Bankruptcy Risk and the Performance of Market-based Pollution Control Policies

We study the impacts of bankruptcy risk on the performance of market-based pollution control policies. In chapter one, we concentrate on emissions trading markets. We find that firms that risk bankruptcy demand more permits than if they were financially secure. Thus, bankruptcy risk in a competitive market for tradable permits causes an inefficient distribution of these permits among firms. Moreover, the equilibrium distribution of permits is dependent on the initial allocation of permits. Thus, the main reasons for implementing emissions trading markets do not hold when some firms are financially insecure. In fact, the inefficiency that is associated with bankruptcy risk is worsened if financially insecure firms are given a smaller share of the initial allocation of permits.In chapter two, we investigate the influences of bankruptcy risk on imperfectly enforced emissions taxes. Under favorable, but not unrealistic conditions, an imperfectly enforced emissions tax produces an efficient allocation of individual emissions control; the aggregate level of control is the same whether enforcement of a tax is sufficient to induce the full compliance of firms or not, and differences in individual violations are independent of firm-level differences. All of these desirable characteristics disappear when some firms under an emissions tax risk bankruptcy—the allocation of emissions control is inefficient, imperfect enforcement causes higher aggregate emissions, and financially insecure firms choose higher violations.