Regulating Externalities with Uncertainty, Investment, and Technology Spillovers

This paper analyzes optimal and non-optimal regulation of environmental externalities with investment in technology and uncertainty about the severity of environmental damages. Investment creates the potential for technology spillovers so that optimal regulation must address externalities from both emissions and investment. Despite these multiple externalities and uncertainty, we show that an optimal outcome can be achieved with freely allocated permits where the allocation is a function of investment. The optimal allocation can also be achieved under emissions taxes and cap-and-trade with auctioned permits with non-linear pricing schemes that are a function of investment. Conventionally applied incentive-based mechanisms, whether taxes or cap-and-trade, which are not functions of investment fail to achieve an optimal outcome. Among non-optimal mechanisms, we show that emissions taxes and auctioned permits are preferable to grandfathered permits in a linear-quadratic model. JEL: H23; Q55