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Tackling climate change requires global policies

How effective are climate change policies, and what are the important considerations to ensure they are effective? This column shows that firms respond to climate change policies with regulatory arbitrage so that localised policies aimed at mitigating climate risk can have unintended consequences. Studying the impact of the California cap-and-trade programme, it shows that firms without financial constraints do not reduce their emissions in response to the policy. In contrast, financially constrained firms shift emissions and output from California to other states. In fact, contrary to the policy objective, these firms increase their total emissions after the cap-and-trade rule.

Given increased concerns about climate change risk, governments around the world are considering regulations to curb greenhouse gas (GHG) emissions in various shapes and forms. However, to date there is no consensus on what the optimal policy approach might be. Consequently, climate policies are highly fragmented across different jurisdictions (Figure 1). This has important implications for the success of localised policies. As a case in point, in 2013, California became the first US state to implement a multi-sector cap-and-trade system to regulate all industrial GHG emissions. It was launched as a pragmatic approach to manage the amount of GHGs produced by companies within the state. This column examines the impact of the cap-and-trade rule in California and reveals some of its unintended consequences.

Figure 1 The segmented world of climate change policies


Source: World Bank

How do corporations respond to climate policies? We know only little…

Policy responses to remedy climate change risk are heatedly debated. Such policies have important implications for the behaviour of private industrial firms and how they respond to regulatory frictions, which are of key interest to financial economists. Understanding these effects are important to guide policy makers to internalize externalities that may otherwise result in unintended consequences and more effectively coordinate solutions to climate change.

However, the economic consequences of climate change have only recently garnered much interest among financial economists (e.g. Bolton and Kacperczyk 2021, Khanna et al. 2021). Fewer studies link financial incentives and corporate environmental policies. For example, Forster and Shive (2020) find that short-termist pressure for financial performance from outside investors forces public firms to emit more GHGs than private firms. Kim and Xu (2020) also show that financial constraints exacerbate toxic pollution by firms due to the costs of waste management, and that this effect is stronger when regulatory monitoring is weak. Similarly, Akey and Appel (2021) find that firm subsidiaries are more likely to increase toxic emissions when parent companies have better liability protection for their subsidiaries’ environmental clean-up costs, consistent with the binding effects of higher financial burdens associated with abatement. How such incentives may affect corporate responses to climate policies remains an unanswered yet important question.

Emission reduction or reallocation?

In a recent paper (Bartram et al. 2020), we examine detailed plant-level data on GHG emissions and parent company ownership made available by the US Environmental Protection Agency. Our dataset includes 2,806 industrial plants and 511 publicly listed firms over the sample period, 2010 to 2015. We focus on the behaviour of industrial corporations around 2013, when the California cap-and-trade policy was introduced.

To illustrate, a major producer of transportation fuels vehemently opposed the adoption of the cap-and-trade policy, as it was still reeling from the financial crisis a few years earlier. When the policy was announced, the firm reduced its emissions at one of its largest California refineries by 8% over the next three years. However, it also increased emissions by more than 10% at some of its largest refineries in other states. Our study investigates whether this kind of response has been typical across companies.

Financial constraints matter

We document significant differences in how firms respond to the policy, depending on their financial constraints. As shown in Figure 2, financially constrained firms (typically small and medium-sized companies with limited access to capital) reduce GHG emissions at their plants located in California by 32% relative to plants they own in other states. However, these companies also increase emissions by 26% at plants in other states, compared to plants in those states owned by firms without a presence in California. In contrast, companies with easy access to capital (i.e. financially unconstrained firms) do not adjust plant emissions at all in response to the new cap-and-trade regulation — not in California nor in other states.

The above findings suggest that the regulation is not costly enough for big companies with deep pockets, but is rather just a slap on the wrist. In contrast, the policy has a large distortionary impact on smaller companies or those having a hard time raising capital to finance their projects. Some of these companies choose to move their emissions elsewhere because they cannot afford the incremental costs of the cap-and-trade. Based on back-of-the-envelope calculations, the additional costs of emissions to constrained firms under the California cap-and-trade rule is equivalent to a 9% increase in tax expenses or 4% increase in interest expenses. For the subset of firms that reallocate their emissions the most in response to the policy, the impact of the policy on costs is more severe, equivalent to a 15% (11%) increase in tax (interest) expenses.

Figure 2 Changes in emissions after the California cap-and-trade rule


Where do firms shift emissions to?

We explore the economic mechanisms for our results and find that constrained firms reallocate their emissions from their plants in California primarily to plants with similar functions in other states, rather than to plants that play different roles within their organisational structure. In response to the cap-and-trade rule, these firms tend to reallocate their emissions toward plants outside of California with greater excess capacity, avoiding large fixed costs associated with capacity adjustments. We find that such emission reallocations across plants are the result of changes in production activity rather than carbon efficiency.

This response partially reflects the appeal of cheaper, less-stringent regulatory environments available to financially constrained companies in other parts of the country (Figure 3). It also reflects the reallocation by companies that had not been investing in clean technologies and thus were not readily prepared to shield themselves from the new regulatory costs. While financially constrained companies are likely behaving optimally from a shareholders’ point of view, this is an adverse outcome from a social and environmental perspective.

Figure 3 Stringency of environmental regulations in target states


Local policies don’t work

A critical policy implication of this reallocation is that the cap-and-trade may not lead to the desired reduction in GHG emissions globally. To the contrary, we find that financially unconstrained firms do not respond to the policy, while constrained firms with plants in California and in other states increase their total emissions by 21% as a result of their reallocation, undermining the goal of the cap-and-trade (and of climate policies in general) to combat climate change at the global level.

The data supports our hypothesis that, for firms with limited access to capital, it is more attractive to reallocate their GHG emissions and plant ownership away from California to avoid the heightened regulatory costs that make doing business in the state expensive. This unintended consequence corresponds to an increase in emissions in less-regulated states and regions throughout the country, while resulting in a reduction in economic activity in sectors within California that are required to curb emissions, as evidenced by a 14% decline in emission-heavy sector employment.

What it means for climate policy design

In conclusion, climate policies designed and implemented at the local level (such as the California cap-and-trade rule) are unlikely to be effective at tackling climate change. Increased regulatory costs from the cap-and-trade rule only raise the burden for less financially capable businesses. They discourage them from investing and producing in states with costly climate change policies and incentivizse them to shift their emissions to plants they own in less-regulated states.

Our study illustrates the interplay between climate policy and firm behaviour and highlights the potential externalities from regionally segmented climate policies. If localised climate policies are not effective within one country, they are unlikely to have the intended effect of reducing emissions across countries. Consequently, climate change solutions at the local level must recognise and account for regulatory differences regionally and globally.

Our findings point to two policy guidelines: (1) climate policies should be harmonised across jurisdictions in order to minimise leakages; and (2) policymakers should carefully devise appropriately differentiated subsidies to mitigate distortions from implementing climate policies.


Akey, P, and I Appel (2021), “The limits of limited liability: Evidence from industrial pollution”, The Journal of Finance 76(1): 5–55.

Bartram, S M, K Hou and S W Kim (2021), “Real effects of climate policy: financial constraints and spillovers”, Journal of Financial Economics, forthcoming.

Bolton, P and M Kacperczyk (2021), “Global pricing of carbon-transition risk”,, 24 March.

Forster, M and S Shive (2020), “Corporate governance and pollution externalities of public and private firms”, Review of Financial Studies 33(3): 1296–1330.

Khanna, G, W Liang, A M Mobarak and R Song (2021), “The productivity consequences of pollution-induced migration in China”,, 8 April.

Kim, T and Q Xu (2020), “Financial constraints and corporate environmental policies”, Review of Financial Studies, forthcoming.

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