Environmental regulation of a power investment in an international market

We examine the optimal environmental regulation of three Norwegian power pr ojects: energy conservation, a natural gas fired CCGT and a new hydro proje ct. All projects reduce emissions elsewhere in the Nordic region, and the e nvironmental costs of these emissions are not, in general, fully reflected in market prices. We develop a theory of second best optimal regulation for this case. The optimal regulation is found to deviate substantially from a purely domestic regulation. For instance, we find it optimal to grant a su bstantial credit to energy conservation. The credit is sensitive to tile va lue of reduced CO2 emissions and whether the current Norwegian end user tax should be interpreted as an environmental or a fiscal tax. (C) 2001 Elsevi er Science B.V. All rights reserved.