Optimal Environmental Policy in a Dynamic Transboundary Pollution Game: Emission Standards, Taxes, and Permit Trading

Global environmental problems such as transboundary pollution and global warming have been recognized as major issues around the world. In practice, governments of all countries are actively exploring various environmental policies to control pollution. The government needs to consider the impact of neighboring regions when formulating environmental policies, especially in the context of transboundary pollution. However, the above problems are less studied, to bridge this gap and aim at solving problems in existing practices, we consider a differential game model of transboundary pollution control to examine which policy is more effective in promoting environmental quality and social welfare in a dynamic and accumulative global pollution context. Three alternative policy instruments, namely emission standards, emission taxes, and emission permit trading, are considered and compared. The results show that the social welfare of each region is the lowest and the total pollution stock is the highest under the emission tax policy due to the “rent-shifting,” “policy-leakage,” and “free-riding” effects. Moreover, the realized level of the environmental policy in the Nash equilibrium of the policy game is distorted away from the socially optimal level. The emission standards policy is found to be better than the emission tax policy and characterized by initiating the rent-shifting effect without the policy-leakage effect. Moreover, the pollution stock of two regions is found to be the lowest and the social welfare is found to be the highest under the emission permit trading policy, which is not associated with any of the three effects. Finally, a numerical example is used to illustrate the results, and a sensitivity analysis is performed in the steady state.