Collective environmental agreements: An analysis of the problems of free-riding and collusion

Collective environmental agreements (CEAs) refer to agreements negotiated between a group of polluting firms and a public regulatory body. The article analyses some potential problems with CEAs. First, we study free-riding. We show how the incentive constraint imposed by moral hazard determines the maximum feasible emission reduction under a CEA. When firms are short sighted, free-riding seriously undermines the effectiveness of a CEA. Adding uncertainty about environmental damage or future government action makes it even harder to satisfy the moral hazard constraint. Second, we show that cooperation on a different activity can reduce the incentives to free-ride, since firms can threaten to stop cooperating in order to deter deviations. This effect could explain why some CEAs may be successful. However, we also show that reciprocally the adoption of a CEA increases the possibilities for cooperation on other activities. This might be socially harmful if it translates into price collusion, for example. Finally, we explore the issue of how firms might allocate the abatement effort toward the collective target. We show that a CEA can help firms to coordinate on a reduction of quantity and a consequent price increase in order to benefit from implicit cartel profits. Our findings thus provide some cautionary arguments against the use of CEAs.