How to Regulate Carbon Emissions with Climate-conscious Consumers

Carbon prices are the most powerful instrument to reduce CO2 emissions, but there is strong political opposition to raising them to the efficient level. Therefore, additional efforts of consumers, firms, and local governments to reduce emissions are required. We study how regulatory regimes affect moral behavior and show that a carbon tax complements voluntary efforts to reduce emissions, while cap-and-trade discourages them. In the model consumers can invest in offsets which increases welfare and buy and delete emission rights which leads to more emissions. Furthermore, cap-and-trade shifts the burden of adjustment to poor consumers and has dysfunctional incentive effects. These results are robust to uncertainty and imperfect competition.