternatives chosen or firms may simply decide to engage in litigation to delay the regulation, which adds an additional cost.

132 Chapter 8: Social Costs 24 However, after the policy is passed, compliance costs are much easier to calculate. In the case of emission taxes, cost minimizing polluters in theory, will reduce emissions up to the point where the marginal cost of control equals the tax. Of course, these conclusions rest upon the assumptions of perfectly competitive markets, low transactions costs, and complete information.

25 Permits may also be weighted based on the impact the pollutant has on air or water quality. After the supply ( or abatement cost) function for each firm is estimated, then the equilibrium amount of pollution generated can be determined. The new production levels can then be calculated for each firm along with how much pollution control equipment will be installed. Finally, the real resource costs and private costs are calculated as is done above for marketable permits. However, here the pollution taxes or charges may involve transfers of tax revenues from the private sector to the government, but because such fees accrue to the government, they are again income transfers and should not be included in total social costs.

<IP_ADDRESS> Bubbles and Offsets Bubbles and offsets allow emissions to be averaged among specific regions or among different sources within a particular facility. The resulting level of emission control must be equivalent to or better than that required by existing regulations. If " banking" is allowed, pollution credits can be traded across time   with potential offsets created in one period to be used in later periods. Bubbles and offsets create incentives to reduce emissions in firms where the private costs of control are relatively low. Compared with direct controls, bubbles and offsets usually result in lower compliance costs ( relative to costs incurred under technology and emission standards).

Additional social costs associated with bubbles and offsets are similar to those encountered with marketable permits. Initial administrative costs may be significant and some additional enforcement costs for monitoring emission levels also may be incurred. The private cost of the offsets traded in a formal market are transfers between the creator and the user of the offset and are not social costs. However, the transactions costs incurred to arrange the trade, both private and public, are part of total social costs.

<IP_ADDRESS> User Charges Charges may be imposed directly on users of publicly operated facilities. Such charges have been imposed on firms that discharge waste to municipal wastewater treatment facilities and on non hazardous solid wastes disposed of in publicly operated landfills. User charges are usually set at a level sufficient to recover the private costs of operating the public system, rather than to create incentives for reducing pollution. Measuring the total social cost imposed by user charges is similar in concept to measuring the social costs of emission charges, but is not always based on a per unit charge of the pollutant.

<IP_ADDRESS> Product Charges Charges may be imposed on intermediate or final products whose use or disposal pollutes the environment. The private and social costs imposed by product charges depend on the extent to which users switch to substitutes, reduce the rate at which the product is used by recycling or other process changes, or continue to use the regulated products Predicting responses and estimating compliance costs is difficult and requires analysis of the social costs and effectiveness of substitute products as well as the social costs of recycling and reuse. Any charges paid as a result of continuing use represent private costs, but are not social costs because these are borne by the consumer who buys less of the more expensive product.

<IP_ADDRESS> Subsidies for Pollution Reduction Subsidies paid to polluters based on their reductions in pollution have the same general effect on behavior as charges on pollution. Sources may reduce pollution up to the point where the private costs of control equal the subsidy Using subsidies instead of charges shifts private costs to the government. This may result in more sources continuing to operate than if a charge system were used. Thus, subsidies and charges may not have the same aggregate social costs or the same degree of pollution control.

Measuring the social costs resulting from a system of pollution subsidies is similar in concept to measuring the social costs resulting from pollution charges, except that private costs are reduced by the amount of the subsidy, rather than being increased by the amount of the fee. Again, the subsidies themselves are income transfers and do not constitute a social cost. Therefore, private real resource costs should be computed excluding the subsidies.

<IP_ADDRESS> Government Cost Sharing In addition to issuing the regulations described above, the government may take actions to lower the private costs of 133 Chapter 8: Social Costs specific actions   most notably, by subsidizing investments in pollution control equipment. These subsidies may take the form of reduced interest rates, accelerated depreciation direct capital grants, and loan assistance or guarantees for pollution control investments. Such policies may not by themselves induce changes in private behavior. However, in conjunction with direct controls, pollution fees, or other regulatory mechanisms, they may influence the nature of private responses and the distribution of the cost burden. In particular, such subsidies may encourage investment in pollution control equipment, rather than other responses that do not require capital investments ( e. g., changes in operating practices or recycling and reuse).

Government cost sharing subsidies reduce the private costs associated with the resulting private investments. However, social costs may arise if cost sharing programs lead to resource misallocations. Additional social costs will result from administration of the subsidy program, but are likely to be minor if the incentives are provided through the existing tax system. However, they may be significant if new administrative structures are required.

<IP_ADDRESS> Refundable Deposits Refundable deposits create economic incentives to return a product for reuse or for proper disposal, providing that the deposit exceeds the private cost of returning the product Therefore, to predict the rates of return, the private cost of returning products must be estimated.

Under a refundable deposit system, compliance costs consist of the resources ( labor, equipment, and transportation required to return the regulated product, and the private cost of preparing products for reuse ( if required), less the cost of new products replaced by recycled products. The private administrative costs of a deposit system vary, depending on where in the production consumption cycle they occur and from whom the deposits are collected. Record keeping requirements may also be a cost component For those that participate in a recycling/ refund program the opportunity cost of the time spent sorting trash is an important component, and the analysis must address whether other behavior changes may be expected to take place ( e. g., whether consumers may adjust their consumption of products marketed in recyclable containers). The deposits themselves represent transfers from one point in the production consumption cycle to another and, hence, are not social costs. These transfers are temporary if the deposit is reclaimed, but permanent if it is not. Enforcement costs are minimal since no standards have been set and no laws are broken if the product is not returned.

A government " buy back" constitutes another type of refundable deposit. Under this system, the government either directly pays a fee for the return of a product or subsidizes firms that purchase recycled materials. They are equivalent to product deposits, except that the government rather than the purchaser, provides the deposit. The government subsidy represents a transfer from the government to the private sector, which offsets the private costs of recycling products.

<IP_ADDRESS> Pollution Indemnity Regulations that impose stricter liability on polluters for the health and environmental damage caused by their pollution may reduce the transaction costs of legal actions brought by affected parties. Such regulations do not impose additional social costs, but only shift the costs from one party to another. However, this may induce polluters to alter their behavior and expend real resources to reduce their probability of being required to reimburse other parties for pollution damages. For example, they may reduce pollution, dispose of waste products more safely, install pollution control devices, reduce output, or invest in added legal counsel.

Other regulations may require firms to demonstrate financial ability to compensate damaged parties by posting performance bonds that are forfeited in the event of damages, by obtaining liability insurance, or by contributing to a pool of funds to compensate victims. The administrative and enforcement costs imposed by such requirements represent the use of economic resources but are not counted as part of the social costs because the funds used to pay damages do not represent a use of resources, but are transfers among private parties ( between polluters, insurers, and victims of pollution). Again, however, these requirements are likely to alter private behavior and lead to increased outlays of real resources to reduce the probability of accidents, or reduce the probability of having to pay using any of the methods cited above.

134 Chapter 8: Social Costs <IP_ADDRESS> Information and Labeling Rules Information or labeling rules may be applied to specific substances or to certain contaminated locations. For example, warning labels may be required for hazardous substances that describe safe handling procedures or describe the risks posed by the product. Purchasers may then switch to less damaging substitutes for some or all uses or handlers of hazardous substances may be better able to prevent damages. Posting information on contaminated locations gives potentially exposed parties the opportunity to avoid hazards   for example, contaminated dump sites or drinking water aquifers.

Calculating the private costs of complying with information and labeling requirements for particular cases is straightforward Compliance costs include the cost of developing the required information ( analyzing the composition of substances, monitoring and testing of sites, testing for health damages, etc.) and the cost of disseminating information ( printing and applying labels, maintaining and publishing information on sites).

Similarly, the direct costs of enforcing and administering the requirements ( including government review and approval of labels) can be calculated directly. Calculating aggregate private costs may be more difficult, however, if the number of containers requiring labels or the number of facilities affected is unknown. In addition, it is difficult to predict responses by the recipients of the information and, hence, the social cost of avoidance.

8.5.3 Voluntary Actions While there can be social costs associated with voluntary actions taken to mitigate environmental polluting behavior, it may be difficult to establish the relation between decisions made by firms or individuals and the role EPA and other regulatory agencies may play in inducing or contributing to the adoption of these practices. EPA and other regulatory agencies are looking to alternative nonregulatory approaches in an effort to change behavior that contributes to health and environmental risks. Examples of EPA programs of this type include the 33/ 50 program for reduction of toxic pollutant discharges and energy conservation and greenhouse gas mitigation measures, such as ENERGY STAR and Climate Wise programs. 26 A basic premise underlying social cost analyses is the assumption that profit maximizing firms undertake investment decisions, voluntary or otherwise, when it is in their private interests to do so ( i. e., where private benefits are greater than private costs). If actions would not have occurred absent EPA's involvement in these programs, then there may be social costs ( beyond those costs incurred by EPA) that are associated with actions taken by participants in the programs. Social costs may arise, for example, from firms exhibiting strategic behavior in their investment decision that incorporates expectations that voluntarily participating in nonregulatory programs may serve to reduce or delay promulgation of future, potentially more stringent enforceable compliance standards. Without some assessment of costs, it is difficult to establish whether a particular voluntary program is cost effective in comparison with other policy actions. As a consequence it is useful to investigate the social costs associated with nonregulatory programs   quantifying how they affect economic markets, and evaluating the relative economic efficiency of these approaches as compared with regulatory policies.

8.6 Summary and Conclusions This chapter has reviewed the theoretical foundations of social cost assessments as well as practical methods for measuring the social costs of environmental policies. Several key conclusions reached in this discussion are worth reiterating.

First, in most cases, the social costs of an environmental policy or other action can be measured with sufficient accuracy by limiting the analysis to the directly affected markets. This allows the analysis to focus on the sectors that must comply with a policy. In these cases, the disturbances that ripple outward from the directly affected markets to numerous other markets should have a minimal effect on the estimation of social costs.

135 Chapter 8: Social Costs 26 More information on the operations and objectives of these types of programs can be found in publications prepared by EPA's Office of Reinvention and at the following website http:// www. epa. gov/ reinvent/ ( accessed 8/ 28/ 2000). Second, a conventional partial equilibrium depiction and modeling of the directly affected markets will often be sufficient to measure social costs. The detail and precision of applying this approach in practice will depend on the availability of information, the resources devoted to the evaluation and the value to policy makers of improved accuracy of the results.

Finally, other modeling techniques, such as CGE, are often used to measure a variety of indirect costs, the many transitional effects of environmental policies, and, when they are significant, transactions costs borne by private sector entities. Nevertheless, the majority of the economic analysis of environmental policies can employ the conventional partial equilibrium modeling approach to evaluate social costs of EPA policies and programs.

136 Chapter 8: Social Costs 8.7 References Arnold, F. S. 1995. Economic Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons, Inc.

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Goulder, L. H. 1995. Effects of Carbon Taxes in an Economy with Prior Tax Distortions: An Intertemporal General Equilibrium Analysis. Journal of Environmental Economics and Management 29: 271 297.

Gramlich, E. M. 1981. Cost Benefit Analysis of Government Programs. Englewood Cliffs, NJ: Prentice Hall, Inc.

Greene, W. H. Econometric Analysis. 1996. 3rd edition. New York, NY: Macmillian.

Harrington, W., R. Morgenstern and P. Nelson. 1999. On the Accuracy of Regulatory Cost Estimates, Discussion Paper 99 18. Resources for the Future, Washington, D. C.

Hazilla, M. and R. J. Kopp. 1990. Social cost of environmental quality regulations: a general equilibrium analysis. Journal of Political Economy, 98 ( 4): 853 873.

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Jorgenson, D. W. 1998b. Growth, Volume 2: Energy, the Environment, and Economic Growth. Cambridge, MA: MIT Press.

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138 Chapter 8: Social Costs 139 9.1 Introduction In an effort to fully understand a regulation's impact and make an informed judgement regarding its desirability, policy makers study many different regulatory consequences. Economic information is important to the evaluation of at least two consequences   a regulation's efficiency and its distributional consequences. In principle, both types of consequences could be estimated simultaneously by a general equilibrium model. In practice, for reasons discussed in Chapter 5, they are usually estimated separately.

A benefit cost analysis ( BCA) calculates the social benefits and costs of an environmental policy and answers the question of whether the benefits are sufficient for the gainers to potentially compensate the losers, leaving everyone at least as well off as before the policy. Its calculation of net benefits helps ascertain the economic efficiency of a regulation. Two other ways to express economic information   an economic impact analysis ( EIA) and an equity assessment   assess changes in social welfare by examining the distributive effects of a regulation. An EIA focuses on traditional classifications of affected populations1 ( e. g., industrial sector classifications). Under the heading of equity assessment analysts can address broad concerns such as changes in the national distribution of income or wealth. In addition, an equity assessment can provide information to decision makers on how policies affect specific sub populations. Disadvantaged or vulnerable sub populations ( e. g., low income households) may be of particular concern.

Economic Impact Analysis ( EIA)

An EIA helps answer the questions, " Who are the losers and gainers from a policy?" and " By how much do they lose or gain?" Traditionally, EIAs have focused on the losers and the negative impacts of an environmental regulation. This focus is in response to existing legislative and administrative statutes and policies which direct analysts to examine the distribution of negative regulatory impacts or costs. Currently, several of these same statutes and policies call for a similar examination of the positive impacts of a regulation.

Unlike a BCA which rests its conclusions exclusively on comparisons of social benefits and costs, an EIA examines the distribution of many different economic impacts. Conventional impacts include monetized effects such as changes in profitability or in government revenues, as well as non monetized effects such as increases in unemployment rates or numbers of plant closures. An EIA will often examine and report on regulatory outcomes that a BCA would not. For example, when measuring impacts on private Chapter 9 Chapter 9: Distributional Analyses: Economic Impact Analyses and Equity Assessments 1 The term " affected" is applied throughout the chapter in its most general use as an economic term. Analysts should be aware of how the authorizing statute for the rule, as well as other applicable statutes and administrative orders noted in this chapter, make more specific use of this term. For example, the Regulatory Flexibility Act includes the clause " subject to the requirements of the rule" when quantifying economic impacts. This results in analyzing entities that are directly affected, so that conclusions can be drawn as to the significance of impacts of the rule. Alternatively, provisions in UMRA and EO 12866 address both direct and indirect impacts, so that the affected population of entities may be more inclusive than only those " subject to the requirements of the rule." For more information Chapter 8, Section 3 on " Social Cost Analysis" covers the economic concepts and terminology relevant to direct and indirect impacts. businesses, an EIA will include changes in transfer payments from firms to the public sector whereas a BCA would not. Transfer payments become important when analyzing the distributional consequences of a regulation. To achieve the objective of an EIA and educate policy makers about who will lose or gain as a result of a particular regulation, analysts have traditionally relied upon the assortment of impacts described in Section 9.2 below.

Equity Assessment Generally, assessments of equity examine a regulation's impact on the distribution of national income or wealth. Decision makers may use this information in conjunction with economic efficiency measures as captured in a benefit cost analysis to evaluate tradeoffs between equity and efficiency. For the most unified treatment, both equity and efficiency issues can be addressed in a computable general equilibrium model. 2 In practice, data constraints will limit analysts to undertake distributional analyses independently from benefit cost analyses.

As is true for an EIA, an equity assessment is generally more concerned with sub populations who experience net costs or other negative impacts than with those who experience net benefits or positive impacts. An equity assessment may consider effects on any sub population, but it should always consider the economic effects of a regulation on disadvantaged or vulnerable sub populations; specifically, sub populations who are physically susceptible to environmental contamination, are less than fully capable of representing their own interests, or are economically disadvantaged or vulnerable. Examples include children, low income or minority communities, and small businesses governments, and not for profit organizations. For many of these sub populations, EPA has been directed by statute or policy to examine the effects of its rules when they are expected to have a " disproportionate," " significant and substantial," or other such impact.

An equity assessment draws on information and analytic tools used in BCA and may report on impacts using measures found in an EIA. Therefore, an early step in an equity assessment is to identify sub populations likely to be affected by a regulation. Once identified, if data permits, the social costs and benefits estimated for the BCA can be disaggregated and net benefits for the sub population( s) or the distribution of net benefits among sub populations, can be examined. An equity assessment may also examine economic impacts, such as increases in rates of unemployment or other traditional impact measures, for the identified sub population( s).

Consistency Between BCA and Distributional Analyses Ensuring consistency in analytic design and interpretation of results for the BCA, EIA and equity assessment supporting a particular regulation is essential. All three examine impacts that, in principle, could be estimated by a single general equilibrium model ( see Section 5.2). Both an EIA and an equity assessment must be conducted following the principles that frame a BCA, even if the formal preparation of BCA is not undertaken. When a BCA is undertaken, to the extent possible, both distributive analyses should adopt the same set of assumptions used in the BCA. For example all three should rely upon the same set of baseline assumptions and all three should assume the same values for relevant elasticities. However, because all the information needed to estimate distributive outcomes is often not integral to the calculations performed in a BCA, in many cases further assumptions must be developed specifically for the EIA or the equity assessment. For example, new assumptions regarding definitions of sub populations must be developed and there might be good reason to assume different elasticities for different sub populations. Even in these cases, analysts should ensure that the implications, if any, of the added assumptions for the outcome of the BCA are understood and made manifest to policy makers.

Using a Social Welfare Function to Evaluate Efficiency Equity Tradeoffs Potentially, a regulation's effects on distribution, analyzed by its EIA and/ or equity assessment, and its effects on efficiency, analyzed by its BCA, can be incorporated into a single social welfare function. A social welfare function establishes criteria under which efficiency and equity outcomes are transformed into a single metric, making them directly comparable. A potential output of such a function is a ranking of policy outcomes that have different aggregate levels and distributions of net benefits. A social welfare function can provide empirical evidence that a policy alternative yielding higher net benefits, but a less 140 Chapter 9: Distributional Analyses 2 Computable general equilibrium models are discussed in section 8.4.5. equitable distribution of wealth, is better or worse than a less efficient alternative with more egalitarian distributional consequences. 3 In practice, developing a universally acceptable social welfare function is difficult because it requires explicit decisions to be made about society's preferences for the distribution of resources. Nonetheless, future research may result in some feasible practical alternatives. 4 These guidelines do not suggest a particular social welfare function or that analysts attempt to use this approach at this time, but the approach may merit further consideration as additional research and applications develop.

Chapter Summary This chapter begins with a brief discussion of an iterative process between analysts and management to facilitate thorough consideration of the output from distributional analyses. The bulk of the chapter occurs in Section 9.2 on Economic Impact Analysis which, after reviewing statutes and policies that require examination of economic impacts, describes methods for estimating economic impacts that are relevant for both EIAs and equity assessments The final section of this chapter discusses the relatively new distributional analysis, equity assessment. Statutes and policies that require equity assessment, definitions of sub populations, and a general framework for conducting an equity assessment, including possible data sources, are reviewed.

9.1.1 A Process for Economic Impact Analyses and Equity Assessments This section describes an iterative process between EPA analysts and senior management5 as an integral part of an EIA and an equity assessment. At several points of the regulatory development process, senior analysts should report the results of distributional analyses to senior management and receive feedback. Only through such ongoing communication can senior management remain sufficiently informed so that potential economic effects of proposed environmental regulations receive proper attention within the regulatory development process.

As discussed above, ensuring consistency between the EIA, equity assessment, and BCA is critical. The methods and results of an EIA and an equity assessment are inherently linked to their corresponding BCA. Consequently, concerns regarding distributional outcomes that arise through the iterative process that necessitate a change in the regulatory approach will also require adjustments to the assessment of social benefits and costs.

This iterative process is not expected to add significant additional administrative procedures to the current EPA regulatory development process. Rather, its objective is to bring greater attention to opportunities for the workgroup and senior management to have ongoing communication related to potential economic impacts and equity dimensions of proposed environmental regulations. Frequent and timely exchanges of information between senior management and the workgroup will focus greater attention on affected sectors of the economy as well as affected subpopulations and may influence the final regulatory alternative selected.

Information contained in Exhibit 9 1 illustrates such a process. Its contents are consistent with the procedures outlined in the document, Regulation Development in EPA ( EPA, 1997) and with the process for promulgating a regulation illustrated by the flow chart in Guidance for Analytic Blueprints ( EPA, 1994). There are two key components of Exhibit 9 1 that are designed to institutionalize the iterative process between the workgroup and senior management for EIAs and equity assessments. The first component is an explicit incorporation of the identification and analysis of economic impacts and equity dimensions such as those listed in Exhibits 9 2 and 9 5 into the regulatory development process. The second component, depicted by the arrows, is a process for initiating multiple 141 Chapter 9: Distributional Analyses 3 For more on the use of social welfare functions in policy analysis see Sen ( 1970), Arrow ( 1977), and Jorgenson ( 1997). An empirical application of this approach can be found in Norland and Ninassi ( 1998).

4 For a recent description of potential alternatives see Farrow ( 1998).

5 Senior management is used as shorthand for persons responsible for authorizing and using these forms of analysis. Most often, these persons will include the Assistant or Regional Administrator of the lead office or region that is considering the regulation or other upper management within that office or region. Chapter 9: Distributional Analyses 142 re evaluations of a regulation during the development process. This process includes three key tasks.

Identify potentially important economic impacts and equity dimensions for senior management to help determine which may be of concern. This should be done as part of the analytical blueprint process. The analytic blueprint provides an opportunity for early identification of important issues in order to enhance the quality of information provided to senior management to assist in decisions for a particular regulation or policy. While required for Tier 1 and 2 regulations, analytic blueprints are encouraged for Tier 3 regulations as well.

Conduct a preliminary analysis of these economic impacts and equity dimensions once senior management has approved the analytic blueprint. This is the second point where the iterative process affects a regulation's development. Analysts should share the results with senior management who should then determine whether to proceed to a more detailed analysis or to revisit the preliminary analysis. Senior management may even decide to alter the overall regulatory approach being considered which could require revising the BCA as well as the analytic blueprint. The potential need to revise the analytic blueprint is consistent with the idea that it is a living document. 6 Develop options and prepare detailed economic analysis after the preliminary analysis is complete. Data and information developed as part of this effort will provide input for conducting distributional analyses for the impacts and dimensions identified earlier. Here is the third point where the iterative process comes into play. It is recommended that input from senior management be sought once more before proceeding to closure. Additional economic impact and 6 For a detailed discussion of the concept of the analytic blueprint as a living document and more information on the " Tiering" of rules, see pp. 12 13 Guidance for Analytic Blueprints ( EPA, 1994) and see section 5, p. 31 Regulation Development in EPA ( EPA, 1997). Tier Assigned & Workgroup Members Identified Early Guidance from Senior Management Workgroup Prepares Analytic Blueprint and Identifies Potential Economic Impacts and Equity Dimensions Senior Management Reviews Analytic Blueprint Approval Workgroup Conducts Preliminary Analysis and Analyzes Economic Impacts and Equity Dimensions Senior Management Reviews Preliminary Analysis Non approval Approval Workgroup Develops Regulatory Options and Analyzes Economic Impacts and Equity Dimensions Senior Management Reviews Detailed Analyses Non approval Approval Workgroup Prepares Rule, Draft Policy, etc. Alternatives Selection OMB Review Workgroup Closure Administrator's Signature Federal Register Publication Non approval Exhibit 9 1 Flow Chart: A Process for Economic Impact Analyses and Equity Assessments equity analysis may be warranted for a variety of reasons including new insights gathered from the regulatory review process.

9.2 Economic Impact Analysis 9.2.1 Introduction to Economic Impact Analysis As discussed in Chapter 5 above, a BCA calculates the total social benefits and total social costs associated with an environmental policy and measures the change in overall economic efficiency. As part of the effort to inform policy makers, it is important to not only understand the change in economic efficiency, but to understand the distribution of negative and positive impacts associated with this change. An EIA contributes to this understanding. It identifies losers and gainers from a policy and estimates the magnitude of their gains and losses. An EIA does this by studying the economic changes occurring across broadly defined economic sectors of society such as industry, government not for profit organizations, and consumers. In addition to these broad categories, an EIA will examine more narrowly defined sectors within these broad categories such as the solid waste industry or an individual solid waste company. Traditionally, EIAs have focused on the losers and the negative impacts of an environmental regulation, although at least two general directives ( see Exhibit 9 2) suggest that the positive impacts be examined as well.

EIAs measure impacts in different ways, from direct impacts on private business   including individual plants, whole firms, and industrial sectors   to indirect impacts on customers and suppliers. EIAs also measure direct and indirect impacts on governments and not for profit entities such as schools or hospitals. Impacts include changes in profitability, employment, prices paid by consumers, government revenues or expenditures, trade balances, and other changes of interest to policy makers.

Ensuring consistency of the EIA with the BCA for a particular regulation is essential. For consistency, an EIA must be conducted within the analytical bounds of its corresponding BCA. To the extent possible, the EIA should adopt the same set of assumptions used by the BCA. Adjustments or additions to these assumptions or to the overall modeling framework used for the BCA should be made only when they help bridge the difference between social and private perspectives, such as the difference between the social cost of a regulation and private compliance costs.

EPA's programs and regulations vary greatly in the types of parties affected and the nature of economic impacts that may be important. The data available for analysis vary widely as well. Thus, while specific methods for estimating impacts are reviewed, it is expected that every EIA will focus on the particular issues associated with the set of regulations under review. The general methods outlined here should be adapted to fit the needs of a particular analysis.

The remainder of this section is divided into twelve subsections The first outlines the statutes and policies that direct EPA, and other government agencies, to study the distribution of positive and negative impacts. The second gives a broad overview of models for estimating social costs and how such models might relate to distributional analyses. In the third section, we begin explaining how to assess economic impacts. We begin with the first step, which is to calculate compliance costs. The next steps   how to screen for significant impacts and how to profile affected entities   are outlined in the fourth and fifth sections Finally, beginning in Section 9.2.7, we review methods for estimating specific impacts, in the following order: impacts on prices; impacts on production and employment impacts on profitability and plant closures; impacts on related industries and consumers; aggregate impacts on innovation, productivity, and economic growth; impacts on industry competitiveness; and impacts on governments and not for profit organizations.

9.2.2 Statutes and Policies Requiring Examination of Economic Impacts There are at least two general administrative laws or orders that direct analysts to examine economic impacts; each is reviewed below. Some parts of environmental statutes also require consideration of economic impacts. Relevant quotations from a selection of these are presented.

143 Chapter 9: Distributional Analyses <IP_ADDRESS> General Administrative Laws or Orders At least one statute   The Unfunded Mandates Reform Act of 1995 ( UMRA)   and one executive order   EO 12866, " Regulatory Planning and Review"   require agencies to analyze various economic impacts of regulatory actions. 7 These directives require analysts to report on economic information that does not directly concern the net benefits tests for efficiency in a BCA. The first calls for analysts to examine the distribution of benefits and costs across different sectors of the economy. The second directs that certain outcomes be examined, such as changes in unemployment rates. For each policy, Exhibit 9 2 gives the dimensions for which impacts are to be analyzed and the corresponding analytical requirements. A discussion of these requirements follow the table.

As outlined by Exhibit 9 2, UMRA requires analysts to examine the costs, benefits, and budgetary effects of regulatory actions as experienced by state, local, and tribal governments regions; urban or rural or other types of communities or particular segments of the private sector. For the national economy, UMRA suggests many impacts that must be examined, including effects on productivity, economic growth, full employment, creation of jobs, and international competitiveness. These requirements apply only to rules that include federal mandates " which may result in the expenditure by state, local, and tribal governments in the aggregate, or by the private sector, of $ 100 million or more in any one year." 8 Exhibit 9 2 also briefly summarizes relevant parts of guidance from the Office of Management and Budget for EO 128669 ( OMB, 1996 or Best Practices) and Guidelines to Standardize Measures of Costs and Benefits and the Format of Accounting Statements10 ( OMB, 2000 or OMB Guidelines). The Best Practices suggests that analysts examine the distribution of impacts across various sectors of the economy: " Information on distributional impacts related to the ( regulatory) alternatives should accompany the analysis of aggregate benefits and costs." 11 In the OMB Guidelines, the focus for a distributional analysis is placed on those sectors that are likely to feel substantial impacts: " If these distributive effects are important, you should describe the effects of various regulatory alternatives quantitatively to the extent possible, including their magnitude, likelihood, and incidence of effects on particular groups." 12 The Best Practices also states, " The term ' distributional effects' refers to the description of the net effects of a regulatory alternative across the population and economy, divided up in various ways . . ." 13 This clearly suggests that both positive and negative impacts are relevant.

OMB cautions analysts conducting distributional analyses to recognize that transfer payments will become relevant, to avoid double counting even when mixing monetized and physical effects, and to describe distributional effects without judging their fairness.

" Since generally accepted principles do not exist for determining when one distribution of net benefits is more equitable than another, you should describe distributional effects without 144 Chapter 9: Distributional Analyses 7 EO 13132, Federalism which took effect on November 2, 1999, and EO 13084, Consultation and Coordination With Indian Tribal Governments which took effect on August 12, 1998, both support the objectives of UMRA.

8 UMRA § 202.

9 U. S. Office of Management and Budget's Economic Analysis of Federal Regulations Under Executive Order 12866, January 11, 1996. This " Best Practices" document can be found at the U. S. White House, Office of Management and Budget website: http:// www. whitehouse. gov/ OMB/ inforeg/ riaguide. html under the section titled " Regulatory Policy" ( accessed 8/ 28/ 2000).

10 U. S. Office of Management and Budget's M 00 08 Guidelines to Standardize Measures of Costs and Benefits and the Format of Accounting Statements, March 22, 2000. The OMB Guidelines serves to implement Section 638( c) of the 1999 Omnibus Consolidated and Emergency Supplemental Appropriations Act and Section 628( c) of the Fiscal Year 2000 Treasury and General Government Appropriations Act. They require OMB to issue guidelines to help agencies estimate the benefits and costs of Federal regulations and paperwork and summarize the results of the associated analysis. The OMB Guidelines can be found at the U. S. White House, Office of Management and Budget website: http:// www. whitehouse gov/ OMB/ memoranda/ index. html under the section titled " Selected Memorandum to Heads of Federal Departments and Agencies" ( accessed 8/ 28/ 2000).

11 Best Practices, p. 10.

12 OMB Guidelines, p. 16.

13 Best Practices, p. 23. judging their fairness. You should describe these effects broadly, focusing on large groups with small effects per capita, as well as on small groups experiencing large effects per capita. You should also note any equity issues not related to the distribution of policy effects if they are important and describe them quantitatively to the extent you can." 17 9.2.3 Models for Assessing Economic Impacts As noted above, the analytic methods used for a distributional analysis of a particular regulation should be consistent with those used for the corresponding BCA. This section returns to the four methods for estimating social costs covered in Chapter 8, adding more insights on their application to distributional impacts. 18 The most sophisticated method   computable general equilibrium ( CGE)   is 145 Chapter 9: Distributional Analyses General Administrative Dimension Analytical Requirements Law or Order UMRA State, local, and tribal Qualitative and quantitative assessment of anticipated governments; the costs and benefits of the federal mandate, including costs private sector and benefits to state, local, and tribal governments or the private sector.

Geographic location Estimates of any disproportionate budgetary effects of the Federal mandate upon any particular regions of the nation or particular state, local, or tribal governments; urban or rural or other types of communities; or particular segments of the private sector.

National economy Estimates of the effect of the federal mandate on the national economy, such as the effect on productivity, economic growth, full employment, creation of productive jobs, and international competitiveness of U. S. goods and services.

OMB Guidance for Population and An economic analysis ( EA) should describe the net effects EO 12866 and economy, divided of a regulatory alternative across the population and Accounting Statements up in various ways economy. ( e. g., income groups, " Irrespective of the presentation of monetized race, sex, industrial benefits and costs, the EA should present available sector) physical or other quantitative measure of the effects of the alternative actions to help decision makers understand the full effects of alternative actions." 16 14 Exhibit 9 2 does not include a discussion of The Regulatory Flexibility Act of 1980 ( RFA), as amended by the Small Business Regulatory Enforcement Fairness Act of 1996 ( SBREFA), as they are discussed below in Section 9.3, " Equity Assessment."

15 The Office of Regulatory Management and Information's Rule and Policy Information Development System ( RAPIDS) http:// intranet. epa. gov/ rapids ( accessed 8/ 18/ 2000, internal EPA document) is a resource for EPA personnel who wish to read relevant statutes, executive orders or Agency policy documents in their entirety or to acquire copies.

16 Best Practices, p. 23.

17 OMB Guidelines, p. 16.

18 For additional information regarding the four methods for estimating social costs see Section 3 of Chapter 8. Exhibit 9 2 Economic Impacts Required by General Administrative Law or Order14,15 treated first and moves to less complex approaches, concluding with direct compliance costs.

<IP_ADDRESS> Computable General Equilibrium Models A CGE framework can be used to describe the effect of a particular policy on overall measures of economic performance such as aggregate output, welfare, and the level of employment. CGE models are particularly effective in assessing static resource allocation and welfare distribution effects. These include the allocation of resources across sectors ( e. g., employment by sector), the distribution of sectoral output, the distribution of income among factors, and the distribution of welfare across different consumer groups, whole regions, and countries. By construction the basic capacity to describe and evaluate these sorts of distributional impacts exists to some extent within every CGE model. More detailed impacts, or impacts of a particular kind, will require a more complex and/ or tailored model formulation ( and the data to support it).

The simplest CGE models generally include a single, representative consumer, a few production sectors, and a government sector, all within a single country, static framework Complexities may be specified for the model in a variety of ways. Consumers may be divided into different groups along the lines of income, occupation, or other socioeconomic criteria. Producers may be disaggregated into dozens, or even hundreds, of sectors, each producing a unique commodity. The government, in addition to implementing a variety of taxes and other policy instruments may produce public sector outputs, provide a public good, or run a deficit. CGE models may be international in scope, consisting of many countries or regions linked by international flows of goods and capital. The behavioral equations that characterize economic decisions may take on simple or complex functional forms. The model may be solved dynamically over a long time horizon, incorporating inter temporal decision making on the part of consumers or firms. This will have implications for the treatment of savings, investment, and the long term profile of consumption and capital accumulation. <IP_ADDRESS> Multi Market Models CGE modeling captures multiple effects of a given policy change throughout an entire economy and can provide comprehensive distributional information across economic sectors ( e. g., employment by sector). A CGE model may not be feasible or practical to use as a consequence of limited data and resources or when the scope of expected significant market interactions is limited to a subset of economic sectors. In such instances a multi market analysis can be adopted as an alternative to a CGE model. 19 Multimarket analysis considers the interactions between a regulated market and other important related markets ( outputs and inputs), requiring estimates of elasticities of demand and supply for these markets as well as crossprice elasticities also found in CGE models. Multi market models are best used when potential economic impacts and equity effects on related markets might be considerable but more complete modeling using a CGE framework would offer a negligible improvement on the quality of information produced.

<IP_ADDRESS> Partial Equilibrium Models Unlike multi market and CGE models, a partial equilibrium framework limits a distributional analysis to considering impacts on entities associated with the directly affected output markets only. Distributional consequences for other output markets and input markets are not estimated using these models. As discussed in Chapter 8, a partial equilibrium framework requires knowledge of demand and supply functions for directly affected markets only.

If information is required for distributional outcomes that this method is not designed to address, it may be possible to adopt further assumptions and acquire additional data to approximate distributional consequences of concern. These new assumptions should be consistent with those used for the corresponding BCA.

<IP_ADDRESS> Direct Costs of Compliance A relatively unsophisticated distributional analysis examines the direct costs of compliance paid by regulated entities Often these analyses simply assume that the quantity of output and state of technology in the regulated industry 146 Chapter 9: Distributional Analyses 19 For a detailed discussion of multi market analysis see Chapter 9 in Just et al. ( 1982). remain unchanged after the regulation becomes effective. An analyst could disaggregate compliance costs for regulated industries or sectors or geographic regions.

9.2.4 Calculating Compliance Costs The first step in assessing impacts is to estimate and verify the costs of compliance. This step is necessary regardless of whether the entities affected are for profit, governmental communities, or not for profit entities. Compliance costs include annual costs ( such as operation and maintenance of pollution control equipment or increased production cost) and any capital costs. In certain situations it may be appropriate to estimate the costs year by year, especially in cases where the costs are expected to vary over time. Depending on the nature of the analysis, these costs may be annualized, so that they can be compared to average annual income and other measures of financial strength. 20 Verifying the compliance cost estimates entails two steps. First, the full range of responses to the rule needs to be identified, including pollution prevention alternatives. Second, the costs for each response need to be checked to determine if all elements are included and the costs are consistent with a given base year. Either a general inflation factor, such as the Gross Domestic Product ( GDP) implicit price deflator, or various cost indices specific to the type of project can be used. 21 The base year and indexing procedure should be stated clearly. Implicit costs that do not represent direct outlays may be important. The cost estimates should include such elements as production lost during installation, training of operators, and education of users and citizens ( for example, for programs involving recycling of household wastes). The cost of acquiring a permit is not so much the permit fee as it is the lost opportunities during the approval process. Likewise, the cost of having a car's emissions inspected is not so much the fee as it is the value of registrant's time.

EIAs and BCAs use different concepts of cost. BCA relies on estimates of the social costs of a regulation. EIA costs are the private costs needed to predict compliance responses and assess economic impacts in several ways. Social costs represent costs to society as a whole, whereas private costs reflect costs as they are experienced by the affected parties. Often, the same basic engineering compliance cost estimates are used as the basis for developing both social and private cost estimates and are adjusted to provide the required costs.

There are several issues analysts must consider when estimating the private costs of environmental polices. These include:

Before versus after tax costs: The costs of complying with regulations are generally deductible as expenses for income tax purposes. The effective burden of compliance costs is reduced for taxable entities because they can reduce their taxable income by the amount of the compliance costs. The effect of a regulation on profits is therefore measured by after tax compliance costs. Different components of engineering cost estimates should be adjusted based on their specific impact on taxes, to provide the inputs needed for an EIA. 22 Operating costs are generally fully deductible as expenses in the year incurred. Capital investments associated with compliance must generally be depreciated over some number of years. 23 In most cases, communities, not for profits, and governments do not benefit from reduced income taxes that can offset compliance costs. Therefore, adjustments to cost estimates, annualization formulas, and cost of capital calculations required to calculate aftertax costs should not be used in analyses of impacts on governments and not for profits.

147 Chapter 9: Distributional Analyses 20 As previously discussed, the discount rate used should be specific to the task. The rate used to annualize costs is dependent on the entity's cost of capital and, thus, the sources of financing used as well as the credit rating of the borrower. When calculating the present value of a stream of future social costs ( or benefits), the social rate of time preference is the appropriate discount rate. See Chapter 6 for a complete discussion of discount rates.

21 The GDP implicit price deflator is reported by the U. S. Department of Commerce, Bureau of Economic Analysis in its Survey of Current Business. The annual Economic Report of the President, Office of the President, is another convenient source for the GDP deflator time series.

22 Engineering costs can often be used in their before tax form to calculate social costs. Adjustments may be required, however, if the available compliance cost estimates do not reflect the social cost of the resources used. Transfers: Social costs reflect the real value of economic resources   labor, equipment, supplies   used to achieve compliance. However, some types of compliance costs incurred by the regulated parties may represent transfers among parties. Transfers, such as payments for insurance or payments for marketable permits do not reflect use of economic resources. Private cost estimates used in the EIA should include such transfers, but these transfers should be excluded when calculating social costs for the benefit cost analysis.

Discounting: Compliance costs often vary over time, perhaps requiring initial capital investments and then annual operating costs. To estimate impacts, the stream of costs is generally discounted to provide a Present Value of Costs ( PVC) that reflects the time value of money. 24 In contrast to social costs and benefits which are discounted using a social discount rate, private costs are discounted using a rate that reflects the regulated entity's cost of capital. 25 The private discount rate used will generally exceed the social discount rate by an amount that reflects the risk associated with the regulated entity in question. 26 For firms, their cost of capital may also be determined by their ability to deduct debt from their tax liability.

Annualized costs: Annualizing costs involves calculating the annualized equivalent of the stream of cash flows associated with compliance. It provides a single annual cost number that reflects the various components of compliance costs incurred over some selected time period ( e. g., 15 or 30 years). 27 The annual value is the amount that, if incurred each year over the selected time period, would have the same present value as the actual stream of compliance expenditures Annualized costs are therefore a convenient compliance cost metric that can be compared with annual revenues and profits. It is important to remember that using annualized costs masks the timing of actual compliance outlays. For some purposes, using the underlying compliance costs may be more appropriate. For example, when assessing the availability of financing for capital investments, it is important to consider the actual timing of capital outlays.

Fixed versus variable costs: Some types of compliance costs vary with the size of the regulated enterprise ( e. g., in proportion to production). Other components of cost may be fixed with respect to production such as the costs involved in reading and understanding regulatory requirements. 28 Requirements that impose high fixed costs will impose a higher cost per unit of production on smaller firms than on larger firms. It is important that the effects of any " economies of scale" be reflected in the compliance costs used to analyze economic impacts. 29 Using the same average annualized cost per unit of production may mask the importance of such fixed costs and understate impacts on small entities.

9.2.5 Screening for Potentially Significant Impacts A comprehensive analysis of all aspects of economic impacts associated with a rule can be highly resource intensive. Detailed and explicit analysis of impacts may not be justified in all cases, if a preliminary analysis 148 Chapter 9: Distributional Analyses 23 Current federal and state income tax rates can be obtained from the Federation of Tax Administrators in Washington, D. C. FTA, State Tax Rates & Structure, available from http:// www. taxadmin. org/ fta/ rate/ tax_ stru. html ( accessed 8/ 28/ 2000).

24 This Present Value of Costs may then be annualized to provide an annual equivalent of the uneven compliance cost stream, as described below.

25 While the discount rate differs, the formula used to discount private costs is the same as used for social costs. See Chapter 6.

26 Risk adjusted rates for different industries can be obtained from the Ibbotsen Associates Handbook or for specific firms from the Value Line Investment Survey.

27 Annualized costs are also discussed in Chapter 6 on social discounting. The formula for calculating annualized costs is presented in Section 6.2.

28 Note that fixed versus variable costs is not the same thing as capital versus operating costs. Capital costs may be fixed or variable with respect to the size of the operation, as may operating costs. This distinction between capital and operating costs is important for calculating after tax costs.

29 Economies of scale characterize costs that decline on a per unit basis as the scale of an operation increases. suggests that economic impacts will be minor. Screening analyses provide a way to focus attention and analytic resources on the areas where economic impacts are most likely to be significant. These screening analyses generally use simplifying assumptions about market outcomes ( e. g., the alternative no cost pass through and full cost passthrough assumptions) or simple tests of financial impacts ( e. g., a ratio of compliance costs to sales or to profits) to screen for potentially significant impacts.

It is important to keep in mind the limitations in screening analyses when interpreting and presenting their results. They typically identify cases of potentially significant impacts. More detailed investigation beyond the screening analysis is usually needed to reach a reliable conclusion about the likelihood of significant impacts.

In addition, screening analysis criteria should be chosen to balance the risk of identifying " false positives" versus " false negatives." That is to say, using too low a threshold will do little to distinguish true differences in potential impacts ( false positives), while using too high a threshold runs the risk of missing some sectors that may be significantly affected ( false negatives).

Finally, when screening analyses are based on alternative assumptions about market responses, it is important to note in presenting the results that they represent extreme assumptions that in practice cannot occur simultaneously. For example, worst case impacts on profits cannot occur simultaneously with worst case impacts on prices. 30 9.2.6 Profile of Affected Entities <IP_ADDRESS> Compiling an Industry Profile and Projected Baseline The impact of a regulation on business profitability and other economic outcomes depends on the magnitude of the compliance costs associated with the rule, on the distribution of compliance costs across firms, and on the economic and financial characteristics of the affected firms and industries. 31 A substantial portion of an EIA involves characterizing the affected firms and industries as a basis for evaluating economic impacts. The following are important inputs to an EIA:

Standard Industrial Classification ( SIC) and North American Industrial Classification System ( NAICS) industry codes: These definitions can be developed by working with engineering analysts, the EPA project team and workgroups, industry roundtables and industry specialists at the Department of Commerce. The SIC codes and their definitions appear in the Standard Industrial Classification Manual: 1987, available from the Government Printing Office ( OMB, 1987). This industry classification system is being replaced by the North American Industry Classification System ( NAICS), which will be reflected in the forthcoming data series ( OMB, 1998). A regulated entity that is a small part of a larger industry may require fractional multipliers in order to estimate the regulated category's share of the larger industry.

Compilation of summary statistics: Data regarding total employment, revenue, number of establishments and number of firms are available from the economic censuses and interim updates ( e. g., Department of Commerce Annual Survey of Manufactures, for non manufacturers, the Department of Commerce County Business Patterns, and Agricultural Statistics from the Department of Agriculture). The profile should also define the industry and its products, describe major production technologies, and discuss important business and regulatory trends.

The level and distribution of compliance costs: Estimates of compliance costs reflect predicted responses to the rule and are often developed based on engineering estimates. It is important to know how costs are distributed among plants and firms in the same industry, since firms that are not affected by the rule or that incur lower compliance costs than their competitors may gain competitive advantage as a result of the rule. If only a few producers in an industry incur added costs, they are less likely to be 149 Chapter 9: Distributional Analyses 30 A more detailed treatment of the considerations in the conduct of sensitivity analysis is presented in Chapter 5.

31 Generally, analysts should presume a perfectly competitive market structure. The purpose of developing an industry profile is to confirm this presumption or discover evidence to the contrary. able to raise their prices to recover costs. In contrast, a rule that affects all industry participants equally is more likely to result in price increases and less likely to change the competitive structure of the industry. In addition, some rules impose different requirements and costs on new versus existing sources. Such rules may affect industry competition, growth, and innovation by raising barriers to new entry.

Baseline industry growth and financial condition: Industries and firms that are relatively profitable in the baseline will be better able to absorb new compliance costs without experiencing financial distress. Industries that are enjoying strong growth may be better able to recover increased costs through price increases than they would have been had there been no demand growth. Section 9.2.9 provides suggestions for using specific ratios to assess the significance of economic impacts on a firm's financial condition.

Baseline industry structure: Industry level impacts depend on the competitive structure and organization of the industry and the industry's relationship to other economic entities. In addition, the number and size distribution of firms and facilities and the degree of vertical integration are important aspects of industry structure that affect the economic impacts of regulations.

Characteristics of supply and demand: Assessing the likelihood of changes in production and prices requires information on the characteristics of supply and demand in the affected industries. The relevant characteristics are reflected in price elasticities of supply and demand, which, if available, allow direct quantitative analysis of changes in prices and production Often, reliable estimates of elasticities are not available, and the analysis of industry level adjustments must rely on simplifying assumptions and qualitative assessments.

The industry profile provides a general understanding of an industry or industries affected by a regulatory action and characterizes their ability to absorb compliance costs. This information provides the basis for assumptions central to the impact analysis, as well as information needed for some of the special analyses such as Regulatory Flexibility Analyses.

<IP_ADDRESS> Profile of Other Affected Entities Careful consideration needs to be given to the question of whether or not a particular rule will affect government entities, 32 not for profit organizations, 33 or households. For example, air pollution regulations that apply to power plants may affect municipally owned electric companies; air regulations that apply to vehicles may affect municipal bus companies, as well as other municipal vehicles such as police cars and public works vehicles; effluent guidelines for machinery repairing activities may affect municipal garages. Thus, the first step is to identify all the government entities that may be affected.

Relevant characteristics of government entities may include:

the community's size ( number of people living in the community);

household income levels ( both median and some measure of the income range);

number of children ( since education is frequently the major service provided by local governments);

number of elderly residents ( who frequently have fixed incomes);

unemployment rate;

revenue amounts by source; and the credit or bond rating of the community.

If the property tax is the major revenue source, then the assessed value of property in the community and the percentage of this assessed value represented by residential versus commercial and industrial property should be determined. If the government entity serves multiple communities, such as a regional water or sewer authority,

150 Chapter 9: Distributional Analyses 32 Government entities that may be affected by a program include states, cities, counties, towns, townships, water authorities, villages, Indian Tribes, special districts, military bases, etc.

33 Examples of not for profits include non profit hospitals, colleges, universities, and research institutions. then this information needs to be collected for all the communities covered by the entity.

Data on community size, income, number of children and elderly, and unemployment levels are available from the U. S. Bureau of Census. Data on property values, amount of revenue collected from each revenue source, and credit rating will need to be collected directly from the community or state finance agencies. If the regulated activity is provided by an " Enterprise Fund" then revenue and cost information will need to be obtained directly from the fund. 34 Depending on the number of communities affected and the level of detail warranted, the analysis may rely on generally available data only. In other cases, a survey of affected communities may be necessary. However, in cases where a survey is needed, there will be a need to comply with the requirements of the Paperwork Reduction Act ( PRA).

Relevant characteristics of not for profit entities include their size, the goods or services they provide, their operating costs, and the amount and sources of their revenue. If the entity is raising its revenues through user fees or in other ways charging a price for its goods/ services ( such as university tuition), then the income levels of its clientele are relevant. If the entity relies on contributions, then it would be helpful to know the financial and demographic characteristics of its contributors. If it relies on government funding ( such as Medicaid) then possible future changes in these programs should be identified.

Relevant features of households are standard socioeconomic and demographic characteristics. These characteristics include, for example, their income level, size, age distribution, education level, and ethnic group.

<IP_ADDRESS> Profile Data Sources Profiles generally draw from at least two types of information 1) literature from economic journals, dissertations, and industry trade publications, and 2) quantitative data describing the characteristics of the industry. The relevant literature can be useful in characterizing the industry activities and markets as well as regulations affecting the industry. Identification of relevant literature is most efficiently performed through a computerized search using on line services such as Dialog, BRS/ Search Services, or Dow Jones News/ Retrieval. These on line services contain more than 800 databases covering business, economic, and scientific topic areas. Exhibit 9 3 lists some commonly used sources.

The industry profile may also identify those situations where sufficient data for an EIA cannot be obtained through published and commercial sources. These situations arise particularly when the affected industry is one of many product lines or other activities of identified facilities in addition, for some industries, identification of the appropriate SIC or NAICS code for all the firms or facilities included in the industry may be difficult if the industry can be categorized in a variety of ways. In these cases, and particularly if facility level data are required to estimate economic impacts, a survey of either a statistical sample or a census of affected facilities may be required to provide sufficient data for analysis.

9.2.7 Impacts on Prices Predicting impacts on prices is the basis for determining how the burden of compliance costs will be shared between the directly affected firms and their customers and suppliers in a typical market. At one extreme, regulated firms may not be able to raise their prices at all and they will bear the entire burden of the added costs in the form of reduced profits. Reduced profits may result from reduced earnings on continuing production, lost profits on products or services that are no longer produced, or some combination of the two. At another extreme, firms may be able to raise prices enough to recover costs fully. In this case, there will be no impacts on the profitability of the directly affected firms but their customers will bear the burden of increased prices. Another possible outcome is that suppliers to the directly affected firms will bear some of the burden in lost earnings if the regulation results in a decline in demand for particular products. 35 151 Chapter 9: Distributional Analyses 34 Public services that are funded entirely by fees charged to users are referred to as " enterprises" and their revenues are referred to as " Enterprise Funds."

35 Regulations limiting sulfur emissions may result in reduced demand for high sulfur coal, for example, which will result in a fall in the price of such coal and lost profits for its producers. In general, the likelihood that price increases will occur can be evaluated by considering whether competitive conditions will allow the affected facilities to pass on their costs. The methods used to conduct the analysis of the directly affected markets will depend on the availability of appropriate estimates of supply and demand elasticities. In many cases, reliable estimates of elasticities will not be available. 37 In these cases, the analyst will need to rely on a more basic investigation of the characteristics of supply and demand in the affected market to reach a judgment about the likelihood of full or partial pass through of costs via price increases. 9.2.8 Impacts on Production and Employment Regulations may raise the cost of doing business sufficiently to make some or all production unprofitable or may reduce the quantity demanded as producers raise their prices to maintain profitability. The associated reductions in output may result from lower operating rates at existing plants, closure of some plants, or reduced future growth in production relative to what would have occurred in the baseline. Losses in employment are typically associated with reductions in output.

152 Chapter 9: Distributional Analyses 36 Economic Censuses include: Census of Manufacturers, Census of Construction Industries, Census of Mineral Industries, Census of Retail Trade, Census of Service Industries, Census of Transportation, and Census of Wholesale Trade.

37 See Chapter 8 for a more complete discussion of costs and elasticity. Source Data Trade Publications Market and technological trends, sales, location, regulatory events, ownership changes.

U. S. Department of Commerce, Total revenue by 4 SIC ( generally); payroll; quantity and value of products shipped Economic Censuses36 and materials consumed; value added; capital expenditures, assets, inventories, employment, and geographic area, distribution by size, kind of business.

U. S. Department of Commerce, Description of industry, trends, international competitiveness, regulatory events. U. S. Industry & Trade Outlook United Nations, Foreign trade volumes for selected commodities, major trading partners International Trade Statistics Yearbook Robert Morris Associates, Income statement and balance sheet summaries, profitability, debt burden and Annual Statement Studies other financial ratios, all expressed in quartiles and available for recent years. Based on loan applicants only.

Dun & Bradstreet, Type of establishment, SIC code, address, facility and parent firm revenues and Information Services employment.

Standard & Poor's Publicly held firms, at 4 digit SIC level. Prices, dividends, and earnings, line of business and geographic segment information, S& P's ratings. Quarterly History ( 10 years): income statement, ratio, cash flow, and balance sheet analyses and trends.

Standard & Poor's, Industry profiles, competitors for selected firms. Firm Level Data: Research Reports ( publicly traded companies) company background, stock prices, major competitors, description of business organization, summary financial data.

Securities and Exchange Income statement and balance sheet, working capital, cost of capital, Commission 10k Filings, employment, outlook, regulatory history, foreign competition, lines of business, EDGAR System Database ownership and subsidiaries, mergers and acquisitions.

Value Line Industry Reports Industry overviews, company descriptions and outlook, performance measures.

FINDS database Facility SIC, latitude and longitude, zip code, size, ownership structure. Exhibit 9 3 Frequently Used Profile Sources EPA has used a variety of methods to assess reductions in production and employment. In some cases, demand and supply elasticities are used directly to calculate changes in output and prices that would result from a shift upward in the supply curve associated with compliance costs. Often estimates of the shape of the supply curve are not available and assumptions are made about its shape in the region of interest to allow use of demand elasticity estimates to predict output and price adjustments.

In other cases, analysts may assess the impacts of rules on the profitability of specific firms or industry segments, and identify potential line or plant closures based on a financial analysis. 38 If partial or full plant closures are projected it is important to consider whether the production lost at the affected facilities will be shifted to other existing plants or to new sources or will simply no longer be produced If there is excess capacity in the industry in the baseline and some plants with excess capacity can operate profitably in compliance with the rule, they may expand production to meet the demand for products no longer produced at plants that can no longer operate profitably. 39 Even if total production does not decline but is simply shifted from higher cost plants to more efficient competitors and even if total employment does not change, localized changes in employment may interest policy makers. This is especially the case for rules that may have a strong regional impact. For example, UMRA § 202 requires such an analysis as an element of the UMRA cost analysis. Data on the ratio of production or sales to employment can help predict the number of jobs lost as a result of reductions in production. The regional distribution of job losses can be calculated based on plant locations.

9.2.9 Impacts on Profitability and Plant Closures The availability of financial information used to assess profitability varies greatly, depending on the industry in question and the extent to which EPA is able to collect new information by surveying the affected entities. With limited exceptions, detailed financial information is not generally available for individual plants or for privately held companies from published sources. Financial data for publicly held companies may be too aggregated to allow analysis of the specific business practices affected by the rule. In the absence of new data collection by EPA, analysts may need to rely on financial profiles constructed for model plants, or on industry average data provided by the Census Bureau and other sources. 40 In some cases, financial profiles used in the analysis of a previous rule making might be adapted and updated to analyze the impacts of the rule in question.

Analysis is conducted by determining how the added costs of compliance will affect the financial strength of the firm. As with predicting price increases, it may be worthwhile to start with a screening analysis based on an extreme assumption about the incidence of costs   in this case, that no costs can be recovered through price increases. This assumption provides a worst case estimate of impacts on profits, potential closures, and employment reductions in the directly affected market. Where firms in an industry do not appear to experience financial distress under the no cost pass through scenario, more detailed analyses to predict actual market adjustments and price increases are not needed.