Entry, exit, and instrument choice in environmental regulation

Abstract

We study market-based regulation where a government tries to avoid excessive firm closures by providing reliefs from emission fees for incumbent firms. Regulation is asymmetric as only incumbents, not new entrants are subsidized by the payment reliefs. We ask whether this feature affects the choice between environmental taxes and tradable permits under uncertainty. We find a trade-off between tax-beneficial inefficiency effect and permit-beneficial volume effect. The latter effect arises as the free quotas makes the number of aggregate permits and the aggregate emissions to fluctuate in the quantity implementation. We show that the subsidization of incumbent firms does not unambiguously favor one of the instruments but the advantage depends on policy- and industry-specific factors.