Environmental regulation: choice of instruments under imperfect compliance

Compliance is an important issue in environmental regulation. We discuss some of the key elements of the problem and analyze a situation where emissions are not random and firms are risk-neutral. We study the firm’s decision on emissions and compliance when the environmental regulation is based on standards and the enforcement agency audits the firm with a certain probability. We compare total emissions when environmental regulation is based on different instruments: standards, taxes, and tradable permits. We show that when compliance is an issue, environmental taxes are superior to the other instruments, and we analyze the (static) efficiency of the solution. This paper originated from the AEE/REE presidential address for the XXX Simposio de Análisis Económico (Murcia 2005). It builds on the research project on optimal enforcement in environmental problems done in collaboration with David Pérez-Castrillo. I would like to thank David Pérez-Castrillo and Pau Olivella for their useful comments. I gratefully acknowledge the financial support from the Ministerio de Ciencia y Tecnología (BEC2003-01132) and the Generalitat de Catalunya (Barcelona Economics - CREA and 2005SGR-00836).