Journal of Public Economics 80 (2001) 199–224

www.elsevier.nl / locate / econbase

Strategic state-level environmental policy with

asymmetric pollution spillovers
Rudy Santore a , *, H. David Robison b , Yehuda Klein c
a
Department of Economics, 505 A Stokely Management Center, University of Tennessee, Knoxville,
TN 37996, USA
b
La Salle University, Philadelphia, PA 37996, USA
c
Brooklyn College, University of New York, New York, NY, USA
Received 1 November 1998; received in revised form 1 November 1999; accepted 1 January 2000

Abstract

This paper examines the strategic behavior of state-level utility regulators in the context
of the federal tradable emissions permits market when state-to-state pollution spillovers are
asymmetric. Strategic behavior is possible because a state’s environmental policy indirectly
affects the price of permits and, therefore, abatement in other states. We show that the
optimal pollution penalty is comprised of two parts: (i) a Pigouvian tax, adjusted for
state-to-state spillovers; and (ii) an optimal tariff designed to improve the terms of trade in
permits. Generally, abatement costs are not minimized and the outcome is Pareto inefficient,
regardless of the size of the market.  2001 Elsevier Science B.V. All rights reserved.

Keywords: Electric utilities; Tradable emissions permits

JEL classification: Q48

1. Introduction

The tradable emissions permit system established by Title IV of the 1990 Clean
Air Act Amendments is intended to provide greater cost efficiency than the
traditional command-and-control approach while reducing sulfur oxide emissions

*Corresponding author.
E-mail address: rsantore@utk.edu (R. Santore).

0047-2727 / 01 / $ – see front matter  2001 Elsevier Science B.V. All rights reserved.
PII: S0047-2727( 00 )00104-3
200 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

by electric utilities.1 Achieving cost efficiency requires a well-functioning market

for tradable emissions permits (hereafter TEPs) free from regulatory interference
or market power.2 However, states also regulate electric utilities and some states
have historically used the regulatory process to control emissions.3 Given the
importance of state-level regulatory policy in affecting electric utility behavior, it
is surprising that little formal analysis of the incentives facing state-level
regulators has been done. This paper examines the behavior of state-level
regulators operating within a single, national market for TEPs characterized by
asymmetric state-to-state pollution spillovers. While our analysis is motivated by
the 1990 Clean Air Act Amendments, it remains a theoretical exercise because we
have been forced to abstract from many real-world institutional and market details
in order to maintain tractability.
Our model assumes that the federal authority has established a national TEP
system and determined both the total number of TEPs to be issued and their initial
allocation. At the same time, state-level regulators (one for each state), acting
independently of the federal authority, are free to impose pollution penalties on the
electric utility companies operating within their home states.4 The state regulators,
who attempt to maximize the welfare of in-state residents, are assumed to be well
informed and rational. In particular, they anticipate the effects of their policies on
the market price of permits. Strategic behavior by the regulators is motivated in
part by the asymmetry of pollution spillovers since, with a fixed supply of permits
and a well-functioning market for permits, any pollution that is abated in one state
will ultimately be emitted in another. However, regulators also attempt to
manipulate the price of TEPs so that the terms of trade are more favorable for their
in-state electric utilities. For example, states with excess permits will, other things
equal, prefer a higher permit price and vice versa.
Most papers examining TEP systems use abatement cost minimization as their
measure of efficiency. At the same time, it is generally recognized that a cost
efficient outcome can be socially inefficient because cost efficiency ignores the
(possibly asymmetric) damage from emissions. Given our assumption that
regulators are seeking to maximize the welfare of residents rather than minimize
abatement costs, we also consider another measure of efficiency, in addition to

1
Stavins (1998) and Schmalensee et al. (1998) provide two insightful reviews of the program to date.
2
Strategic manipulation of the TEP market can be found in Hahn (1984) and Misiolek and Elder
(1989). In both cases, firms with market power are manipulating the market to gain competitive
advantage.
3
The array of treatments can be found in Rose et al. (1994). Dollar value of environmental adders
can be found in National Coal Council (1992). Wisconsin has its own stringent emissions regulations
described in Coggins and Swinton (1996).
4
Another paper that examines state-imposed environmental penalties is Levinson (1999). That paper
studies interjurisdictional tax and regulatory competition in the context of state hazardous waste
disposal. In particular, it models NIMBY taxes with two instruments, one on transported pollution, and
another on locally generated and deposited pollution.
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 201

cost efficiency. This other measure, which we call permits-constrained Pareto

efficiency, is similar to Pareto efficiency except that it recognizes the total national
level of pollution cannot be changed once a total number of permits has been
allocated. If an outcome is permits-constrained Pareto efficient, a social planner
with perfect information could not make residents of one state better off without
making residents of another state worse off, while keeping the national quantity of
unabated pollution equal to the total number of permits. In general, abatement cost
minimization is neither necessary nor sufficient for an outcome to be permits-
constrained Pareto efficient.
We find that regulators will impose a two-part pollution penalty on in-state
utilities consisting of a Pigouvian tax, adjusted for state-to-state spillovers, and an
optimal tariff designed to improve the terms of trade in permits. If the market is
sufficiently large so that a regulator’s policy does not affect the market price, then
the optimal tariff portion goes to zero, but the adjusted Pigouvian tax does not
(unless spillovers are symmetric). Thus, an important implication of our analysis is
that state-level regulators will generally interfere with the market, regardless of its
size.
With regard to efficiency, our results are generally negative. Differences in the
pollution penalties across states drive wedges between the marginal abatement
costs of electric utilities, yielding an outcome in which abatement costs are not
minimized. Furthermore, the outcome is generally not permits-constrained Pareto
efficient. Only when the regulators are price-takers and the pollution spillovers are
symmetric can the TEPs system guarantee efficiency. In fact, since the allocation
of permits affects a regulator’s optimal pollution penalty, the efficiency of the final
outcome depends on the initial allocation of permits, a result that is in marked
contrast to traditional thinking about TEPs.5
The idea that state-level regulators might interfere with the market for TEPs is
not new. Cropper and Oates (1992) suggest, but do not develop, the point. Bohi
and Burtraw (1992), in addition to demonstrating the importance of state
regulatory policies in affecting utilities’ abatement efforts, suggest that coal-
producing states might act strategically to protect in-state coal interests. Conrad
and Kohn (1996) indicate that some utilities may be prevented from acquiring
TEPs by state regulations aimed at improving air quality. Coggins and Swinton
(1996) find that utilities in Wisconsin have marginal abatement costs substantially
higher than TEP prices as a result of stringent state emissions laws. While these
studies demonstrate the impacts of a variety of state-level policies on electric
utility behavior, they do not model the behavior of the regulators as is done in the
current paper.
Other papers have suggested that governments may set environmental policy in
a strategic manner. For example, Barrett (1994) demonstrates that, with a single

5
Montgomery (1972) demonstrates conditions under which the initial allocation would not affect the
final outcome.
202 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

domestic firm competing in an imperfectly competitive international market, the

government has an incentive to protect the domestic firm by imposing a weak
environmental standard. Bui (1998) empirically examines the costs of sulfur oxide
abatement by the US and Canada under a variety of scenarios including joint
efforts to achieve ambient air quality standards. She finds that strategic behavior
results in higher than minimum total abatement costs. Bui’s comment, ‘the very
phenomenon that creates opportunities for gains from trade — the transboundary
flows of sulfur dioxide — simultaneously produces incentives to noncooperative
conduct,’ 6 applies equally well to states in a national TEP market as it does to
countries in the international realm. We find that both the transboundary flows and
the financial gains from more favorable TEPs prices contribute to the noncoopera-
tive conduct of individual state regulators.
A key feature of our model is that there are two levels of regulations, federal
and state. The only papers of which we are aware that formally allow for two
levels of regulation are Silva and Caplan (1997) and Caplan and Silva (1999). In
each of these papers environmental regulations are determined by a hierarchical
system consisting of a central government and two regional governments.
Although both papers allow for asymmetric spillovers, neither considers a
pollution permits market. Our model contributes to this literature by focusing on
the interaction of a national TEP system with state-imposed environmental
policies.

2. The model

There are S states. Throughout most of the model’s specification, it will suffice
to focus on state i since the description of the others is analogous; for example, the
quantities of unabated pollution emitted from states i and j are P i and P j ,
respectively.

2.1. Electric utility behavior

Each state has one publicly-owned electric utility that produces all electricity in
the state. The cost of electricity generation is characterized by the function Ki (E),
where Ki ( ? ) is strictly increasing in E, the quantity of electricity produced.7
Electricity and pollution are joint products, and the units of pollution are such that
pollution and electricity are produced in a one-to-one ratio. Thus, if E units of
electricity are produced, then E units of pollution are also produced. Pollution may
be abated, at a cost.

6
Bui (1998), page 1000.
7
Ki ( ? ) is a reduced-form cost function, given a fixed technology.
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 203

Pollution abatement costs for electric utility i are described by the function
Hi (q, Q) 5 QA i (q /Q), where Q is the total units of pollution generated, q is the
number of units abated, and A i ( ? ) is a strictly convex function (described in more
detail below). As such, Hi (q, Q) is linearly homogenous.8 The marginal abatement
cost is A i9 (). We assume A 9i (0)50 and A i99 (?).0 so that the marginal cost of
abatement is zero when the electric utility is abating zero units, and is strictly
increasing. Finally, we assume that the marginal cost of abatement becomes
arbitrarily large as the percentage of total pollution being abated approaches 100%;
that is, lim t →1 A 9i (t) 5 `.
Electric utilities behave as price-takers in the TEPs market. Let w denote the
price of TEPs and x i denote electric utility i’s initial endowment of emission
permits, where (x i .0). Electric utility i must hold one TEP for each unit of
pollution that is not abated. We let P i denote the total quantity of unabated
pollution emitted by electric utility i (so, for any state P i 5Q i 2q i ). Therefore, by
definition, electric utility i’s net demand is exactly (P i 2x i ) permits. Note that if
(P i 2x i ),0, then electric utility i is a net supplier of TEPs. We assume that excess
TEPs are sold rather than held or ‘banked.’ Similar to Carlson et al. (1998), our
model should be viewed as an analysis of a steady state in which annual emissions
equal the number number of TEPs.
We allow state i’s regulator to impose a nonnegative pollution penalty, denoted
by v i , on the in-state utility for each unit of unabated pollution. The total pollution
penalty paid by electric utility i is thus v i P i . We assume that the regulator sets the
price of electricity and requires the electric utility to meet electricity demand at the
regulated price (hence, below we simply refer to the quantity of electricity, rather
than the quantity demanded and the quantity supplied). In this case, cost-
minimization subject to the output requirement, E i , is equivalent to profit-
maximization. Let E i denote the quantity of electricity demanded in state i at the
regulated price. We can define the full-compliance cost function (which includes
the costs of complying with state and federal pollution regulations) as:

S Ei 2 Pi
C i (E i , v i , w) 5Min Ki (E i ) 1 v i P i 1 w(P i 2 x i ) 1 E i ? A i ]]
Pi Ei
D
subject to P i # E i
and Pi $ 0

Given the assumption that lim s →1 A i9 (s) 5 `, it follows that the electric utility will
always allow some pollution to go unabated. On the other hand, since (w1v i ).0
and A i9 (0)50, the electric utility will never allow all pollution to go unabated.

8
That is, doubling Q and q (thus abating the same share of pollution) doubles abatement costs.
204 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

Therefore, the solution, P i (E i , v i , w), is implicitly defined by the following first

order condition:

Ei 2 Pi
w 1 v i 2 A i9 ]]
Ei
S
50 D (1)

Eq. (1) requires the electric utility to equate the marginal cost of abatement to the
cost of an additional permit plus the state penalty for discharging an additional unit
of pollution. It should be clear from Eq. (1) that an appropriately chosen pollution
penalty can induce any level of abatement beyond that which would have been
chosen without the state-level regulation.
By differentiating (1), we can calculate the effect of changes in E i , v i , and w on
electric utility i’s cost-minimizing level of unabated pollution, P i (E i , v i , w):

≠P i ( ? ) ≠P i ( ? ) 2 Ei
]] 5 ]] 5 ]] , 0 (2)
≠v i ≠w A 99
i

i i
≠P ( ? ) P
]] 5 ]i . 0 (3)
≠E i E
Since the cost of unabated pollution is (v i 1w), increases in either the pollution
penalty or the price of permits will cause the electric utility to pollute less, as seen
in Eq. (2). Eq. (3) says that unabated pollution increases with the amount of
electricity generated, or that it is a normal ‘input’ if the electric utility is viewed as
having two inputs: abated pollution and unabated pollution.

2.2. Equilibrium in the market for TEPs

Recall that each state electric utility behaves as a price-taker and the initial
allocation of permits is exogenously determined at the federal level. Electric utility
i is a net demander when, at a given market price, P i (?).x i . Similarly, electric
utility i is a net supplier when, at a given market price, P i (?),x i . For a given
initial allocation of permits, the equilibrium price of TEPs, w*, is implicitly
defined by the following market clearing condition:

O P (E , v , w* ) 5O x
S S
i i i i
(4)
i51 i 51

1 S 1 S
As defined, w * 5 w * (v, E), where v 5 (v , . . . ,v ) and E 5 (E , . . . ,E ) although
in what follows we will frequently suppress these arguments for compactness. Eq.
(4) assumes there will not be so many permits that the equilibrium price is zero.
This possibility will be ignored as it is neither realistic nor interesting.

Proposition 1. For any state i, an increase in the pollution penalty decreases the
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 205

equilibrium price of permits and an increase in the quantity of electricity increases

the equilibrium price of permits.9 Specifically,
≠P i ()
2 ]]
dw * ≠v i
(i) 2 1 , ]] i 5 ]]]] ,0
dv S
j51 O
≠P j ()
]]
≠w
≠P i ()
2 ]]
dw * ≠E i
(ii) ]]i 5 ]]]] . 0.
dE S
O
≠P j ()
j 51 ]]
≠w
Intuitively, higher pollution penalties decrease the demand for pollution rights
which, in turn, decreases the price of TEPs. Furthermore, the more responsive state
i’s power company is to changes in the price of TEPs (or, equivalently, the
pollution penalty) the more the market price will decline when v i increases. This
equilibrium effect will tend to counteract attempts to discourage in-state pollution
because a one dollar increase in v i will cause a udw * / dv i u decrease in the price of
permits. Therefore, the net increase in the per unit cost of unabated polluting is
(1 1 (dw * / dv i )) , 1. Other things equal, the penalties necessary to achieve a
desired effect on in-state pollution will have to be larger when dw * / dv i is
relatively large in absolute value, which will be true when there are relatively few
states.
It will be convenient to define P i * (v, E) ; P i (E i , v i , w * (v, E)), which is
electric utility i’s cost minimizing level of unabated pollution when evaluated at
the equilibrium price of permits. We will often suppress the arguments of P i * for
compactness. Differentiating both P i * and P j * with respect to v i and E i yields:
≠P i * ≠P i (E i , v i , w * ) ≠P i (E i , v i , w * ) ≠w *
]] 5 ]]]] 1 ]]]] ]]i . 0 (5)
≠E i ≠E i ≠w ≠E
≠P j * ≠P j (E j , v j , w * ) ≠w *
]] 5 ]]]]] ]]i , 0 for j ±i (6)
≠E i ≠w ≠E
≠P i * ≠P i (E i , v i , w * ) ≠P i (E i , v i , w * ) ≠w *
]] 5 ]]]] 1 ]]]] ]] ,0 (7)
≠v i ≠v i ≠w ≠v i
≠P j * ≠P j (E j , v j , w * ) ≠w *
]] 5 ]]]]] ]] . 0 for j ±i (8)
≠v i ≠w ≠v i
The signs in Eqs. (6) and (8) follow from Eq. (2), and Proposition 1.

9
The stated expression in (i) is derived by differentiating Eq. (4) with respect to v i and w * . The sign
and magnitude follow from Eq. (2). The stated expression in (ii) is derived by differentiating Eq. (4)
with respect to E i and w*. The sign of the expression follows from Eqs. (2) and (3).
206 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

A change in either v i or E i affects P j * (where j ±i) in only an indirect manner

through changes in the equilibrium price of permits. However, changes in either v i
or E i have both direct and indirect effects on P i * . The first term in Eqs. (5) and
(7) represents the direct effect on electric utility i’s choice of unabated pollution,
while holding the price of permits constant. The second term represents the
indirect effect on electric utility i’s level of unabated pollution that occurs when
w * adjusts to the changes in demand. Note that the direct and indirect effects work
in opposite directions, though the net effect is unambiguous (this can be shown
using Eqs. (2), (3) and Proposition 1). Eqs. (6) and (8) present the indirect
impacts on state j given changes in E i and P i .

Proposition 2. An increase in state i’s pollution penalty (quantity of electricity)

will cause a decrease (increase, respectively) in state i’s equilibrium level of
unabated pollution, and an increase (decrease, respectively) of equal magnitude in
the equilibrium levels of unabated pollution for all other states.10 That is:

≠P i *
(i) ]]
≠v i
5 2 O≠P j *
]]
j ±i ≠v
i ,0

O
i j
≠P * ≠P *
(ii) ]] i 5 2 ]] i .0
≠E j ±i ≠E

Not only will the decreased price of TEPs offset a regulator’s attempt to
discourage in-state pollution, it will also make pollution cheaper for the other
states. Thus, an increase in the pollution penalty provides an indirect pollution
subsidy to out-of-state electric utilities.

2.3. The regulator’ s objective

Regulator i is assumed to maximize the utility function of a representative

resident of state i. The utility function of the representative agent is U i (z, E, P),
where z is the quantity of a composite good, E is the quantity of electricity, and P
is a measure of pollution in the state. To incorporate spillovers into the model, we
define P ; o Sj51 b i, j P j , where b i, j is the fraction of P j that spills over into state i
(note that b i,i should be interpreted as the fraction of P i that remains in state in i).
Utility is increasing in the composite good and in electricity, but is decreasing in
pollution. That is:

≠U i () ≠U i () ≠U i ()
]] ; U iz . 0, ]] ; U iE . 0, and ]] ; U Pi , 0
≠z ≠E ≠P
10
The expressions given in both (i) and (ii) follow from differentiating Eq. (4). The signs of the
expressions follow from Eqs. (5) and (7).
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 207

We normalize the price of the composite good, z, to unity. We also assume the
representative resident owns the power company, receives all revenue from
pollution penalties, and has other exogenous income, y i . Under these assumptions,
the budget constraint for the regulator can be written as:
z i 5 y i 2 C i (E i , v i , w * ) 1 v i ? P i *
In other words, the representative agent’s expenditure on the composite good, z i ,
must equal her exogenous income, y i , less the costs of the electric utility, C i (?),
plus the revenue from the pollution penalty, v i P i * .11
State i’s environmental regulator wishes to maximize the utility of the
representative resident, while satisfying the budget constraint and taking the
behavior of the other states as fixed. Since the regulator is perfectly informed and
the electric utility must satisfy demand at the regulated price, having the ability to
choose the regulated price of electricity is equivalent to being able to directly
choose the quantity of electricity. However, it turns out to be analytically more
convenient to model the regulator as choosing the quantity of electricity rather
than the price. So, for simplicity, the instruments available to the regulator are a
nonnegative pollution penalty, v i , and a nonnegative quantity of electricity, E i .
The regulator is assumed to be fully rational and, therefore, recognizes the
implications of her behavior on the equilibrium price of permits.

3. The regulation game

We now consider the pure-strategy Nash equilibria of a ‘regulation game’ in

which each regulator simultaneously chooses a pollution penalty and a quantity of
electricity (sometimes referred to as policies). In equilibrium, each regulator
chooses a best-response policy to the other regulators’ choices. For a vector
of policies for each of the other regulators, (E2i , v2i ) ; ((E 1 , . . . ,E i 21 ,
E i 11 , . . . ,E S ), (v 1 , . . . ,v i21 , v i 11 , . . . ,v S )), the best-response of regulator i, de-
noted by (E i * (E2i , v2i ), v i * (E2i , v2i )), is the solution to:

S
Max U i y i 2 C i (E i , v i , w * ) 1 v i P i * , E i ,
E i, v i
Ob
S

j 51
i, j
D
P j*
i
subject to v $ 0
Ei $ 0
y i 2 C i (E i , v i , w * ) 1 v i P i * $ 0
11
The budget constraint could also be written as:

y i 5z i 1Ki (E i )1w(P i 2x i )1E i ? A i S

E i 2P i
]]
Ei
D
However, the form provided in the body of the text turns out to be more convenient.
208 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

where the budget constraint has been used to substitute out z i . We will assume that
the best-response policy is unique.
The first constraint in the above maximization problem should be thought of as
being due to pressure from environmental groups. Any attempt to subsidize
in-state pollution is likely to be nothing short of political suicide. Nonetheless, we
do discuss allowing the subsidization of pollution in Section 3.4. The second
constraint prevents negative consumption of electricity. Finally, the last inequality
constraint requires that the residents consume a nonnegative quantity of the
composite good.
In all that follows, we make the very reasonable assumption that the last two
constraints do not bind. Given these assumptions and substitutions, the regulator’s
problem is:

S
Max U i y i 2 C i (E i , v i , w * ) 1 v i ? P i * , E i ,
E i ,v i
Ob
S

j 51
i, j
P j* D
subject to v i $ 0

The first-order conditions defining the best-response of regulator i are:

H
≠C i () ≠C i () ≠w *
U iz 2 ]]
≠E i 2 ]]
≠w ≠E
≠P i *
]]i 1 v i * ]]
≠E i 1 U Ei 1 U Pi J
S

j 51
≠P j *
b i, j ]]
≠E i
50 O
(9)

D#0 (10)

vi * ? D 5 0 (11)

where

D;U i
z H 2
≠C i () ≠C i () ≠w *
]]
≠v i
2 ]]
≠w ≠v i
]] 1v i
*
≠P i *
]]
≠v i
1P i
* i
1UP
S

j 51
b J O ]]
j
i, j ≠P *

≠v i

A Nash equilibrium of the regulation game, denoted by:

(EN , vN ) 5 (E 1N , . . . ,E SN , v 1N , . . . ,v SN )

is a pollution penalty and a quantity of electricity for each state such that each
regulator is choosing a best-response to the other regulators’ policies.
The next proposition characterizes the best-response pollution penalty. Since, by
definition, the regulators must choose best responses in a Nash equilibrium, the
characterization also applies to the pollution penalties chosen in a Nash equilib-
rium.
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 209

Proposition 3. If v i * . 0, then:

U iP
O
i i
i i,i i, j j,2i (P * 2 x )
v *5 2 i
] (b 2 b ) a 2 ]]]
U z j ±i ≠P j
]
j ±i ≠w
O
and
i i
≠C () U E
]] 5 ]i
≠E i Uz

where

≠P j
]
≠w
a j,2i ; ]]]
O ≠P h
]]
h±i ≠w

and all functions are evaluated at regulator i’ s best-response policies.

When the pollution penalty is strictly positive, it will consist of two com-
ponents. The first component is a Pigouvian tax which has been adjusted to take
into consideration the pollution spillovers from other states into state i. If there
were no spillovers ( b i, j 5 0, for all i ± j), the first term reduces to the traditional
Pigouvian tax since o j ±i a j,2i 5 1. When spillovers are nonzero, additional
abatement by state i will result in sales of additional permits. Air quality in state i
will improve by o j ±i ( b i,i 2 b i, j ) a j,2i for each additional unit of pollution abated
in state i. More generally, the adjustment to the Pigouvian tax depends on size of
the spillover effects ( b i, j ) multiplied by the proportion of permits sold by state i
purchased by state j (a j,2i ). When states purchasing a large share of permits also
have large spillovers back into state i, state i will reduce its pollution penalty.
Conversely, if the states purchasing a large share of permits have little spillover
into state i, the regulators in state i will use a pollution penalty closer to the
traditional Pigouvian tax.
The second component is an optimum tariff which attempts to shift the terms of
trade in favor of electric utility i. When state i is a net demander of permits, the
regulator wishes to impose a tariff on the ‘imported’ pollution. However, since
there are only two goods being traded (pollution permits and the composite good),
the net exporter of pollution permits must be a net importer of the composite good.
Thus, the net supplier of permits would like to impose an optimum subsidy on
pollution (or, equivalently, an optimum tariff on the ‘imported’ composite good).
The subsidy effect would reduce the size of any pollution penalty, but actual
subsidization does not occur because of the assumption that negative pollution
210 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

penalties are not feasible.12 The size of the optimal tariff component varies with
the number of states in the model. As S gets arbitrarily large, the tariff component
gets arbitrarily small.
At first, one might suspect regulator i would not impose a positive pollution
penalty when o j ±i ( b i,i 2 b i, j ) a j,2i ,0 since, in this case, any decrease in electric
utility i’s unabated pollution will ultimately cause air quality in state i to diminish
once other states have purchased the permits sold by electric utility i. However,
this is only unambiguously true when state i is a net supplier of permits. When the
state is a net demander of permits, the regulator must consider the fact that a lower
price of permits ultimately translates into a lower cost of electricity for its
residents.
Proposition 3 also tells us that the regulator will set the marginal (full-
compliance) cost of electricity equal to the marginal rate of substitution between
the composite good and electricity. While this result is consistent with standard
intuition, it is not true when the regulator finds it optimal to set the pollution
penalty equal to zero.
Although the regulator is not allowed to impose negative pollution penalties, the
desire to subsidize pollution may be present. This desire to subsidize pollution
may arise because spillovers are large and, therefore, state i’s air quality improves
as more pollution is emitted in-state rather than out-of-state. Or, if electric utility i
is expected to be a sufficiently large net supplier of permits, the regulator may
want to subsidize in-state pollution to drive up the market price of permits.
Regardless of the motivation, a regulator who wishes to subsidize pollution will
set the pollution penalty equal to zero since negative penalties are not allowed. The
next proposition addresses this possibility.

Proposition 4. If v i * 5 0, then, in general,

i i
≠C () U E
]] . ]i ,
≠E i Uz

where all functions are evaluated at regulator i’s best-response policies.

Proposition 4 says that a regulator who would otherwise wish to subsidize in-state
pollution will choose a quantity of electricity such that the marginal (full-
compliance) cost of electricity is strictly greater than the marginal rate of
substitution.13 Thus, the regulator selects a larger E i than she would if pollution
penalties were allowed to be negative. To understand this result, recall that
increases in E i will have the same qualitative effects on the equilibrium price of
permits as decreases in the pollution penalty (see Proposition 1). Since regulator i

12
See Dixit and Norman (1980) pp. 150–152.
13
Given the low price elasticity of demand for electricity, this policy option is quite limited.
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 211

cannot actually subsidize pollution, she will attempt to increase the price of
permits by choosing a relatively higher quantity of electricity than she would if
allowed to actually subsidize pollution. Thus, the marginal cost of electricity will
not equal the marginal rate of substitution because using more electricity has an
additional benefit: it increases the price of permits. In reality, there may be other
ways of encouraging in-state pollution that are less likely to catch the eye of the
general public; for example, pollution abatement equipment may not be tax
deductible.

3.1. Inefficiency

Once the federal government has set the number of permits, the total quantity of
pollution is no longer an issue. Thus, in assessing the merits of a market for
pollution rights, it would not be appropriate to criticize the market institution for
inefficiencies that arise due to federal authorities choosing to allow too many or
too few permits. For this reason, we define the notion of permits-constrained
Pareto (PCP) efficiency, which takes the total level of abatement as exogenous. (In
Appendix A we derive the necessary conditions for an outcome to be PCP
efficient.)

Definition 1. An outcome, u 5 (z 1 , . . . ,z S , E 1 , . . . ,E S , P 1 , . . . ,P S ), is feasible,

given the country’s exogenous income, o Sj 51 y j , if

OSz 1 K (E ) 1 E ? A S]]] DD #O y
S j j S
j j E 2P j j
j j j
j51 E j 51

Definition 2. An outcome, u 5 (z 1 , . . . ,z S , E 1 , . . . ,E S , P 1 , . . . ,P S ), satisfies the

permits constraint if o Sj 51 P j 5 X, where X is the total quantity of permits.

Definition 3. Consider an outcome u 5 (z 1 , . . . ,z S , E 1 , . . . ,E S , P 1 , . . . ,P S ) that is

feasible and satisfies the permits constraint. u is permits-constrained Pareto
efficient (hereafter, PCP efficient) if there does not exist another outcome, call it
u 9 5 (z 1 9 , . . . ,z S 9 , E 1 9 , . . . ,E S 9 , P 1 9 , . . . ,P S 9 ), such that: (i) u 9 is feasible; (ii) u 9
satisfies the permits constraint; (iii) U j (z j 9 , E j 9 , o Sh51 b i,h P h 9 ) $ U j (z j , E j ,
S i,h h i i i S i,h h i i i
o h51 b P ) for all j; and (iv) U (z 9 , E 9 , o h51 b P 9 ) . U (z , E ,
S i,h h
o h51 b P ) for some i.

Formally, we are adding the constraint that the federal government has determined
the total number of TEPs to be allocated across utilities to the standard definition
of Pareto efficiency.14 As such, an outcome can be PCP efficient without being

14
For a discussion of Pareto efficiency, see Cornes and Sandler (1986, p. 15).
212 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

Pareto efficient since Pareto efficiency would typically require a total level of
abatement for all states that is not equal to the total quantity of permits. However,
PCP efficiency simply takes the total quantity of abatement as exogenous. The key
point is that with PCP inefficient outcomes a social planner could improve welfare
without altering the total level of abatement, so the inefficiencies are not merely
the result of having too few or too many TEPs.
PCP efficiency is also quite different from cost efficiency; that is, minimizing
pollution abatement costs. From Eq. (1) it follows that the marginal abatement
costs of any two states will be equal if and only if the pollution penalties are
exactly equal, which will not generally be true. Thus, the TEPs system will not
generally achieve cost efficiency. However, minimizing abatement costs ignores
pollution spillovers and the disutility created by the spillovers. An electric utility
with high marginal abatement costs and large spillovers into a population center
might do little abatement to achieve cost minimization and more abatement to
achieve PCP efficiency. The next proposition addresses the inability of TEPs
system to achieve PCP efficiency.

Proposition 5. The outcome of any trading equilibrium 15 is generally not permits-

constrained Pareto efficient, regardless of the size of the market.

Intuitively, PCP efficiency requires that the net marginal benefit of having state i
abate another unit equal the net marginal benefit of having state j abate another
unit. Mathematically, this statement can be written as:

Ob Ob
S S
h,i
(U Ph /U zh ) 2 A 9i 5 2 h, j
2 (U hP /U hz ) 2 A 9j (12)
h51 h51

where the first term on each side of the equation is the combined marginal benefit
to all states associated with having the state in question (here i or j) abate another
unit of pollution, the second term is the marginal abatement cost (see Appendix A
for a derivation of this condition). If circumstances had the left-hand side of Eq.
(12) greater than the right-hand side, welfare could be improved by having state i
abate more and state j abate less.
Eq. (12) demonstrates two important points. First, PCP efficiency does not
require that a state’s marginal abatement cost equal the marginal benefit of
abatement. Even if a PCP efficient outcome is obtained, the net marginal benefit of
having each state abate more will be positive when the federal government has
issued too many TEPs and negative when it has issued too few. Second, the
condition does not require that the marginal abatement costs be equalized across
states, except in the special case discussed in the next section. In other words, PCP
efficiency does not require abatement cost minimization.

15
We use the term ‘trading equilibrium’ to refer to any Nash equilibrium of the regulation game in
which at least one electric utility sells at least one permit to another utility.
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 213

An important implication of Proposition 3 is that the initial allocation of TEPs

affects both the distribution of gains from trading and the efficiency of the final
outcome. This result is counter to traditional thinking about TEPs which suggests
that the initial allocation affects the distribution of gains, but not the efficiency of
the final outcome. Looking back at the expression for the pollution penalty, it is
clear that a state’s initial allocation of permits will affect the magnitude of the
pollution penalty chosen by its regulator, which in turn affects the level of
abatement in that state. Thus, the efficiency of the final outcome depends on the
initial allocation.
This result raises the question of the sources of the inefficiency. One source is
the single national market for TEPs with no recognition of the differential impacts
of emissions. Inside this system, states facing large spillovers can, at best, only
indirectly affect the pollution spilling into the state. A second source of
inefficiency is the strategic attempt by state-level regulators to improve the terms
of trade in TEPs. However, as discussed in Section 3.3, even when S is large
enough eliminate the optimal tariff portion of the pollution penalty, states have
incentives to impose pollution penalties to affect in-state emissions and spillovers
from other states.

3.2. Uniform impacts of all emissions

In this section, we consider the special case when the air quality in each state
does not depend upon the location of the pollution; all that matters is the sum of
all pollution emitted from all utilities. This case is relatively simple to analyze
because, once the total number of permits has been set, regulators cannot affect air
quality. Equilibrium in the TEPs market requires that the total quantity of unabated
pollution equal the total quantity of pollution permits. Nevertheless, it does not
follow that there is no role for pollution penalties: As long as regulators can affect
the price of permits (S is finite), they will attempt to shift the terms of trade in the
permits market.

Proposition 6. Consider a trading equilibrium for the case when each state’s air
quality is solely a function of total pollution ( b i, j 5 d for all i and j, where d is
any positive constant). Only those states that are net demanders of permits
(P i * . x i ) will impose strictly positive pollution penalties (v iN . 0). Furthermore,
the pollution penalties, when positive, are simply optimum tariffs. That is:

(P i * 2 x i )
v iN 5 2 ]]] . 0 whenever v iN . 0
O
j ±i
≠P j ()
]]
≠w
where all functions are evaluated at the Nash equilibrium policies.16

16
We do not prove Proposition 6 as it follows from the straightforward substitution of b i, j 5 d (for
all i and j) into the pollution penalty expression provided in Proposition 3.
214 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

The key to understanding Proposition 6 lies in recognizing that states cannot

change the size of the externality given the federally-designated number of TEPs.
Thus, regulator i simply imposes an optimum tariff on the ‘imported pollution.’
Regulator j, on the other hand, wishes to subsidize pollution (or, equivalently,
impose a tariff on imports of the composite good), but cannot. As discussed by
Proposition 4, regulator j will then use relatively more electricity since doing so
causes upward pressure on the price of permits.
Given the assumption that b i, j 5 d for all i and j, Eq. (12) reduces to:

A 9i ( ? ) 5 A j9 ( ? ) (13)

In the absence of the asymmetry, PCP efficiency requires that marginal abatement
costs should be equalized across states. However, from the first-order conditions of
the cost minimization problem faced by electric utilities (Eq. (1)), each state’s
marginal abatement cost must equal the permit price plus the state-imposed
pollution penalty. As demonstrated in Proposition 6, the penalties will not be equal
and thus the marginal abatement costs will not be equal. That is, in the absence of
asymmetrical air flows, efficiency is still not achieved due to state-level strategic
behavior. Therefore, not only is the outcome PCP inefficient, pollution abatement
costs are not minimized under the TEPs system. The one exception is when the
number of states is sufficiently large to cause the optimal tariffs to go to zero in
which case cost efficiency is achieved, but not PCP efficiency.

3.3. Thick markets

In large markets the policy chosen by an individual regulator has only a

negligible effect on the price of permits. Regardless of the size of the market
though, regulators will nevertheless impose pollution penalties to improve in-state
air quality (as long as emissions do not have uniform impacts). Recall that positive
pollution penalties have the form:

U iP
O
i i
i i,i i, j j,2i (P * 2 x )
v * 5 2 ]i (b 2 b ) a 2 ]]] (14)
U z j ±i ≠P j
]
j ±i ≠w
O
However, the last term, the optimum tariff, goes to zero when the market grows
without bound yielding:

Ui
i P
v * 5 2 ]i
Uz
O( b
j ±i
i,i i, j
2b ) a
j,2i
(15)

Note that the remaining adjusted Pigouvian tax term is a weighted average (where
a is the weight) and, therefore, does not go to zero when the number of states
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 215

grows without bound. The upshot is that the regulators will find it optimal to
impose pollution penalties even if they do not have any effect on the price of
permits. Further, as shown in the proof of Proposition 5, it is easy to give an
example in which the outcome is clearly not PCP efficient. Thus, the inefficiencies
discussed above are not merely the result of market power, unless emissions have
uniform impacts. Finally, if emissions have uniform impacts and the market is
arbitrarily large, then regulators set a pollution penalty equal to zero as positive
pollution penalties affect neither the price of permits nor in-state air quality.

3.4. Subsidizing pollution

Throughout we have not permitted states to subsidize pollution by imposing

negative pollution penalties. In this section, we briefly discuss the impacts of
relaxing the non-negative pollution penalty assumption. With a pollution subsidy,
the cost of emitting a unit of pollution is the permit price minus the subsidy.
Emitting pollution is still a cost to the electric utility but switches from a revenue
to a cost in the regulator’s budget constraint. As long as the subsidy is smaller than
the price of TEPs (v i . 2 w), the proof of Proposition 5 goes through without any
substantive modification; that is, the outcome remains PCP inefficient.
A subsidy greater than the price of TEPs would change our analysis. However,
some examination of this point is possible without fully reworking the model.
First, note that a subsidy larger than the price of TEPs (v i , 2 w) would mean that
increasing emissions increases revenues to the electric utility. Utilities would now
seek to increase pollution to gain the benefit of the state subsidy and abatement for
that state would drop to zero. (In reality, firms could increase emissions by turning
off pollution control equipment and / or by switching to higher-sulfur coal.) As the
electric utility purchases enough permits to cover all emissions, there would be
upward pressure on TEP prices. With a pollution subsidy, cost efficiency would be
impossible since the marginal abatement cost for this state is, at most, zero. Of
course, subsidizing pollution would also produce substantial controversy and
reaction from environmentalists, residents, other states, and potentially federal
officials.

4. Summary

The traditional argument in favor of TEPs relative to a command-and-control

approach is that the TEP system will minimize abatement costs. However, we have
shown that cost minimization is generally not achieved by a national TEP market
when state-level regulators can impose pollution penalties on in-state utilities.
Only in the special case of a ‘thick’ market with uniform impacts of all emissions
across all states would cost minimization occur. Otherwise, differences in the
pollution penalties across states drive wedges between the marginal abatement
216 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

costs of electric utilities, limiting the reduction in abatement costs. In addition, we

demonstrated that the individually optimal pollution penalties depend on the initial
allocation of TEPs.
Cost efficiency, however, may not be the best criterion to judge a TEP system if
spillovers are asymmetric since it does not recognize the source of the pollution.
For this reason, we developed the permits-constrained Pareto efficiency concept
and demonstrated that the Nash equilibrium outcome is also not permits-con-
strained Pareto efficient. Thus, in principle, a social planner could make residents
of all states better off by reallocating resources, without altering the total quantity
of national pollution. This negative result also holds for ‘thick’ markets as long as
the pollution spillovers are asymmetric.
While the strategic behavior of state-level regulators interferes with the working
of the TEP market, the TEP system may also limit the ability of state regulators to
achieve their goals. Under the command-and-control, a state-imposed pollution
penalty would lead to greater abatement by the electric utility with no other
effects. With a TEP system, the same penalty produces abatement which, in turn,
leads to the excess TEPs being sold and, potentially, more pollution spilling into
the state. While the TEP approach gives state regulators some ability to affect
emissions in other states, the fungible nature of TEPs makes it virtually impossible
to target emissions from particular states for reduction. This point re-emphasizes
the importance of multiple geographic markets or spatially-adjusted permits made
in Baumol and Oates (1988).
Finally, our paper has examined some of the incentives facing state-level
regulators, but has done so in a simplified model. We assumed that regulators
maximize a simple welfare function when, in fact, regulators must balance the
interests of politicians, investors, consumers, and voters. In addition, there are
other mechanisms by which regulators could affect the market for TEPs. Among
these are encouraging or forcing utilities to hold, rather than sell, excess TEPs or
applying pollution volume caps in addition to per-unit penalties. We have also
assumed away issues such as the ‘banking’ of permits for later use and other
groups purchasing, but not using permits. Thus, more work along these lines is
clearly appropriate.

Acknowledgements

This paper has benefited greatly from the comments of James Peck, Alan Viard,
and two anonymous referees. We are responsible for any remaining errors.

Appendix A. Permits-constrained Pareto efficient outcomes

In this appendix we characterize a PCP efficient outcome. For any such

(feasible) outcome, it is impossible for a national policy maker to make the
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 217

resident of one state better off without making the resident of at least one state
worse off, subject to the constraint that a fixed quantity of pollution, X, will be
emitted. Thus, the constraint that needs to be incorporated is o Sj 51 P j 5 X.
Formally, the problem can be written as:

Max S O D
(E 1 , . . . ,E S ,P 1 , . . . ,P S , z 1 , . . . ,z S )
U i z i, E i,
S

j51
b i, j P j

Subject to U j
S O D
j
z ,E , j
S

h51
b j,h P h $ Uˆ
j
for all j ±i

E j 2 P j $ 0 for j 5 1, . . . ,S

O P 5X
S
j

j51

OSz 1 K (E ) 1 E ? A S]]] DD #O y
S j j S
j E 2P j j j
j j j
j51 E j 51

as well as nonnegativity constraints for each of the choice variables.

The first set of constraints indicates that the utility level in the other states is
held constant. The second set of constraints simply states that it is impossible for
any state to abate a negative quantity of pollution. The third constraint is the
requirement that exactly X units of pollution go unabated. The last constraint
requires that the outcome be feasible, given the total exogenous income of the
country o Sj 51 y j .
The above problem can be simplified substantially as follows: The first set of
constraints will each bind since utility is increasing in the composite good. For
simplicity, we make the assumption that the second set of constraints does not
bind, which is equivalent to assuming that it is never optimal to have one state do
no abatement.17 Given the assumption that lim t →1 A i9 (t) 5 `, the solution will not
require P i 5 E i . Finally, we make the very reasonable assumption that the solution
will not entail zero consumption of either the composite good or electricity. Thus,
the nonnegativity constraints can be ignored.
Given the above assumptions the Lagrangian can be written as:

Max
E 1 , . . . ,E S , P 1 , . . . ,P S
S O D SO
U i z i, E i,
j 51
S

b i, j P j 1 c
S

j 51
Pj 2X D
z 1 , . . . ,z S , m , c , l 1 , . . . , l S

17
We should point out that simply because A 9i (0) 5 0, it does not necessarily follow that each state
must abate a positive quantity. The reason is that when looking for a permits-constrained Pareto
efficient outcome, the question is which state should do the abatement, up to the total available number
of permits. Thus, hypothetically, if state i’s pollution causes very little harm, we might not want i to
abate at all because for every unit that it abates some other state j, whose emissions are more harmful,
must do less abatement.
218 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

O l FU Sz , E , O b P D 2 Uˆ G
S
h h h h h,k k j
1
h±i k51

1 m O S y 2 z 2 K (E ) 2 E ? A S]]]DD
S h h
h E 2Ph h h
h h h
h51 E

The F.O.C.s are:

for E i : U Ei 5 m [K 9i 1 A i 1 (P i A i9 ) /E i ] (A1)

for E j ( j ± i): l jU jE 5 m [K 9j 1 A j 1 (P j A j9 ) /E j ] (A2)

for P i : b i,iU Pi 1 Olb

h±i
h h,i
U Ph 1 c 1 m A 9i 5 0 (A3)

j
for P ( j ± i): b i, jU iP 1 Olb
h±i
h h, j h
U P 1 c 1 m A 9j 5 0 (A4)

i i
for z : U z 5 m (A5)

for z j ( j ± i): l jU jz 5 m (A6)

i j j
Using Eqs. (A5) and (A6) it follows that m 5 U z 5 l U z for all j ± i. We can then
simplify Eqs. (A1)–(A4) to get the following necessary conditions for efficiency:

for E i : U Ei /U zi 5 [K i9 1 A i 1 (P i A i9 ) /E i ] (A7)

for E j ( j ± i): U jE /U jz 5 [K 9j 1 A j 1 (P j A 9j ) /E j ] (A8)

for P i : b i,i (U Pi /U zi ) 1 Ob
h±i
h,i
(U Ph /U zh ) 1 (c /m ) 1 A i9 5 0 (A9)

j
for P ( j ± i): b i, j (U iP /U iz ) 1 Ob
h±i
h, j h h
(U P /U z ) 1 (c /m ) 1 A j9 5 0 (A10)

Thus, necessary conditions for PCP efficiency are:

For all j: U jE /U jz 5 [K j9 1 A j 1 (P j A j9 ) /E j ] (A11)

Ob
S
h, j
For all j: 2 (U Ph /U zh ) 2 A 9j 5 (c /m ) (A12)
h51

Condition (A11) tells us that the marginal rate of substitution between electricity
and the composite good should equal the full-compliance marginal cost of
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 219

electricity, at the optimum. Condition (A12) makes two important points: First, the
net marginal benefit (to society) of abatement for each state must be equalized.
And, second, given that m is the increase in resident i’s utility when society’s
exogenous income is increased by one dollar, it must be positive. So the sign of c,
which is the increase in resident’s i’s utility when X is increased by one unit, is
positive if and only if the net marginal benefit (to society) of abatement for each
state is positive. That is, a positive c implies that society would be better off, at
the optimum, if less pollution were allowed (i.e. fewer TEPs were issued by the
federal government).
The reader should note that there are (infinitely) many PCP efficient outcomes,
each corresponding to a different point on the (S21) dimension utility frontier,
j
given the number of permits. The specification of Uˆ for each j ± i picks out a
specific point on the utility frontier.

Appendix B. Proofs of the propositions

Proof of Proposition 3
First, note that when v i * . 0, Eq. (11) implies that, in general, Eq. (10) must
hold with equality. Using the envelope theorem, it follows that:

≠C i () i ≠C i ()
]] 5 P * and ]] 5 P i * 2 xi
≠v i ≠w

Then, substituting Eq. (7) and the above into the equation D 5 0 (from Eq. (10))
we obtain:

U iP
O
j
≠w * i, j ≠P ≠w *
i i
(P * 2 x ) ]] ] b ] ]]
i ≠v i U iP i,i U iz j ±i ≠w ≠v i
v * 5 ]]]]] 2 ]i b 2 ]]]]]] (B1)
≠P i * Uz ≠P i *
]] ]]
≠v i ≠v i

Before further simplifying the above equation, note that using Eqs. (6), (2), and
Proposition 1 (i) it follows that:

≠w *
]]
≠v i 21
]] i
≠P *
]]
≠v i 1O 2
5 ]]]

j ±i
≠P j ()
]]
≠w
(B2)

Using Eq. (B2) we can write Eq. (B1) as:

220 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

U iP
O
j
i, j ≠P
i ] b ]
i i
(P * 2 x ) U P i,i U zi j ±i ≠w
v i * 5 2 ]]] 2 ]i b 1 ]]]]] (B3)
O O
j j
≠P Uz ≠P
] ]
j ±i ≠w j ±i ≠w

Simple rearrangement of Eq. (B3) yields the expression given in Proposition 3.

Now using the expression given in the proposition to eliminate v i * from Eq.
(9), and once again making use of the envelope theorem to calculate (≠C i () / ≠w) 5
P i * 2 x i , we get:
i
U iP i,i ≠P i * U iP
O
i j
≠C () U E i i ≠w * ≠P *
]] i 2]i 5 2 (P * 2 x ) ]] i 1] i b ]] i 1] i b i, j ]]
≠E Uz ≠E Uz ≠E U z j ±i ≠E i
U Pi
O
j
i, j ≠P
] ]

1 2
i b
i
≠P *
i i
(P * 2 x ) U P i,i U zi j ±i ≠w
1 ]] 2 ]]] 2 ] b 1 ]]]]] (B4)
O O
i j i j
≠E ≠P Uz ≠P
] ]
j ±i ≠w j ±i ≠w

i i
Using Eq. (6) to substitute out ≠P * / ≠E in the above equation, and canceling
terms, we find that the right hand side of Eq. (B4) equals zero, which implies
(≠C i () / ≠E i ) 2 (U iE /U iz ) 5 0. Q.E.D.

Proof of Proposition 4
A condition of the proposition is that v i * 5 0. And, by the envelope theorem,
we have (≠C i () / ≠w) 5 P i * 2 x i . So, Eq. (9) can be rearranged to yield:
i
U iP S
O
i j
≠C () U E i i ≠w * i, j ≠P *
]] 2 ]i 5 2 (P * 2 x ) ]]i 1 ]i b ]] (B5)
≠E i Uz ≠E U z j 51 ≠E i

Using Eq. (6) and Proposition 2 (ii) we can rewrite the above as:

S D SO ]
≠w D
1
i i j i i
1 ≠C () U E ≠P (P * 2 x )
]] ]] 2 ] 5 2 ]]]
≠w * ≠E i
]]i
≠E
U zi j ±i
O
≠P j
]
j ±i ≠w

O( b ≠P j
i,i
2 b i, j ) ]

2
i
U P j ±i
≠w
2 ] ]]]]]] (B6)
O
i j
U z ≠P
]
j ±i ≠w

Given that o j ±i (≠P j / ≠w) , 0 and (dw * / dE i ) . 0, it follows that:

 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 221

Os b
j
i, j ≠P i,i
d ]

1 2
2 b
S
≠E
i
≠C () U E
sign ]] i 2]
i

i
Uz
D
5 2 sign 2 ]]]
i

≠P
]
j
i i
(P * 2 x ) U P j ±i
2 ]i ]]]]]]
Uz
O
≠P
]
j
≠w

O
j ±i ≠w j ±i ≠w

(B7)

However, the term in parentheses on the right-hand side of Eq. (B7) is the
pollution penalty that the regulator would set if she were not constrained to use a
non-negative penalty. In general, that term will be negative, which implies
(≠C i () / ≠E i ) . (U iE /U iz ). Q.E.D.

Proof of Proposition 5
First, consider the case when at least one of the regulators, say regulator j, sets a
pollution penalty equal to zero in the Nash equilibrium; that is, v jN 5 0. By the
envelope theorem we know:

≠C i ()
]]
≠E i 5 K9 F i A i9 ()
i 1 A i 1 P ( ? ) ]]
Ei
S DG for all i (B8)

Combining Eq. (B8) with Eq. (A11), derived in Appendix A, a necessary

condition for the outcome to be PCP efficient is:

U iE ≠C i ()
] 5 ]] for all i (B9)
U iz ≠E i

However, by Proposition 4, if the best-response of regulator j is to set a pollution

penalty equal to zero (that is, v j * 5 0), then, in general, Eq. (B9) will not be
satisfied. It follows that the Nash equilibrium outcome cannot be PCP efficient
when v jN 5 0 (for some j) since in any Nash equilibrium the regulators choose
best-responses.
Now consider the case when all regulators choose strictly positive pollution
penalties: v iN . 0 for all i. A direct implication of Eq. (A12), derived in Appendix
A, is that in order to have a PCP efficient outcome we must have:

O (b
S
h, j
2 b h,i )(U Ph /U zh ) 5 A 9i 2 A j9 for all i and j
h51

By Eq. (1), cost minimization by the electric utilities implies:

A 9i ( ? ) 2 A j9 ( ? ) 5 v i 2 v j for all i and j

Combining the two previous equations, we find that a necessary condition for a
Nash equilibrium to be PCP efficient:
222 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224

O (b
S

v Ni 2 v Nj 5 h, j
2 b h,i )(U Ph /U zh ) for all i and j (B10)
h 51

To determine if a Nash equilibrium is PCP efficient when v Ni . 0 for all i, we

substitute the expression for the pollution penalties derived in Proposition 3 into
Eq. (B10) which yields:

i
(P * 2 x ) U
i 2 b i,h ) ]]
i
≠w
O(b
≠P h
P h ±i
i,i
j
(P * 2 x )
j

2 ]]] 2 ] ]]]]]] 1 ]]]

O ≠P h
O O
i
U ≠P h z ≠P h
]] ]] ]]
h ±i ≠w h±i ≠w h±j ≠w

O(b
h
≠P
j, j
j 2 b j,h ) ]]
U P h±j
1 ]j ]]]]]]
≠w ? S h, j h,i h h
5 sb 2 b d U P U z O S Y D
Uz ≠P h
]]
h±j ≠w
O h51

for all i and j (B11)

While there is no reason to expect the above equation to hold as is required for
efficiency, there is no way to rule out the possibility that an equilibrium ‘just
happened’ to be efficient. As such, the remainder of the proof consists of a couple
of simple parametric examples for which the equilibrium is not efficient (that is,
Eq. (B11) is not satisfied). The first example assumes that regulators have market
power, whereas the second considers the extreme case in which no regulator can
affect the market price of permits.
For the first example, assume that there are only two states, i and j. Then, Eq.
(B11) reduces to

(P i * 2 x i ) (P j * 2 x j )
]]] 5 ]]]
≠P j ≠P i
] ]
≠w ≠w

which cannot be satisfied as long as trade takes place since market clearing
requires (P i * 2 x i ) 5 2 (P j * 2 x j ). Thus, when there are only two states, it is
clear that Nash equilibrium outcome is not PCP efficient.
The previous example might give the (false) impression that market power is the
sole cause of the inefficiency. So we now turn to the case when regulators cannot
affect the market price of permits. For this extreme case, Eq. (15) gives the
expression for the pollution penalty (the optimum tariff term goes to zero). In this
case, with some rearrangement of terms, Eq. (B11) reduces to:
 R. Santore et al. / Journal of Public Economics 80 (2001) 199 – 224 223

U iP U jP
Uz S
i, j
2 ]i b 2
h±i
O D S
b i,h a h,2i 1 ]j b j,i 2 b j,h a h,2j
Uz h ±j
O D
5
?
O sb
h±j,i
h, j
S Y D
2 b h,id U hP U hz for all i and j (B12)

where a h,2i is as defined in Proposition 3.

However, the above will not hold for some parameters. Suppose that for some i
and j

(Condition 1) b h, j # b h,i for all h ± i, j

(Condition 2) b i, j , b i, h for all h ± i, j
(Condition 3) b j, i . b j, h for all h ± i, j

These conditions are independent of one another. Condition 1 guarantees that the
right hand side of Eq. (B12) is non-negative. Condition 2 guarantees that the first
term on the left-hand side is strictly negative since o h±i a h,2i 5 1. And, Condition
3 guarantees that the second term on the left-hand side is strictly negative since
o h±i a h,2i 5 1. Therefore, if all three conditions are satisfied for some i and j, the
outcome is not PCP efficient. Q.E.D.

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