In Part II of this book we focus on the design of environmental policy by considering several generalizations and extensions to the model developed in Chapter 3. We begin in Chapter 4 by examining the effects of uncertainty on policy design. Here we will see that the welfare equivalence of emission tax and cap and trade systems, established in Chapter 3, breaks down under some types of uncertainty. In Chapters 5 and 6 we consider how competitive and imperfectly competitive output markets, respectively, interact with policy design. The focus on competitive output markets also enables an initial look at distributional issues in environmental policy, and our analysis of imperfect competition allows us to introduce second-best policy considerations. Second-best considerations then become the primary focus in Chapter 7, in which we examine how environmental policy interacts with other, pre-existing distortions in the economy, such as income taxes. This yields some important insights that differentiate revenue raising and non-revenue raising policy prescriptions. In Chapter 8, we consider a range of topics that are relevant for the real-world design and performance of cap and trade systems. It is here, for example, that we formally address the spatial and temporal aspects of environmental policy, and consider issues related to monitoring and enforcement. In Chapter 9, we introduce the non-point pollution problem, whereby a potentially stochastic ambient pollution level is observed, but emissions cannot be attributed to individual polluters. We will see that the inability to observe polluter behavior creates challenges for implementing the policy options discussed in the earlier chapters, and explains the relative dearth of economic incentive-based approaches to regulating many types of non-point source pollution.

Taken as a whole, Chapters 4 through 9 cover the main topics related to domestic environmental policy for flow pollutants, and they constitute the core themes in many graduate offerings on environmental policy. In the remainder of Part II, we cover several additional, and in some cases more advanced, topics. We begin in Chapter 10 with a discussion of liability rules. When an economic activity creates the risk of an environmental spill, as with nuclear power production or petroleum transport, liability rules can be designed that incentivize the proper level of accident prevention effort. We study the performance of liability rules under different assumptions about risk reduction effort observability, solvency, organizational structure, and insurance coverage.