Dynamic environmental policy with strategic firms: prices versus quantities

Environmental regulators often have imperfect information about regulated firms’ abatement costs. In this paper we compare taxes and emissions permits in a dynamic setting in which firms behave strategically. The regulator updates policy over time based upon previous aggregate industry performance, assuming that firms are not strategic. We find that strategic firms facing an emissions tax have an incentive to overabate in order to obtain a lower tax in the future. Firms that trade emissions permits have a strategic incentive to reveal an artificially high permit price to obtain more permits in the future. Whether permits or taxes are preferred from a welfare standpoint depends upon how permit prices are determined. Taxes generate higher welfare when the low-cost firm sets the permit price but permits generate higher welfare when the high-cost firm sets the permit price.