Optimal emission regulation under market uncertainty

Abstract

Government regulations on emission control can be broadly divided into two categories: price instruments and quantity instruments. In this paper, we develop a stylized model to compare the two instruments in the presence of market uncertainty. We find that when the emission intensity (i.e., emissions per unit of production) and the market uncertainty are both high or low, the expected social welfare under the price instruments will be higher; otherwise, the performance of the quantity instruments is comparatively better. The results are robust when incorporating firm competition and national/regional pollution damage. Afterward, we demonstrate that the government's quick‐response capability or a hybrid of the price and quantity instruments can improve the expected social welfare, especially for high‐emitting industries when the market uncertainty is intermediate. Lastly, for heterogeneous firms, we find that allowing permit trading in the quantity instrument may not be beneficial when pollution from each firm is more likely to have regional effects.