Successful implementation of pollution regulation often requires redistributing a portion of the benefits back to firms who incur abatement costs. When firms have private information on their costs, they have an incentive to overstate these costs and demand higher compensation. Optimal pollution regulation in this environment sacrifices allocative efficiency to reduce information rents. I measure the gains from optimal pollution regulation by empirically examining the effect of sulfur dioxide emissions regulation on electric utilities. These electric utilities also face economic regulation, and I exploit this institutional detail.

I derive estimates of marginal abatement costs from the cost of jointly producing electricity and emissions, allowing for time-varying unobserved heterogeneity to capture cost efficiency. Cost efficiency consists of exogenous (intrinsic type) and endogenous (managerial effort) components which are private information of the firm. To separately identify these components, I model economic regulation as a signaling game of auditing. I show that a particular equilibrium exists where the firm does not exert effort during the "rate case", but it exerts a positive level of effort afterwards. I provide empirical evidence for the plausibility of this equilibrium using cost and rate case data. This equilibrium generates exclusion restrictions that are used to estimate parameters of the cost function and disutility of effort. I show that the type distribution can be nonparametrically identified using deconvolution methods, and estimate this distribution via a smoothed discrete approximation. Finally, I conduct counterfactual welfare simulations.

I find that annual welfare gains from optimal pollution regulation relative to a uniform emission standard range from $32 million to $155 million per electric utility, or about 10% to 47% of combined electricity generation and abatement costs. Implementing the optimal form of regulation is difficult, if not impossible, so I examine simpler regulatory regimes. A class of regimes with uniform emission taxes captures 52% to 80% of these gains.