This paper demonstrates that a voluntary agreement between a polluting industry and an environmental regulator can be Pareto superior to a scheme with second-best emission taxes. Further, such agreements differ from direct regulation in a non-trivial way. If the regulator's formal definition of the pollutant is ambiguous, emission taxes will not be fully effective, due to substitution effects. Still, self-enforcing agreements may be possible; and the first-best situation may even be attainable through such agreements.

However, if the industry anticipates the agreement and makes the first move, it may capture the entire Pareto gain, leaving the regulator with exactly the same benefits as in the second-best taxation case.