Controlling a Stock Pollutant with Endogenous Abatement Capital and Asymmetric Information

Non-strategic firms with rational expectations make investment and emissions decisions. The investment rule depends on firms’ beliefs about future emissions policies. We compare emissions taxes and quotas when the (strategic) regulator and (nonstrategic) firms have asymmetric information about abatement costs, and all agents use Markov Perfect decision rules. Emissions taxes create a secondary distortion at the investment stage, unless a particular condition holds; emissions quotas do not create a secondary distortion. We solve a linear-quadratic model calibrated to represent the problem of controlling greenhouse gasses. The endogeneity of abatement capital favors taxes, and it increases abatement. JEL Classification numbers: C61; D8; H21; Q28.