Working Paper Number
Since firms in an emissions trading program are linked together through a permit market, so too are their compliance choices. Thus, enforcement strategies for trading programs must account for not only the direct effects of enforcement on compliance and emissions decisions, but also the indirect effects that occur because changes in enforcement can induce changes in permit prices. This paper uses laboratory experiments to test for these direct and indirect market effects. Consistent with theoretical predictions, we find a direct effect of enforcement on individual violations, as well as a countervailing market effect through the permit price. Thus, the productivity of increased enforcement pressure to reduce noncompliance is partially offset by a countervailing price effect. Furthermore, there is no direct effect of enforcement on the emissions choices of firms, only a negative price effect. This suggests that the only way increased enforcement can have an impact on environmental quality is if it is large enough and applied widely enough to induce an increase in the equilibrium permit price.