Uncertain Evolution of the Pollution Stock and its Effect on the Environmental Regulation of a Polluting Oligopoly

This article analyzes a model of regulation for a dynamic oligopoly when firms are able to control emissions through production and abatement, and furthermore there exists uncertainty in the evolution of the pollution stock. Under the first-best regulation, more competition results in a higher aggregate abatement increase compared to the increase in aggregate production hence decreasing the expected emissions and having a positive effect on the expected present value of social welfare. However, a more uncertain environment will make firms be more cautionary on production which will decrease the emission path and hence environmental damages but having an overall negative effect on social welfare due to a stronger decrease in consumer surplus. When analyzing the gains from regulation we find that the more uncertainty and firms in the industry the more important regulation becomes. With regards to the regulatory tools, we find that the first-best emission tax is always positive for any level of the pollution stock. Furthermore not considering uncertainty results in underestimating the optimal tax value, suggesting that previous literature which found the optimal emission tax value to be negative (market power dominates) could be biased because of ignoring uncertainty effects