Imperfect verification,appeals, and limited liability

We examine the effect of an imperfect verification and a subsequent appeals process in regulatory settings where legal or institutional restrictions impose an upper bound on penalties. We show that the verification always enhances social welfare despite the limit on penalties. The subsequent appeals process, which allows the firm to challenge an unfavorable finding by the regulator, is never socially optimal when it is costless. However, when the appeals process is costly, it can be optimal even if it is less accurate than the verification. Moreover, social welfare can increase as the cost of the appeals process increases.     

Performance versus design standards in the regulation of pollution

This paper presents a model of pollution regulation in an oligopolistic market. Two forms of regulation are considered: performance standards which regulate pollution directly by an upper limit on emissions, and design standards which regulate pollution indirectly by a minimum usage requirement of an enissions control input. Equilibria under each regulatory regime are characterized. A welfare analysis reveals that performance standards are preferred to design standards if the objective is minimization of emissions plus pollution damage costs. However, the comparison is indeterminate if the regulator's objective is total surplus less pollution damage. An equivalence between emissions taxes and performance standards is established, so the above welfare comparisons also apply to emissions taxes versus design standards.     

Controlling Pollution with Relaxed Regulations

We investigate the features of optimal environmental policies composed of pollution standards and costly inspection processes, where fines for exceeding the standards depend both on the degree of transgression and the environmental technology that the firm uses to reduce the social impact of its polluting activity. We show that the main characteristics of these policies depend crucially on when the firm selects that technology with respect to the timing of the policy announcement. In fact, the firm has incentives to over-invest in green technologies when the policy is announced afterwards; and to under-invest in them if the environmental authority plays first. Surprisingly, we find that both the firm and the regulator prefer that the firm invests in technology before the policy is announced, even when this implies that expected penalties for noncompliance might be zero.     

How does the design of international environmental agreements affect investment in environmentally-friendly technology?

In this paper, we investigate how the design of international environmental agreements (IEAs) affects the incentives for the private sector to invest in environmentally-friendly technology. The givens are a transboundary pollution problem involving two asymmetric countries in terms of benefits arising from global abatement. There is a single polluting firm in each country. We account for two types of IEAs: an agreement based on a uniform standard with transfers and an agreement based on differentiated standards without transfers. To carry out this study, we use a two-stage game where the private sector anticipates its irreversible investment given the expected level of abatement standards resulting from future negotiations. Our findings indicate that the implementation of the agreement based on a uniform standard with transfers may be preferable for the two countries, as it creates greater incentives for firms to invest in costly abatement technology. This result arises when this technology’s level of the sunk cost of investment is low. If this level is sufficiently high, the implementation of the same agreement is not beneficial to countries, because it takes away the incentive of each firm to invest in new abatement technology. Moreover, this agreement is not able to generate any positive gains for either country through cooperation, thus no country is motivated to cooperate.     

Regulating a risk-averse firm under incomplete information

We examine the optimal regulatory policy for a risk-averse firm when the firm is imperfectly informed about its efficiency parameter for a project at the time of contracting. The firm’s risk aversion shifts the optimal regulatory policy from a fixed-price contract to a cost-plus contract. The optimal regulatory policy entails undereffort by an inefficient firm as in Laffont and Tirole (J Polit Econ 94(3):614–641, 1986) and the effort distortion increases as the firm becomes more risk-averse. Further, the regulator benefits from sequential contracting with the firm where the firm chooses contract terms gradually as it acquires information, albeit the benefit diminishes as the firm becomes more risk-averse.      

Strategic manipulation of a pollution permit market and international trade

We consider a framework where firms which compete in an international product market are not all submitted to a pollution permit market. Using the Brander and Spencer’s framework (J Int Econ 18:83–100, 1985), we seek to determine the optimal strategies of both a dominant firm in the pollution permit market and the regulator in a such context. We first show that the dominant firm pursues a strategic manipulation to increase its profit. We also find that the regulator uses a sophisticated strategic policy to increase the domestic welfare by using two instruments: the initial allocation of pollution permits and the pollution cap.     

Pollution,public disclosure,and firm behavior

This paper looks at whether a government regulator should publicly announce the amounts of pollution emitted by individual firms and plants. Disclosure may be important if there is incomplete information about firm costs, since pollution levels may be used by the regulated firm as a signal of costs to rival firms. We compare the signaling games under public disclosure and no disclosure. Welfare is likely reduced by disclosure, but if the regulator can adjust the stringency of the relevant pollution regulations, then the loss in welfare can be smaller. The implications of these results for pollution permits markets are discussed.     

Optimal Fines under Announced and Surprise Inspections

This paper examines optimal fines in a regulatory framework where the regulator can choose either surprise or announced inspections to monitor a firm for compliance. The firm can invest in detection avoidance, but it receives a fine if the regulator discovers that it is noncompliant. In the welfare maximization problem, we focus on the trade‐off between the frequency of inspections and the magnitude of the fine. We find that when inspections are unannounced, the optimal fine is maximal, but when they are announced, the optimal fine may be less than maximal.     

Investment Incentives of a Regulated Dominant Firm

We study the investment incentives of a regulated, incumbent firm in a deregulation process. The regulator cannot commit to a long-term regulatory policy, and investment decisions are taken before optimal regulatory policies are imposed. We characterize the regulated incumbent's incentive to invest when a deregulation process is initiated and an unregulated firm enters the market as a result. The change in the marginal return to investment depends on how the investment changes the firm's virtual cost—the sum of its physical production and information costs. When the marginal return to investment increases due to deregulation, social welfare increases as a result of higher investment and more competition. Otherwise, the change in social welfare depends on the total of the effects in the fall of investment and increased competition. We also present conditions under which deregulation enhances welfare.     

Pollution standards, technology investment and fines for non-compliance

In this paper, we analyze whether it is socially desirable that fines for exceeding pollution standards depend not only on the degree of non-compliance but also on technology investment efforts by the polluting firms. For that purpose, we consider a partial equilibrium framework where a representative firm chooses the investment effort and the pollution level in response to an environmental policy composed of a pollution standard, an inspection probability and a fine for non-compliance. We find that the fine should strictly decrease with the investment effort when (i) there are administrative costs of sanctioning; (ii) the optimal policy induces non-compliance; and (iii) either the fine is sufficiently convex in the degree of non-compliance or the investment effort decreases marginal abatement costs significantly.     

Intertemporal Emission Permits Trading Under Uncertainty and Irreversibility

This paper analyzes the effect of emission permit banking on clean technology investment and abatement under conditions where the stringency of the future cap is uncertain. We examine the problem of heterogeneous firms minimizing the cost of intertemporal emission control in the presence of stochastic future pollution standards and emission permits that are tradable across firms and through time. A firm can invest in clean capital (an improved pollution abatement technology) to reduce its abatement cost. We consider two possibilities: that investment is reversible or irreversible. Uncertainty is captured within a two period model: only the current period cap is known. We show that if banking is positive and marginal abatement costs are sufficiently convex, there will be more abatement and investment in clean technology under uncertainty than there would be under certainty and no banking. These results are at odds with the common belief that uncertainty on future environmental policy is a barrier to investment in clean capital. Moreover, under uncertainty and irreversibility, we find that there are cases where banking enables firms to invest more in clean capital.     

Pollution Abatement Subsidies and the Eco-Industry

This paper considers the combination of pollution taxes and abatement subsidies when some polluting firms procure their abatement goods and services from an oligopolistic eco-industry. The regulator must here cope with two simultaneous price distortions: one that comes from pollution and the other which is caused by the eco-industry’s market power. In this context, we show that taxing emissions while subsidizing polluters’ abatement efforts cannot lead to first-best, but the opposite occurs provided it is the eco-industry’s output which is subsidized. When public transfers also create distortions, welfare can be higher if the regulator uses only an emission tax, but subsidizing abatement suppliers while taxing emissions remains optimal when the eco-industry is concentrated.     

Command-and-control revisited: Environmental compliance and technological change in Swedish industry 1970–1990

This paper addresses the issue of environmental policy instrument choice for achieving deep emission reductions in the industrial sector. Specifically, it provides: (a) a theoretical and empirical review of the conditions under which performance standards can provide efficient incentives for deep emission reductions and technology adoption; and (b) an analysis of the design and the outcomes of the standards-based regulation of industrial pollutants in Sweden during the period 1970–1990. Our empirical findings suggest that the Swedish regulatory approach comprised many key elements of an efficient policy-induced transition towards radically lower emissions in the metal smelting and pulp and paper industries. The regulation relied solely on performance standards, thus granting flexibility to firms in terms of selecting the appropriate compliance measures. These standards were implemented in combination with extended compliance periods. R&D projects and the new knowledge that was advanced incrementally in interaction between the company, the environmental authorities and research institutions provided a direct catalyst to the regulatory process. In these ways the Swedish regulatory approach provided scope for creative solutions, environmental innovation, and permitted the affected companies to coordinate pollution abatement measures with productive investments.     

Prices Versus Quantities: Technology Choice,Uncertainty and Welfare

Technological improvements have proven essential in mitigating environmental problems such as climate change, depletion of the ozone layer and acid rain. While it is well-known that price- and quantity-based regulatory instruments provide different investment levels, the effects on the choice between different technologies have received scant attention. This paper expands on the prices versus quantities literature by investigating firms’ technology choice in the face of demand and supply side uncertainty. I show that the regulator can not design tradable emissions permits and an emissions tax such that the two regimes are equivalent, even in terms of expected values. Moreover, a tax encourages the most flexible abatement technology if and only if stochastic costs and the equilibrium permit price have sufficiently strong positive covariance, compared with the variance in consumer demand for the good produced. Finally, the firms’ technology choices are socially optimal under tradable emissions permits, but not under an emissions tax.     

Analysis of vertical separation of regulators under adverse selection

We analyze the vertical separation of a regulator when a government delegates the task to monitor a regulated firm to an intermediate institution called a “middleman”. We deal with the double adverse selection problem between the government and the middleman, and between the middleman and the firm. We reach three main conclusions. First, we clarify the condition under which vertical separation is socially superior to vertically integrated regulation. Second, we show that when the middleman and the firm are able to collude by using a side contract, collusion can lead to information-sharing effects that enhance social welfare. Third, it is socially desirable for the government to offer a collusion-proof contract to the middleman if the collusion inefficiency is much larger than the expected socially desirable information-sharing effects.      

Eco-labels, Trade and Protectionism

Eco-labels are suspected to serve protectionist purposes. We analyze the choice between an environmental standard and a voluntary eco-label scheme in a partial trade model with one domestic firm and one foreign firm. The environmental standard will only apply to the domestic firm, while both firms can adopt the eco-label. Pollution is production related, and domestic consumers demand products that are produced in an “environmentally friendly” way. Our results show that it may be optimal for the domestic government to introduce an eco-label and get both firms to adopt the label, instead of setting an environmental standard. However, to what extent this policy serves protectionist purposes is ambiguous. In particular, if the willingness to pay for green products is sufficient to cover the pollution abatement costs of the foreign firm, foreign firm profit will increase while domestic firm profit will decrease compared to the outcome with a domestic environmental standard. On the other hand, if the willingness to pay for green products is insufficient, the foreign firm would be better off with a domestic environmental standard.     

Behavioral economics: implications for regulatory behavior

Behavioral economics (BE) examines the implications for decision-making when actors suffer from biases documented in the psychological literature. This article considers how such biases affect regulatory decisions. The article posits a simple model of a regulator who serves as an agent to a political overseer. The regulator chooses a policy that accounts for the rewards she receives from the political overseer—whose optimal policy is assumed to maximize short-run outputs that garner political support, rather than long-term welfare outcomes—and the weight the regulator puts on the optimal long run policy. Flawed heuristics and myopia are likely to lead regulators to adopt policies closer to the preferences of political overseers than they would otherwise. The incentive structure for regulators is likely to reward those who adopt politically expedient policies, either intentionally (due to a desire to please the political overseer) or accidentally (due to bounded rationality). The article urges that careful thought be given to calls for greater state intervention, especially when those calls seek to correct firm biases. The article proposes measures that focus rewards to regulators on outcomes rather than outputs as a way to help ameliorate regulatory biases.     

Voluntary Environmental Investment and Responsive Regulation

Instances of corporate voluntary environmental investments have been rising in recent years. Motivations for such activities include corporate image building, regulatory preemption, and production cost savings. While some of these investments arise from industry attempts to set environmental standards where none currently exist, many investments seem to be aimed at reducing the costs of complying with existing regulations. Using a simple game-theoretic model, we investigate firm motivations for, and welfare consequences of, these types of voluntary investments by focusing on the role regulatory enforcement might play. We find that such investments unambiguously increase when an enforcement regulator acts as a Stackelberg follower (a regulatory structure we refer to as responsive regulation) in setting its monitoring and enforcement strategy. These additional investments may be socially undesirable, necessitating a restructuring of non-compliance penalties.     

Host-country policy – commitment or no-commitment: a theoretical analysis

This paper develops a model of foreign entry strategy and examines welfare of the host-country under two situations - (i) where host-country government commits to the tax policy, (ii) where host-country government does not commit to the tax policy. It turns out that under the non-committed government policy the foreign firm does not prefer to hold equity share in the domestic project. The host-country welfare, however, is more under the committed government policy than the non-committed government policy when the foreign firm has sufficiently higher bargaining power. The possibility of technology choice by the foreign firm reduces the range of bargaining power of the foreign firm over which the host-country welfare is more under the committed policy compared to the non-committed policy.     

TECHNOLOGY CHOICE AND ENVIRONMENTAL AWARENESS IN A TRADE AND ENVIRONMENT CONTEXT*

Assuming that an environmentally‐friendly technology not only reduces pollution emissions but also strengthens the preference of consumers for goods produced with such a technology, we show that a legally stipulated choice of cleaner technologies, requiring resources and hence reducing output, can improve the welfare of the economy even when other economies do not choose such technologies, and that the driving force can be the terms‐of‐trade effect. Therefore, even a unilateral regulation on the choice of technology would be approved in the economy when the environmental awareness of consumers is sufficiently raised.