Accidents Happen: The Effect of Uncertainty on Environmental Policy Design

Major externality cases are random accidents which are not adequately addressed by the deterministic environmental policy literature -­‐ that of Pigouvian taxes, abatement subsidies and cap-­‐and-­‐trade. We consider a risk-­‐neutral industry where firms control the probability andSeverity of accidents by preventive and responsive choices, but asymmetric information meansGovernment only observes outcomes. We show that even without intervention, some care will be taken, however -­‐ we identify three policies that lead to the optimal solution: strict liability, aStochastic subsidy, and a mandatory mutual insurance scheme. The subsidy policy may be very costly to taxpayers, especially when prevention affects the probability of accident occurrence, and strict liability may be excessively draconian; polluters are also victims and liabilities must exist regardless of adherence to professional standards of care. Thus, we propose a revenue-­‐neutral liability-­‐pooling scheme which plays a similar role to tradable pollution permits in the deterministic case.