Emission Regulation of Markets with Sluggish Supply Structures

I examine regulation in the presence of convex investment costs and technology specific capacity stocks. Announcement of future emission taxes reduces current emissions unless fossil fuels are scarce, in which case the effect is ambiguous. Substantial future emission reductions require action today, because it takes time to build up clean production capacity and phase out dirty capacity. The Pigou tax must be coupled with sector specific investment taxes or subsidies to induce the socially optimal trajectory if the private discount rate differs from the social discount rate. If such investment taxes or subsidies are unavailable, a (time-inconsistent) second-best alternative may be to tax emissions above the Pigouvian level during the transition phase. The theory is complemented with a stylized numerical model of the US electricity market.