Emissions Trading and Firm Innovation: Evidence from a Natural Experiment in China

This study investigates the impact of market-based environmental regulations on firm innovation by examining one of the first large-scale market-based regulatory attempts in a developing country, China’s sulfur dioxide emissions trading program. Based on the difference-in-differences method, triple differences, and a rich set of robustness checks, we find robust evidence that the emissions trading program has led to a significant increase in patents and environmental friendly production practices among regulated firms. Furthermore, our analysis shows that private firms are more responsive to the regulation than state-owned firms. Our findings suggest that market-based environmental regulations could incentivize regulated firms to innovate even in a weak institutional environment.