Carbon Trade-offs

How Firms Respond to Emission Controls

August 7, 2023Written by European Central Bank

Carbon pricing policies are on the rise globally and researchers say firms should reduce overall emissions and increase green investment for an optimal carbon management strategy. In addition, carbon pricing can have a positive impact on firm value if companies successfully transition from being “net polluters” to “net cleansers”.

In this European Central Bank research bulletin, Maria Cecilia Bustamante and Francesca Zucchi outline a novel and unified theoretical approach to study the incentives and trade-offs posed by carbon pricing, as well as outlining the optimal response to maximise value for shareholders.

The authors use a continuous-time dynamic model to consider how changes in firms’ behaviour affect optimal carbon management over time. The model considers how firms optimally balance emissions, output, green investment and carbon credits under three regulatory regimes: a carbon trading scheme, a carbon tax scheme and a laissez faire control scenario.

Under carbon trading systems, carbon credits entitle firms to release a set volume of emissions into the atmosphere. The credits are tradeable, meaning firms with a shortage can buy them and those with an excess can sell them. Under carbon taxes central authorities set carbon prices.

The results show that under carbon taxes – and to a lesser extent carbon trading schemes – firms have an incentive to reduce overall emissions. Reducing output and increasing investment in greener industrial processes are the two primary avenues for businesses to reduce net emissions.

To maximise green incentives under carbon trading schemes, the authors say authorities should limit the number of free carbon credits. Trading schemes will lead firms to adopt a forward-looking and precautionary approach to emissions, as there will be an incentive to accumulate credits to guarantee production and avoid costly carbon markets. If fewer credits are available to firms, they will have far greater incentives to curb emissions.

The authors also propose that subsidies for green innovation should complement carbon pricing tools. Subsidies are needed to offset the tilt in the mix of green investment caused by carbon pricing, away from green innovation and towards more immediate yet short-lived options, such as abatement. A shift which the authors say “can slow down the transition” to green technology.

The authors define green innovation as pioneering inventions that accelerate the transition by having a long-term impact on sustainability. They describe abatement as short-term efforts to clean up emissions through, for example, planting trees or carbon storage and capture.

Finally, the authors find that the impact of carbon pricing on firm value varies depending on if businesses reduce their emissions. If they become net cleansers, they will benefit from lower risk premiums, access to subsidies and valuable carbon credit balances which can increase firm value.

This page was last updated August 7, 2023

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