Collective Agreements : Incentive Contracts

The paper considers collective agreements that are signed by a government agency and an industry which have an energy saving target. The target achievement is observable, but the energy saving actions undertaken by firms in the industry are not. We consider such agreements as firm contracts that depend on whether the industry complies with the target or not. We show that first best regulation can be achieved when the agency can punish firms in case of non-compliance and reward firms in case of compliance. This result is in accordance with the moral hazard literature. However, if the agency, due to political constraints, is unable to punish firms, first best regulation cannot be achieved and this type of regulation is no longer collusion-proof. Furthermore, we show that when firms’ benefit from compliance with the agreement is measured as an exemption from paying a CO2 tax, welfare is highest when agreements are signed with a homogenous industry.