Stock image of air pollution

In 2013, California became the first U.S. state to implement a multi-sector cap-and-trade system to regulate all industrial greenhouse gas emissions. It was launched as a pragmatic approach to managing the prodigious amount of greenhouse gasses produced annually by companies within the state.

Seven years later, a team of researchers has examined the impact of cap-and-trade in California and revealed some of its unintended consequences. In particular, the research team looked at:

  • companies’ emissions output
  • how companies have reallocated resources in the face of regulation
  • what role financial constraints (the companies’ ability to access funding) played in their response to the policy

The research, funded by the Risk Institute at The Ohio State University, provides critical insights about climate policy, how companies respond to these regulations, and what policymakers should know about the effectiveness and limitations of climate regulation strategies.

Emissions Output

The researchers — Söhnke M. Bartram, of the University of Warwick and CEPR; Kewei Hou, of The Ohio State University Fisher College of Business; and Sehoon Kim, of the University of Florida — examined plant-level data on greenhouse gas emissions and parent company ownership made available by the U.S. Environmental Protection Agency. The dataset includes 2,806 industrial plants and 511 publicly listed non-utility and non-governmental firms over the sample period 2010 to 2015.

Their paper, "Real Effects of Climate Policy: Financial Constraints and Spillovers," shows that financially constrained firms (typically small and medium companies with limited access to capital) reduced greenhouse gas emissions among plants located in California by 35 percent relative to plants in other states. But these companies also significantly increased emissions at plants in other states by 29 percent more compared to plants owned by firms without a presence in California.

That difference, Hou said, reflects the appeal of cheaper, less-stringent regulatory environments available to these companies in other parts of the country.

“From a social and environmental perspective, that data doesn’t look good; but it terms of maximizing profits or shareholder value, these companies — especially financially constrained firms — are probably doing the right thing,” said Hou, the Ric Dillon Endowed Professor in Investments at Fisher College of Business.

In contrast, financially unconstrained companies (those with more capital) did not adjust plant emissions at all in response to the new cap-and-trade regulation — in California or in other states.

“We found that the regulations aren’t tough enough for the big companies with deep pockets — they’re a slap on the wrist,” Hou said. “But for smaller companies or those having a hard time raising money to finance their projects, these regulations can have a huge impact. Some companies will choose to move their emissions elsewhere because they can’t afford the incremental cost of the cap-and-trade.”

Resource Reallocation

The researchers cited one such example of this resource reallocation: when California’s policy was announced in 2013, an international manufacturer of transportation fuels reduced the emissions at one of its large California refineries in Los Angeles County by 8 percent over the next three years. But it also sharply increased emissions at some of its large refineries in other states, including in New Orleans, Louisiana, and Jefferson, Texas, by more than 10 percent.

The data supported the researchers’ belief that, for firms with limited capital, it is more attractive to reallocate their greenhouse gas emissions and plant ownership away from California to offset the heightened regulatory costs that make doing business in the state expensive. This unintended consequence can reduce the amount of investment that companies make in cap-and-trade states while increasing the emissions output in less-regulated states and regions throughout the country.

Conclusion

So is cap-and-trade effective at reducing emissions? In a vacuum, potentially.

For companies with money, increased regulatory costs from the cap-and-trade rule aren’t enough to deter them from polluting. These costs only raise the burden for less financially capable businesses and industries, discouraging them from investing in states with cap-and-trade policies while they outsource — and sometimes increase — their emissions to less-regulated states.

Climate change solutions like cap-and-trade — proposed at the local level — must recognize and account for regulatory differences regionally and globally.

What is cap-and-trade?

An approach to reducing pollution that has two key components: a limit (or cap) on pollution, and tradable allowances equal to the limit that authorize allowance holders to emit a specific quantity of the pollutant.

Source: epa.gov

Kewei Hou Ric Dillon Endowed Professor in Investments
Faculty Profile