Environmental Policy Design and the Distribution of Pollution Control Techniques in a Regulated Industry

Abstract

This paper analyzes the choice of pollution control techniques by regulated firms, under three policy instruments: emissions standards, emissions taxes, and tradeable permit systems. In this model, heterogeneous firms choose from a menu of abatement techniques, which may include some that have higher marginal costs (but lower capital costs) than a widely available benchmark technique. I show that the cost savings from any technique relative to the benchmark is larger under an emissions tax than under an emissions standard. An analogous result holds for tradeable permits. As a result, the distribution of techniques chosen by firms is more dispersed under market-based instruments than under an emissions standard. This offers a novel twist on the relationship between abatement cost heterogeneity and market-based instruments. I also compare a tax with tradeable permits, and show that the aggregate marginal abatement cost curve lies further from its benchmark value under a tax than under a tradeable permits. Thus the marginal cost curve is endogenous to the choice of policy instrument.