Within-country leakage due to the exemption of small emitters from emissions pricing

• Published in: Journal of environmental economics and management 2024-03, Vol.124, p.102933, Article 102933
• Main Author: Kurz, Antonia
• Format: Article
• Language: English
• Subjects: Asymmetric emissions pricing; Emissions leakage; Heterogeneous firms; Monopolistic competition
• ISSN: 0095-0696; 1096-0449
• DOI: 10.1016/j.jeem.2024.102933

I show how the exemption of small-scale emitting firms from emissions pricing results in within-country emissions leakage — an emissions price increase for the regulated firms prompts an increase in the emissions of the unregulated. I use a heterogeneous firm model in which a fixed share of firms is subject to emissions pricing. The firms at the lower part of the productivity distribution benefit from being exempted, such that the higher the emissions price, the more and dirtier firms can survive in the domestic market. Leakage is stronger if firms are exempted only if they emit less than a fixed threshold (as for the EU Emission Trading System) because some firms strategically bunch below the threshold, making the emissions price an even weaker tool to reduce total emissions. In environments with low social costs of emission or high fixed regulatory costs, an exemption may be justified; over time, however, the criteria for exemptions should be adjusted accordingly. •Exempting firms reduces the effectiveness of emissions pricing.•A higher emissions price allows dirtier firms to survive and, additionally,•it increases the market share of exempted firms: total non-regulated emissions rise.•This effect is called within-country leakage in my model.•An exemption can still maximise welfare when regulatory costs crowd out production.•For ambitious emission reduction goals, exemption criteria should be revised over time.•Changes in the social costs of emissions or regulatory costs also require revisions.