Measurement of the productive efficiency of firms that generate environmental pollution (air and water pollution, and land degradation) and face the environmental regulation has to account for their efficiency in producing good output as well as in reducing pollution, the bad output. A measure of technical efficiency based on conventional input or output- based methods that ignore the firm’s efforts to reduce pollution may understate the productive efficiency of firms.

This paper focuses on the technology of an air polluting industry, namely the coal fired thermal power generation in India. It uses a methodology that could account for the industry’s performance in producing electricity and reducing pollution thereby measuring the productive efficiency of the firm.

The methodology used is directional output distance function. Estimates of firm-specific shadow prices of pollutants (bad outputs), and elasticity of substitution between good and bad outputs are also obtained. The technical and environmental inefficiency of a representative firm is estimated as 0.10 implying that the thermal power generating industry in Andhra Pradesh state of India could increase production of electricity by 10 per cent while decreasing generation of pollution by 10 per cent.

This result shows that there are incentives or win-win opportunities for firms to voluntarily comply with the environmental regulation. It is found that there is a significant variation in marginal cost of pollution abatement or shadow prices of bad outputs across the firm and an increasing marginal cost of pollution abatement with respect to pollution reduction by the firm. The paper concludes that variation in marginal cost of pollution abatement and non-compliance to regulation across firms could be reduced by having economic instruments like emission tax.