Cap-and-trade system, firm selection, and emission intensity

We investigate the impact of cap-and-trade on firm selection and emission intensity in an economy with heterogeneous firms. A cap-and-trade system with free allowances may worsen firm composition by acting as a subsidy and reallocating production resources across sectors, allowing less productive firms to remain operative. This effect can distort the allocation of emission permits, leading to a higher emissions per unit of output in the economy than when environmental regulations are absent. To analyze the role of this effect, we develop a general equilibrium model that incorporates firm heterogeneity, input–output linkages, and green technology innovation. This framework allows us to evaluate how cap-and-trade policies shape firm composition, innovation incentives, and emission allocation across firms. We then calibrate the model to the EU Emissions Trading System and conduct simulations to evaluate the effects of its planned phase-out of free allowances. Our results show that the removal of free allowances, either partially or fully, substantially improves firm composition, enhances innovations and emission efficiency. Under the existing allowance allocations, a cap-and-trade system results in a higher economy-wide emission intensity than an unregulated economy, despite lowering total emissions. Our simulations show that properly phasing out free allowances reverses this effect, primarily through improved firm composition.