Environmental protection, public finance requirements and the timing of emission reductions

The effects of four environmental policy options for the reduction of pollution emissions, i.e. taxes, emission standards, auctioned permits and freely allocated permits, are analyzed. The setup is a real option model where the amount of emissions is determined by solving the firm's profit maximization problem under each policy instrument. The regulator solves an optimal stopping problem in order to find the critical threshold for policy adoptions taking into account revenues from taxes and auctioned permits and government spending. In this framework we find the ranking of the alternative policy options in terms of their adoption lag and social welfare. We show that when the output demand is elastic emission standards are preferred to freely allocated permits. Taxes and auctioned permits are always equivalent in terms of their adoption lag and social welfare and also equivalent to emission standards when the regulator redistributes revenues.