Environmental Regulation, Abatement Capital and Investment: Evidence from EU ETS

We study how carbon pricing affects firms’ investment and capital productivity relative to comparable firms not exposed to environmental regulation. Using matched EUTL–Orbis data for European firms over 2005–2020, we estimate the effects of Phase 3 of the EU Emissions Trading System (EU ETS) on investment, productivity, and profitability through propensity-score matching and two-way fixed-effects difference-in-differences regressions. We find that ETS firms invest more than comparable non-ETS firms along both the intensive and extensive margins, while displaying lower measured capital productivity and no significant changes in total factor productivity, profitability, or fixed assets. To interpret this evidence, we develop a two-sector RBC model with abatement capital. In the regulated sector, firms accumulate a durable capital stock that reduces emissions intensity and future permit requirements but does not enter the production function. The model shows how carbon pricing can generate stronger investment in regulated firms while lowering measured capital productivity, highlighting the importance of distinguishing productive from compliance-related capital when evaluating the effects of environmental policy.