Essays on Optimal Environmental Regulation and Information Economics

This monograph studies optimal environmental regulation under asymmetric information and carbon leakage risk. I use tools from the fields of mechanism design and microeconomic theory to study how the possibility of firms' relocation to less regulated countries as a result of domestic regulation, i.e. carbon leakage affects incentive-compatible environmental regulation. To address this question, I build a stylized model of a single country which regulates global externalityproducing firms by way of incentive-compatible regulatory schemes, i.e. mechanisms. I allow the firms to possess private information on their costs of abatement and carbon leakage risk as typedependent outside options.

In the first chapter of this monograph, I introduce my main model and derive the optimal secondbest regulatory mechanism for the monopolist country. I find that novel regulatory distortions arise from relocation risk and that the optimal second-best mechanism sometimes implements stricter regulation that would be socially optimal. Interestingly, I find that carbon leakage is also not necessarily an indication of a failed regulatory policy, but rather an optimally induced result of it. The second chapter of this monograph extends the basic model by relaxing the assumption that the domestic regulator cannot commit to cross-border transfers. I show that conditional crossborder transfers rectify the major drawback of the simple mechanisms discussed previously: the fact that the regulator is losing socially valuable firms and therefore also abatement. With crossborder transfers, the regulator is able to buy the otherwise leaked abatement directly from the relocating firms themselves, essentially outsourcing both the firms and their abatement. The second extension considers exogenous regulatory policies implemented in the other country. I show that the regulator benefits from any such policies - be they price or quantity-based, since they serve to decrease the outside options of the firms, thus making the firms more captive in the home country at the outset.

The third and final chapter of this monograph analyzes a situation where two countries compete for externality-producing firms by way of incentive-compatible regulatory mechanisms. Using a simplified version of my main model, I show that a Bertrand-like race to the bottom results, where both countries' social welfare dissipates fully in the resulting equilibrium. The main cause of this is the lack of relocation frictions for the firm, pitting the countries against one another as Bertrand competitors. I extend the model to account for a fixed preference of a firm in favor of the other country and show that in this case, the preferred country reaps this preference for its own benefit in every resulting equilibrium.

Contact Topi Hokkanen

Email: topi.hokkanen@aalto.fi