Adverse Selection, (Non-Tradable) Emission Permits and Optimal Price Differentiation

In this paper, we focus on the adverse selection issue that prevails when the regulator is not able to observe the type of the abatement costs of the firms. The regulator decides the total level of emission that minimizes the expected social cost of pollution and she sells them to the firms. In an environment where firms can hide their type relative to their true abatement costs we consider a regulator who wants to maintain her first-best objective in terms of quantities: deviating from this objective is too costly for Society. A second important point of the model is that firms are compelled to participate in the environmental policy even if they loose some expected wealth in doing so: the participation constraint is no longer consistent with this setting. Second-best prices are distorted with respect to the types of the firms and they drive all the incentives for the firms to choose the contract (prices and quantities) that is built for each of them. An original result concerns the rent, which still benefits to high-cost types, but which appears to be a fee paid by low-cost types when firms have high elasticities of demand.