The United States Environmental Protection Agency's Project XL is an example of a new environmental management approach called "tailored regulation" (TR) wherein firms volunteer to negotiate site-specific, performance-based pollution control agreements with regulators and community stakeholders. While the program has been touted by some as a "regulatory blueprint for the future," XL has floundered in practice, in part because no theoretical analysis exists to guide policy design. Our research develops an economic theory of tailored regulation to describe the conditions under which it is to be preferred to command and control and economic incentive instruments, and to generate recommendations for designing and implementing it.

The paper has three parts. In the first part we develop a simple baseline analytical model to illustrate the presumptive benefits of TR. In the second part we relax a number of simplifying assumptions (firms are homogenous, information is perfect, no uncertainty) in a series of extensions in order to assess the robustness of the presumptive benefits of TR. The final section presents policy prescriptions.

Our models suggest that TR has the potential to improve efficiency by according firms more control over technology choice, creating incentives to innovate, and improving the regulator's ability to monitor. TR may even be preferable to economic incentive instruments when monitoring and transactions costs are high. However, TR may favor large firms in mature industries and those with special relationships with local stakeholders.

This would be undesirable if it discouraged the participation of firms likely to have innovative pollution control strategies, impeded competition, or exacerbated rent seeking, but would be desirable if it sparked races to secure TR agreements. It should be possible to mitigate TR's undesirable impacts and magnify its desirable ones by carefully structuring program rules governing participation, the allocation of participation costs, and negotiations. For example, the regulator could encourage small or innovative firms to participate by limiting participation in some industries to better enable firms to appropriate the benefits of TR.