Center for the Study of Energy Markets

Policy makers are increasingly relying on emissions trading programs to address environmental problems caused by air pollution. If polluting firms in an emissions trading program face different economic regulations and investment incentives in their respective industries, emissions markets may fail to minimize the total cost of achieving pollution reductions. This paper analyzes an emissions trading program that was introduced to reduce smog-causing pollution from large stationary sources (primarily electricity generators) in 19 eastern states. I develop and estimate a random-coefficients discrete choice model of a plant's environmental compliance decision. Using variation in state-level electricity industry restructuring activity, I identify the effect of economic regulation on pollution permit market outcomes. There are two important findings. First, plants in states that have restructured electricity markets are less likely to adopt more capital intensive compliance options. Second, this economic regulation effect, together with a failure of the permit market to account for spatial variation in marginal damages from pollution, have resulted in increased health damages. Had permits been defined in terms of units of damages instead of units of emissions, more of the mandated emissions reductions would have occurred in restructured electricity markets, thereby avoiding on the order of hundreds of premature deaths per year.