Emission pricing, emission rebound, and the coverage scope of incomplete regulations

This paper studies the emissions pricing of incomplete regulations when accurate firm-level information is unavailable. In an economy with monopolistically competitive heterogeneous firms, the equilibrium can be sufficiently characterized by an aggregate statistic, which we call the “coverage scope”. Given the coverage scope, emissions leakage to the unregulated firms results in a “U-shaped” relationship between the aggregate emissions and emissions price. As the coverage scope expands, the second-best emissions price increases. Firm heterogeneity and market power, the two defining features of the monopolistically competitive economy, affect emissions pricing differently. While both of them affect the second-best emissions price indirectly through coverage scope, market power has an additional direct effect. As a result, the optimal emissions price does not always decrease in market power, which contrasts the traditional wisdom on emissions pricing under complete regulations. A multi-sector model is numerically simulated using parameters for five Chinese manufacturing sectors to be incorporated into a proposed national carbon emissions pricing program. Quantitatively, the second-best price varies substantially with coverage scope and market conditions.