Association for Public Policy Analysis & Management

Environmental regulation is nowadays facing the threat of potential rollbacks. For instance, in March 2018, the Environmental Protection Agency (EPA) announced it will start a process to repeal the Clean Power Plan policy, easing car fuel efficiency rules put in place under Obama's administration. While abolishing environmental regulation can yield an increase in damaging emissions, our paper shows that, in certain industries, the policy uncertainty that firms face in their R&D decisions produces a larger welfare loss than that originating from policy abolishment alone.

We consider a polluting industry where, first, the regulator sets an emission fee; second, every firm responds choosing its R&D investment; and, third, every firm selects its output level. In our benchmark setting, we assume that the fee remains into effect with a given probability but is abolished otherwise. We find equilibrium behavior and evaluate social welfare. While welfare under policy uncertainty is higher than in the absence of policy, we show that a potential regulatory rollback yields a welfare loss. To identify the origin of this welfare loss, we consider two counterfactual scenarios. Scenario 1, the regulator assumes that the policy remains into effect, while firms consider that regulation may be rolled back. We show that players’ behavior coincides with that in the benchmark setting. Scenario 2, firms assume that the policy remains into effect, while the regulator does not. By comparing firms’ behavior against that in the benchmark, we can isolate the effect of policy uncertainty on firms’ R&D decisions.

We compare the welfare loss from policy uncertainty against that from abolishing regulation, identifying in which cases the former is larger than the latter. This occurs when: (1) policy is unlikely to remain into effect; (2) several firms compete; (3) pollution causes severe damages; and (4) R&D investment costs are low. Our results indicate that, in industries where (1)-(4) concur, regulators should be careful at suggesting that environmental policies can be revisited in the future.