In choosing environmental regulatory instrument and setting standards, a government relies on an Environmental Protection Bureau's (EPB) informational advantage, even though these two entities may have different preferences for internalizing environmental damage. A three-level hierarchical model between the government, the EPB and polluting firms is constructed to derive the government's optimal delegation policy for the EPB. Given the uncertainty in firms' costs and asymmetric information on transaction costs, this paper presents a demonstration of the communication process between the government and the EPB in formulating the standards of environmental regulation and choosing between the instruments of emission trading and tax schemes. This paper seeks to determine how the decisions in the environmental regulation should be delegated for the government to trade-off the cost to it of EPB's discretion versus the benefits of taking advantage of the EFB's expertise. Results suggest the bureaucratic political issue leads to a tendency towards either an emission trading or a tax scheme, depending on the direction of the EPB's environmental preferences. Compared with the case where only emission trading can be chosen, the choice of instrument results in less discretion left to the EPB in setting up the trading emission allowance and a higher tax, irrespective of whether the EPB is more or less concerned about the environmental damage than the government.
Keywords: Adverse selection; Delegation; Discretion; Emission tax scheme; Emission trading scheme; Transaction costs.
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