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

Under a heterogeneous firm framework, this paper demonstrates a novel channel through which emissions cap-and-trade mitigates production-side distortion vis-à-vis an emissions cap. Specifically, a pro rata emissions cap across firms is excessively stringent for more productive firms, leading to negative reallocation in favor of less productive firms. Allowing firms to trade emission permits restores the efficiency loss via positive reallocation without increasing total emissions. Our empirical investigation that exploits the regional and temporal variation in the implementation of cap and cap-and-trade policies in China shows that the emission intensities of more productive firms declined and then increased relative to those of their less productive counterparts following the sequential implementation of emissions cap and cap-and-trade, confirming our key theoretical prediction. Provinces that implemented emissions cap-and-trade achieved greater output growth while being equally effective in curbing total emissions.