Pollution Pricing in Equilibrium: Production, Reallocation, and Aggregate Impacts

How much does pricing pollution cut aggregate emissions, and at what cost? We develop a microfounded equilibrium model of firm production and abatement that can be estimated from standard firm financial and emissions data, without observing abatement effort directly. The model captures three adjustment margins: short-run input substitution, reallocation of output from dirty to cleaner firms, and long-run clean technology adoption. Applying it to the first 17 years of the European Union Emissions Trading System (EU-ETS), we find input substitution is rigid: firms cannot cut emissions in the short run without cutting output. Reallocation instead drives nearly all of the short-run aggregate emissions response, concentrated in sectors with heterogeneous emissions intensities, like power and cement, or with elastic demand, like refining. Clean technology adoption also responds causally to permit price shocks, reducing firms’ emissions intensity over the five years that follow. Doubling the permit price cuts aggregate emissions 23% in the short run and 31% in the longer run after induced clean technology adoption. In the short run, output falls by 4%, primarily because carbon costs pass from upstream polluting industries like electricity to downstream producers. In the long run, output falls just 2.5%, as clean technology adoption dampens these supply-chain impacts. Carbon pricing thus delivers substantial emissions reductions with moderate output effects, and much of the economic burden falls on downstream firms through higher upstream input costs.