Andries Nentjes, Ph.D., Department of Law and Economics, University of Groningen, P.O. Box 716, Groningen, 9700 AS, Netherlands and Frans P. de Vries, Ph.D., Department of Economics, University of Stirling, Stirling Campus, Stirling, FK9 4LA, United Kingdom.
The negotiated agreement (NA) is modeled as an exchange of emission reduction commitments between parties to preempt costly regulation. The simultaneous aim is to optimize the probability that the environmental authority will endorse the NA and to maximize cost savings from preempting direct regulation. In equilibrium, the group's collective emission reduction offer equals each member's demand for emission reduction. Firms with high potential cost savings take the largest share in the group's total emission reduction. The NA is constrained Pareto-efficient, implying total emission reduction is not fully optimal and not all potential cost savings are realized. The greater the firm's cost heterogeneity, the larger is the discrepancy between potential and actual cost savings. In cost efficiency the NA ranks between market-based instruments and direct regulation.