Environmental Policy and Tournaments: A Theoretical Formulation with Over-compliance

Abstract

In this paper the concept of rank-order tournament is illustrated as an incentive mechanism targeting potential over-compliant polluters - those already complying with existing environmental regulations but can further develop the capacity to exceed such regulatory requirements. Employing partial equilibria in a game theoretic framework it is demonstrated that (1) participants have the tendency to over-invest in pollution abatement, contrary to the standard result in principal-agent problems where the principal’s choice of contract fails to induce an agent’s efficient level of effort;  (2) higher expected returns from the game induce lower emissions for each player; and (3) emissions with high risks of negative impacts, or emissions reductions with the most benefits should be accorded high prizes in the game; (4) low cost firms achieve a higher environmental improvement than high-cost firms for any given standard and prize structure.  A scheme of the nature presented here is attractive in several ways: the cost of emissions reductions from ‘losers’ in the game are incurred privately but the benefits of these emissions reduction are a public good; it provides firms with a reason to over-comply, without which they have no incentive to exceed regulatory requirements.

Keywords: environmental regulation, incentives, over-compliance, tournaments