The Reallocation Effect of Emissions Cap-and-Trade : Evidence from China

This paper demonstrates a novel mechanism through which emissions cap-and-trade mitigates production-side distortion vis-à-vis an emissions cap policy under a heterogeneousfirm framework with imperfect competition. When clean and dirty inputs are gross substitutes, we find that a pro rata emissions cap is excessively stringent for more productive firms, leading to negative reallocation in favor of less productive firms. Emissions trading restores the efficiency loss via positive reallocation without increasing total emissions. Exploiting the spatial variation in policy implementation in China, our empirical results show that emission intensities of more productive firms declined and then increased relative to those of less productive firms following the sequential implementation of emissions cap and cap-and-trade policies, respectively, consistent with the unique implication of our theory. Provinces that implemented emissions cap-and-trade achieved greater output growth while being equally effective in curbing total emissions