Adverse Selection as a Policy Instrument: Unraveling Climate Change

This paper applies principles of adverse selection to overcome obstacles that prevent the implementation of Pigouvian policies to internalize externalities. Focusing on negative externalities from production (such as pollution), we evaluate settings in which aggregate emissions are known, but individual contributions are unobserved by the government. We propose giving firms the option to pay a tax on their voluntarily and verifiably disclosed emissions, or pay an output tax based on the average of rate of emissions among the undisclosed firms. The certification of relatively clean firms raises the output-based tax, setting off a process of unraveling in favor of disclosure. We derive sufficient statistics formulas to calculate the welfare of such a program relative to mandatory output or emissions taxes. We find that our mechanism would deliver significant gains over output-based taxation in two empirical applications: methane emissions from oil and gas fields, and carbon emissions from imported cement. ∗We are grateful to Thom Covert, Meredith Fowlie, Michael Greenstone, Suzi Kerr, Gib Metcalf, Mark Omara, James Sallee, Joseph Shapiro, Andrei Shleifer, Allison Stashko, Bob Topel and seminar participants at Yale, Harvard, the Utah Winter Business Economics Conference, UC Santa Barbara, UC Berkeley, and the University of Chicago for helpful comments. Iván Higuera-Mendieta provided excellent research assistance. Cicala gratefully acknowledges funding from the 1896 Energy and Climate Fund at the University of Chicago, and along with Olsen thanks the University of Zurich for hospitality. All errors remain our own. e-mail: scicala@gmail.com, david.hemous@gmail.com, graugaardolsen@gmail.com