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This paper explores the role of uncertainty, in the form of measurement error, in pollution regulation under a tradable permit system. In particular, we showed the neutrality between the penalty and the audit frequency does not hold when agents (firms) are risk averse. Firms respond to the weight change between penalty and monitoring effort by adjusting their demand for pollution permits, as well as their production/pollution decisions. We studied two forms of the measurement error when observing the emissions: additive and multiplicative. While there are some analytical results for a model with additive error, the same cannot be said when the error is multiplicative to the real emission. We then used numerical methods to simulate firms behavior and the industry equilibrium with multiplicative error, and to identify the best policy for the government.

Enforcement and equilibrium in the permit markets when firms are risk averse