Making Clean Firms Cleaner: Targeting Environmental Regulation to Maximize Returns

Many environmental regulations are designed to clean up the dirtiest firms. However, if pollution intensity is negatively correlated with market share, this approach may not be the most cost-effective way to reduce pollution. This paper illustrates the theoretical conditions under which it is more cost effective to incentivize pollution intensity improvements among relatively cleaner firms. I provide a decision rule for regulators designing pollution reduction policy, and I show that the California wholesale electricity sector exhibits investment behavior consistent with the trade-off implied by this rule.