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

This paper investigates the reallocation effects of emissions cap-and-trade policy, leveraging China’s phased implementation of chemical oxygen demand (COD) regulations as a quasi-experiment. Our theoretical model posits that a pro rata emissions cap is more stringent for more productive firms, resulting in negative reallocation, whereas emissions trading restores efficiency through positive reallocation by reallocating emissions towards more productive firms. Utilizing the spatial and temporal variation in policy implementation, our empirical findings demonstrate that emission intensities of more productive firms, relative to less productive counterparts, declined after adopting the cap policy but subsequently increased with the introduction of cap-and-trade, aligning with our theoretical predictions. We also find that firms operating under a cap-and-trade regime, on average, experienced faster output growth compared to those operating under a cap-only regime, highlighting the role of emissions trading in enhancing production efficiency, even within imperfect markets.