Inelastic Supply of Fossil Energy and Competing Environmental Policies

The inelastic supply of fossil energy in the international input market precipitates failure of Pigouvian taxation consequent to competition among governments, as imposition of an environmental tax increases (decreases) the marginal cost of domestic (foreign) firms. This paper demonstrates that unless the supply of fossil energy is perfectly elastic, cap-and-trade outperforms Pigouvian taxation in terms of the domestic welfare of adopting countries, and global welfare is maximized when all countries implement the alternative scheme. We further demonstrate that the linkage of permit markets, when the energy supply is sufficiently inelastic, improves global welfare.