An Internal Fuel Efficiency Credit Market Mechanism for Meeting the CAFE Standard: Internalizing a Regulation Caused Externality

Abstract

The paper develops and analyzes an internal market based mechanism that enables a decentralized enterprise to meet the conditions of the Corporate Average Fuel Economy (CAFE) regulations. Divisions that produce vehicles with fuel economy (miles per gallon fuel) above the regulatory requirement receive Fuel Efficiency Credits (FEC). These credits can be sold in an internal FEC market to divisions that produce vehicles with fuel economy levels below the regulatory requirement. The FEC available for sale by fuel efficient vehicle production and the FEC needed as a condition of production of fuel inefficient vehicles are tied to the respective fuel efficiency levels. Experimental tests demonstrate that the enterprise can achieve near profit maximum levels while continuing to operate through decentralized profit centers. The FEC market “internalizes” the externality across divisions created by the CAFE regulation. The behavioral model supported by the data suggests that the policy can be successfully crafted to include multiple firms trading FECs.