Optimal Emission Regulation under Market Uncertainty

Problem definition: To mitigate the impact of global climate change, an increasing number of countries in the world have adopted emission control. Government regulations on emission control can be broadly divided into two categories: price instruments and quantity instruments. In this paper, we compare the two instruments in the presence of market uncertainty.Methodology/results: We develop a stylized model that captures essential elements of environmental regulations. 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. Afterwards, we demonstrate that 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. The results are robust when incorporating abatement efforts and firm competition. Furthermore, the numerical study also shows that allowing permit trading in the quantity instrument may not be beneficial when pollution from different firms is more likely to have local effects.Managerial implications: Our results help to understand the pros and cons of each regulatory tool and provide guidance for regulation across industries. We also show the benefit of adopting a hybrid mode and clarify whether to allow permit trading under different market conditions