Environmental Regulation in Oligopoly Markets: A Study of Electricity Restructuring

Abstract

In an oligopoly market subject to environmental regulation through tradable pollution permits, polluters' output decisions affect the price of polluting. With a pollution tax, this feedback effect is absent. In a permit regime, I show that the feedback effect increases strategic firms' production and improves welfare. I empirically test the environmental implications of oligopoly behavior in the Pennsylvania, New Jersey, and Maryland electricity market. Air pollution fell substantially during 1999, the year in which both electricity restructuring and a tradable permit system took effect. Surprisingly, I show that 33-42 percent of the emissions reductions resulted from strategic behavior in the electricity market. Simulations suggest that welfare loss would have been seven percent greater under a tax than with tradable permits.

Keywords: Environmental regulation, tradeable permits, pollution tax, oligopoly, electricity

JEL Classification: H23, L11, L94