Environmental regulation of technically inefficient firms

•We present an externalities model with a technically inefficient polluting firm.•Technical efficiency is the firm's private information.•We study the control of emissions through two policy instruments, a tax and a quota.•The paper derives second-best regulatory schemes.•The choice of policy instrument is affected by the entire distribution of efficiency.

This paper presents a model in which a technically inefficient firm is responsible for the emissions of pollutants. We derive second-best regulatory schemes (tax and quota) assuming that the firm's technical efficiency is unknown to the regulator.