On the Relative Effectiveness of Voluntary Agreements and Mandatory Regulation, When Consumers are Environmentally Conscious

We examine the impact of environmental policies in imperfectly competitive markets, when consumers care about the environmental damage of their consumption, and firms respond to consumers’ worries using end-of-pipe abatement. We focus on the choice of tax base between emissions and output, considering a flexible regulator who offers a Voluntary Agreement (VA) in the form of stick & carrot approach: the regulator offers a credible menu of tax rates based on firms’ abatement, and the firm chooses its abatement and the tax rate that will apply on its output or emissions. We find that the emissions tax base provides higher welfare for most levels of consumers’ environmental consciousness because the output tax may lead to over-abatement. Moreover, for low (high) levels of consumers, environmental consciousness, an emission (output) tax provides better environmental conditions. Comparing with the previous results where the regulator resorts to mandatory regulation, we find that the emissions tax when the regulator offers a VA menu leads to higher welfare. In contrast, in the case of the output tax, the decision between committing to a tax rate (mandatory regulation) or not (VA) depends on the level of environmental consciousness. Considering the environmental impact of a VA relative to mandatory taxation, the output (emissions) tax is generally superior when the regulator is not (is) able to commit.