Pollution and production control when emission standard depends on cumulative emission

This paper deals with the effect of pollution regulatory standard on firms’ production　and emission levels in a dynamic setting. When an economy suffers from environmental disruption caused by pollutants emitted through firms’ production activity, economic development must be harmonized with environmental concern not to disrupt it too much.

We consider an economy where firms are, subjected to certain pollution emission standards, producing goods and emitting pollution under two types of emission permit trading schemes. They are “cap and trade” and “rate-based trading”.  In either scheme firms do not care for environmental damage in the economy as a whole.  Thus, we consider the social planner’s problem as well, as the third scheme, assuming that the planner selects the pair of goods production and pollution emission levels for each firm in order to maximize the time discounted sum of consumer surplus, firm profits and social damage from pollution accumulation. The problem is how to set standards. This paper proposes a regulatory standard on emission in terms of the cumulative amount of pollution from the past till the present time. Taking account of the fact that environmental degradation proceeds as the stock, rather than the flow level, of pollutants increases, we model it by endogenizing the emission standard as a function of accumulated pollution.

The main results obtained in the paper are (1) the optimal time paths of goods production and pollution emission always move in the same direction under a cap and trade scheme or under socially optimal planning, namely whenever goods production increases (decreases) the emission increases (decreases) over time, (2) the existing static result that the optimal production under rate-based trading scheme is larger than that under cap and trade does not survive in the dynamic analysis, and (3) the socially optimal production and emission paths can be reproduced by a cap and trade scheme but not by a rate-based trading scheme.