Although it is widely acknowledged that serious attempts should be made to reduce environmental degradation, there continues to be much reluctance in many countries to adopt stringent environmental policies. An important reason for this reluctance is the belief that environmental policies in a country may have a negative impact on the competitiveness of domestic industries (see, e.g., Baumol & Oates, 1988, ch. 16; Simpson & Bradford, 1996). This was apparently one of the reasons why the Bush administration was against the ratification of the Kyoto agreement. Even in the Netherlands, where the environmental lobby is powerful, there have been suggestions by the government that exporting sectors should face less stringent environmental policies than other sectors because of the need to be competitive in the international market.1 One response to the apparent trade-off between stricter environmental policy and industrial competitiveness has been to argue that it might not exist, once one allows for dynamic effects of environmental policy on innovation (Porter & van der Linde, 1995). However, this proposal remains controversial (see Xepapadeas & de Zeeuw, 1999, for an assessment). Moreover, a potential solution based on industry-specific exemptions from environmental taxes, which have been introduced in several European countries, has been shown not to have the desirable results for either the environment or efficiency (Elkins & Speck, 1999). The issue therefore remains high on the agenda of policymakers and international bodies (see, e.g., OECD, 2003, 2006 & 2010; United Nations Economic Commission for Europe, 2006 & 2007). A comprehensive review of theory and evidence on the effects of environmental policy (OECD, 2006; see also Cebreiro-Gómez, 2006) describes a number of options for alleviating the impact of environmental taxes on competitiveness, including the recycling of tax revenue to the industries affected through output subsidies.2 It is this idea—which has been explored in the literature—that we shall explore further.3 Before turning to the specific issue at hand, that is, the effect of environmental policies on competitiveness, it may be helpful to discuss a related literature that examines the use of multiple instruments (including production subsidies) in the presence of environmental externalities. An earlier literature has examined the joint effect of emission taxes and abatement subsidies (e.g., Conrad, 1993; Kohn, 1990). Strand (1998) has analyzed the joint effect of emission taxes and various types of subsidies on employment in a perfectly competitive industry in the presence of unions. More recently, Fullerton and Wolverton (1999) have proposed combining output taxes and environmental subsidies in circumstances where polluting activities are difficult to tax, whereas Fullerton and Mohr (2003) have shown that the joint use of output taxes and input or abatement subsidies can increase welfare more than the use of just one of these instruments. More generally, Bennear and Stavins (2007) have argued that under a fairly broad set of circumstances the use of multiple policy instruments is optimal in a second-best world. Returning to the main issue at hand, Bovenberg, Goulder, and Gurney (2005) analyze the efficiency cost of a scheme whereby tradable emission permits are given free to firms affected by environmental taxes on the basis of their historical presence in the industry. They use a model with two competitive vertically related pollution-generating industries.