Optimal Deterrence for Environmental Damage Under Asymmetric Information
27 Pages Posted: 17 Feb 2022
Under circumstances where enterprises engage in environmentally hazardous production, regulators often assess penalties in addition to imposing liability for harm. In this paper, we examine optimal accident deterrence under circumstances where the regulator observes a subset of safety investments but not all actions undertaken by the enterprise to reduce the risk and magnitude of accidents. We demonstrate that whenever a subset of safety investment exists that is ex ante unobservable to the regulator, adherence to regulation distorts safety investments among enterprises engaged in risky activities towards measurable safety investments that reduce ex post penalties, resulting in a sub-optimal mix of safety measures that fail to minimize costs. Instead, the social optimum can be attained under perfect competition through a policy involving strict liability for damages and no additional penalties. We extend the analysis to the case of regulated utilities and demonstrate that the socially optimal resource allocation can be attained through a policy that combines strict liability with rate-of-return regulation that compensates the enterprise with an excess return equal to the expected marginal damage of the productive inputs.
Keywords: Tort liability, accident deterrence, environmental policy, rate of return regulation
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