Abstract
This paper analyzes policies for regulating polluting firms under imperfect monitoring. The main finding is that a certain emission target is always more costly to enforce if there exists a market for emission permits than if there is none. The intuition is that a market restricts the regulatory agency to imposing incentive schemes which are linear in firms' emission levels, and these are less powerful than the best non-linear incentive schemes. Another result is that monitoring and monetary incentives are complementary policy instruments.