Emission permits, innovation and sanction in an evolutionary game

This paper studies the evolutionary dynamics of a market regulated by an auctioned
emission trading system with a price floor in which there exist three populations
of firms that interact strategically: (i) non-polluting, (ii) polluting and compliant,
(iii) polluting but non-compliant. Firms that adopt a non-polluting technology need
no permits to operate, while firms that use a polluting technology can either buy
the required permits (and be compliant) or not (being non-compliant). The latter do
not buy emission permits and face the risk to be sanctioned if discovered. From the
analysis of the model emerges that all three types of firms coexist at the equilibrium
only under specific parameter values. More precisely, it can generically be excluded
the coexistence between non-polluting firms and non-compliant polluting ones. The
regulatory authority can favor the extinction of non-compliant firms by increasing
their probability of being discovered and/or the sanction level. Moreover, the
regulatory authority can favor the diffusion of innovation by increasing the permits
price floor since polluting-compliant firms exit the market and new non-polluting
firms enter the market. However, this policy instrument should be used with caution
because it tends to increase also the number of non-compliant firms.