Emission taxes and feed-in subsidies in the regulation of a polluting monopoly

The paper studies the use of emission taxes and feed-in subsidies for the regulation of a monopoly that can produce the same good with a technology that employs a polluting input and a clean technology. In the first part of the paper, we show that the efficient solution can be implemented combining a tax on emissions and a subsidy on clean output. The tax is lower than the environmental damages, and the subsidy is equal to the difference between the price and the marginal revenue. In the second part of the paper, the second-best tax and subsidy are also calculated solving a two-stage policy game between the regulator and the monopoly with the regulator acting as the leader of the game. We find that the second-best tax rate can be the Pigouvian tax, but only if the marginal costs of the clean technology are constant. Using a linear–quadratic specification of the model, we show that the clean output is larger when a feed-in subsidy is used than when the tax is applied, but the dirty output can be larger or lower depending on the magnitude of marginal costs of the clean technology and marginal damages. The same occurs for the net social welfare, although we find that for low enough marginal costs of the clean technology, the net social welfare is larger when a feed-in subsidy is used to promote clean output regardless the importance of the marginal damages.