Buying or performing abatement: environmental policy and welfare when commitment is not credible

Abstract

We investigate an asymmetric duopoly featuring two polluting firms that are heterogeneous in terms of production efficiency. The less efficient firm performs abatement by buying an environmental good (EG) in exchange of a fixed fee, while the more efficient firm engages directly in abatement effort. The cost asymmetry across the two firms is therefore determined by the nature (fixed or variable) of abatement costs. In this set-up, we compare two environmental policy settings: one where the regulator commits to policy before observing abatement investment, and one where such commitment is not credible (i.e. time-consistency). We conclude that, in the latter setting, emission taxes are lower, whilst environmental innovation, aggregate profits and consumers’ surplus are enhanced with respect to the case with commitment. The welfare ranking is however not straightforward, as commitment may make society better off than under time-consistency, depending on the degree of technological asymmetry in product on. Moreover policy makers might be †trapped†in a time-consistent policy scenario, due to the interest of involved stakeholders, at the expense of environmental policy effectiveness.