Time-inconsistent environmental policies with a consumer-friendly firm: Tradable permits versus emission tax

This study considers the timing of environmental policies with a consumer-friendly firm having abatement technology and compares two market-based regulatory instruments, tradable permits and emission tax regulations. When the government can credibly commit its policy, we show that the equilibrium outcomes under both policies are equivalent in terms of permits price and tax rate. Under the non-committed policy, however, the equivalence breaks down because firms have opposite incentives to induce time-consistent policy to be adjusted ex post. In particular, compared to pre-committed government, firms abate less emission to induce higher emission quotas under the permits policy while a consumer-friendly firm abates more emissions to reduce tax rate under the tax policy. Finally, we show that tax policy will result in higher welfare and lower environmental damage unless the concern on consumer surplus is large.