Environmental Policy and Firm Performance in Europe: A Difference-in-Differences Approach with Spillovers

In this paper we investigate the causal impact of the European Union Emissions Trading System, a cap-and-trade scheme limiting greenhouse gas emissions of firms, on their environmental performance. Although previous studies have focused primarily on the effect of the emission cap imposed by the policy, we argue that the trading mechanism creates complex interdependencies among firms that can change the policy's intended effects. We develop a novel Difference-in-Differences approach that disentangles the direct causal effects of the scheme on regulated firms from the indirect spillover effects arising from trading among firms. By incorporating potential interference between treated units, our methodology allows a more comprehensive assessment of the policy's overall effectiveness. Monte Carlo simulations show that our proposed estimators perform well in finite samples, confirming the reliability of our approach. To assess the direct and indirect effects of the scheme, we construct a novel database on emissions of European industrial sites by matching information on treated plants from the European Commission's Community Independent Transaction Log with emission data from the European Pollutant Release and Transfer Register for the years from 2001 to 2017. We find that the scheme reduced emissions only for non-trading plants, but such reduction is entirely offset when accounting for spillovers from trading plants, thus suggesting that the trading mechanism neutralizes the environmental benefits of the policy. Our findings have important implications for the design of future environmental policies and the ongoing evaluation of cap and trade policies.