Designing markets for pollution when damages vary across sources: What are the gains from di¤erentiation?

A majority of the air pollution currently regulated under U.S. emissions trading programs is nonuniformly mixed, meaning that health and environmental damages depend on the location and dispersion characteristics of the sources. Most emissions trading programs ignore this fact. Emissions are penalized at a single permit price, regardless of the location of the source. In theory, di¤erentiated policies can be designed to accommodate non-uniformly mixed pollution using emissions penalties that vary with emissions damages. We present a simple framework to illustrate the theoretical gains from di¤erentiation in …rst-best and second-best settings. This serves as foundation for a detailed analysis of the gains from di¤erentiation in a major U.S. emissions trading program. We take two complementary approaches to estimating these gains. Our preferred estimate, which is generated using an econometrically estimated model of …rms’compliance choices, is surprisingly small given the extent of the variation in damages across sources. A more standard approach to simulating of policy outcomes, one that assumes strict cost minimization on behalf of all …rms, predicts larger gains. A comparison of the two approaches provides insights into the determinants of the gains from policy di¤erentiation, some of which are inadequately captured by standard policy simulation models. Keywords: Market-based Policy, NOx Budget Program, Policy Instrument Choice. JEL Classi…cations: Q54, Q53, Q58 Fowlie: Department of Agricultural Economics, UC Berkeley, and NBER. Muller: Department of Economics and the Environmental Studies Program, Middlebury College. We thank Larry Goulder, Jacob LaRiviere, Steven Puller, Christian Vossler, and seminar participants at Carnegie Mellon, Resources for the Future, University of Pittsburgh, the University of California Energy Institute, the University of Tennessee, and the US EPA for helpful discussions and comments. We thank Dilek Uz for invaluable research assistance. Muller thanks the United States Environmental Protection Agency for support under award: EPA-OPEI-NCEE-08-02.