Abatement and Permits when Pollution is Uncertain and Violations are Fined

This paper considers a firm’s choice of abatement and of the number of permits if actual pollution is stochastic such that full compliance cannot be ensured. This straightforward extension induces non-trivial and unexpected comparative static properties, such as: permits and abatement can be either substitutes or complements, higher fines can lower the number of acquired permits (or abatement), and higher permit prices can reduce abatement. Yet integrating these reactions into a (competitive) permit market eliminates puzzling features. This is an additional justification of tradable permits over standards, where regulators must cope with potentially counterproductive firm reactions. A first version of the paper was written at the School of Finance and Economics, University of Technology, Sydney and I am grateful for the enjoyed hospitality. I am also grateful for the valuable comments from an anonymous referee.