The Optimal Pricing of Pollution When Enforcement is Costly

Abstract

We consider the pricing of a uniformly mixed pollutant when enforcement is costly with a model of optimal, possibly firm-specific, emissions taxes and their enforcement. We argue that optimality requires an enforcement strategy that induces full compliance by every firm. This holds whether or not regulators have complete information about firms' abatement costs, the costs of monitoring them for compliance, or the costs of collecting penalties from noncompliant firms. Moreover, ignoring several unrealistic special cases, optimality requires discriminatory emissions taxes except when regulators are unable to observe firms' abatement costs, the costs of monitoring individual firms, or any firm-specific characteristic that is known to be jointly distributed with either the firms' abatement costs or their monitoring costs. In many pollution control settings, especially those that have been subject to various forms of environmental regulation in the past, regulators are not likely to be so ill-informed about individual firms. In these settings, policies that set or generate a uniform pollution price like conventional designs involving uniform taxes and competitive emission trading with freely-allocated or auctioned permits will not be efficient.

Keywords: Compliance, Enforcement, Emissions Taxes, Monitoring, Asymmetric Information, Uncertainty

JEL Classification: L51, Q58