Some incentive-based pollution-abatement policies (including typical pollution taxes and auctioned tradeable permits) have the attraction of cost-effectiveness but impose a very large share of the economy-wide cost of regulation on the regulated firms, causing substantial losses of profit in the regulated industries. Other incentive-based policies (such as systems of grandfathered tradeable permits) manage to avoid imposing such large costs on the regulated firms, but accomplishing this involves a very large sacrifice of cost-effectiveness, that is, a very large increase in the regulatory cost to the economy as a whole. The inability to avoid placing a large economic burden on key industries without significantly increasing the overall economic cost has seriously hampered the broader use of incentive-based policies, and accounts in part for the continued predominance of command-and-control policies in the regulatory landscape.

Building on encouraging results from initial work, this project will identify a class of somewhat more sophisticated but administratively feasible incentive-based policies that both avoid serious losses of profit in the regulated industries and involve relatively small sacrifices of economic efficiency or cost-effectiveness. We will examine the efficiency costs of "insulating" producers that have an especially large stake in the economic outcomes of pollution policy, and explore how efficiency costs change as the "insulation net" becomes broader to protect a wider group of industrial stakeholders. We wish to identify relatively cost-effective pollution-control policies that provide a reasonable degree of compensation or insulation to key stakeholders - thus enhancing the prospects for political feasibility. Such insulation is achieved through inframarginal exemptions to pollution taxes, partial grandfathering of pollution permits, or (in the case of downstream firms) industry-specific corporate tax cuts or tax credits.

The research will employ both analytically solved and numerical general equilibrium models to delineate the circumstances under which the cost of insulating key sectors is small. We will consider the costs of avoiding serious impacts both on "upstream" suppliers of polluting fuels and on "downstream" firms that utilize such fuels intensively. The first major component of the project focuses on CO2-abatement policies. The second component generalizes the analysis so that it can be applied to other pollutants such as NOx and SO2. The third component - to be performed in tandem with the first two - involves empirical work to improve key parameters of the theoretical and numerical models and to introduce important "bottom-up" details into the energy system of the numerical model.