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Optimal Federalism

Scale economies and spillovers provide economic rationale for Federal regulation of oil and gas drilling.

Last week Mitt Romney released a new energy plan (available here). The plan includes a proposal to reduce federal oversight of oil and gas drilling on public lands.  National standards for air and water pollution would remain in place, but the Bureau of Land Management’s role in permitting and bonding drilling projects, for example, would be eliminated, overturning legislation going back to the Mineral Leasing Act of 1920, and ceding regulatory authority to the states.

The plan raises a number of interesting questions. Tied up in the shift away from federal control is the question about the overall level of regulation. Earlier this summer, I blogged about bonding requirements for oil and gas producers, arguing that the existing system should be modernized to meet the increased risks from hydraulic fracturing. But there is also the separate question of how governmental responsibilities should be shared between state and federal governments. Turns out this is a question that economists have thought about for a long time. Usually referred to as “optimal federalism”, there are a number of key considerations:

(1)    Federal control makes sense when there are spillovers. Oil and gas drilling have the potential for large-scale ground and surface water spills and states share lakes, rivers, and groundwater resources. In addition, the argument could be made that these federal lands have a broader public interest. I enjoyed driving through Utah on a family vacation this summer, even though I don’t get out there very often.

(2)    Federal control also makes sense when there are scale economies. Most states, particularly in the West, already have regulatory bodies in place for managing drilling on private lands, but how cost-effectively can they be ramped up?  In contrast, a single,  federal regulatory agency can hire specialized engineers and disseminate best practices across states. Oil and gas drilling is going through a period of intense technological innovation, so having highly-trained experts is crucial.

(3)    State control makes sense when policies can be better tailored to local tastes.  Expertise about local geology is certainly important, but I’m not sure why this can’t be leveraged within a federal system. The Bureau of Labor Management already maintains field offices in many states. And are preferences for environmental quality really so different across states?  I’m not sure. Instead, I would worry about a “race to the bottom” in which production moves to a handful of states with relatively lax regulation.

So I’m not convinced that reducing federal control makes sense from an economic perspective. To see whether the proposal makes sense politically, we will have to wait until November.

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Suggested citation: Davis, Lucas. “Optimal Federalism” Energy Institute Blog, UC Berkeley, August 27, 2012,



Lucas Davis View All

Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is a Faculty Affiliate at the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Research Associate at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.

3 thoughts on “Optimal Federalism Leave a comment

  1. I wonder about the ability to resolve this challenge:

    “Oil and gas drilling is going through a period of intense technological innovation, so having highly-trained experts is crucial.”

    Yes, I agree. What is the ability to hire highly-trained experts, presumably with field experience, away from highly lucrative (because of the intense technological innovation) drilling companies and into the much less lucrative regulatory bodies?

    Or, how effective is regulation of any kind during periods of intense technological innovation if the highly-trained experts required for regulation are themselves engaged (even driving) the intense technological innovation?

    Aren’t those who are highly-trained typically those who drive periods of intense innovation?

  2. Great post.

    And for a company planning to explore in multiple states, a single federal regulatory framework should simplify their operations and compliance process. Understanding and complying with varied state regulations would increase costs and reduce economies of scale (a complaint I have heard in the financial services sector). If exploration companies favor the Romney plan (as I think they do), it must because they expect greater benefits from the race-to-the-bottom that you describe.

  3. Indeed a clear stand, Lucas. I agree with most of it – State control will not be optimal when dealing with regional – transboundary development and environmental issues / phenomena. It does not seem to make a lot of sense to turn regional control back to individual States since we will have to make them decide on issues that may go beyond their jurisdiction. – Omar

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