Making climate policies work for firms

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The recent COP26 summit in Glasgow brought together coalitions and alliance that vowed to act on climate change by putting into effect the Paris Accord. A crucial part of this commitment is to implement policies that rectify the carbon price signal. Yet, macroeconomic models have shown that carbon taxes to reduce greenhouse gas emissions would lead to modest reductions in GDP, making countries and businesses reluctant to embrace such policies.

A new study, however, makes a fundamental shift in our thinking on the consequences of carbon taxes. The NBER paper by two professors at Tufts University, Alan Shapiro and Gilbert Metcalf, demonstrates that, far from curbing economic growth, carbon taxes can deliver positive consumption and output effects in the long run. So, how do we reconcile their findings with the past evidence? Well, their research considers micro channels of adjustment among firms.

When faced with  carbon taxes, firms can adjust on both the intensive and the extensive margin. The regulatory costs associated with environmental policy not only change firms’ input choices and their decisions to abate emissions (intensive margin), but they also shift the incentive for companies to enter the market in the first place, as well as their decisions to adopt technology (extensive margin). The consideration of the extensive margin of firm adjustment in Shapiro and Metcalf plays a decisive role in limiting the adverse labor-market effects of carbon taxes, along with expansion in output and consumption.

With carbon taxes in place, the benefits of entering and operating as a brown firm falls, making it relatively more attractive to adopt greener technology or not enter a market at all. Without understanding these micro-level margins of adjustment by firms, increasing carbon taxes entails both short- and long-term consumption and output costs. Environmental policies solely informed by macro models may miss the micro-level implementation details. Macro models involve general equilibrium principles. Yet firm-level data suggest that the adjustment process from one point of equilibrium to the next matters a great deal to the way firms respond. So do the specifics of policy implementation. 

The flight or fight response to climate policies: Emissions leakage versus innovation

Firms that experience higher energy prices may seek alternatives to costly technology adoption. These choices are articulated in two competing theories: The pollution haven hypothesis predicts that stringent environmental policies that increase compliance costs shift emissions-intensive production toward firms, regions or countries with lower abatement costs, causing emissions leakage. By comparison, the Porter hypothesis argues that such policies foster innovation and adoption of technologies that enhance competitiveness. If environmental policies are asymmetric, which is often the case, their effects will vary by types of firms, regions and countries. For example, in the EU Emissions Trading Scheme (ETS), carbon price signal is tempered by extensive preferential treatment, which results in varying carbon prices across sectors. In the Netherlands, the price for basic metals is in the range of 3-7 euros per ton, while it is 76 euros per ton for the food processing sector. Small firms typically face much higher prices than large incumbent firms.

Such specificities in implementation of environmental policies determine firms’ responses on emissions displacement versus innovation. While the EU ETS did not induce leakage across firms within countries, a tightening of U.S. air-quality standards increased the relocation of battery recycling to Mexico. In China, evidence supports an “internal” variant of pollution havens: market shares of firms in cities with more stringent environmental regulations declined compared with those with weaker regulations.

The Porter hypothesis does not seem to have played out the way climate policy enthusiasts envisaged. While environmental policies such as the climate change levy in the UK, the EU ETS and the withdrawal of fossil fuel subsidies in Indonesia led to a decline in energy use and emissions, they had no effect on the productivity of plants or competitiveness of firms. In Germany, manufacturing firms passed on their carbon costs to insulate from profit losses. The U.S. Clean Air Act amendments (CAAA) had a negative impact on plant-level productivity in regulated counties relative to others. In China, environmental regulations had a negative effect on firm performance including profits, capital, labor and market share across all industries.

The presence of so-called threshold effects implies that unless firms realize productivity benefits from better management, incentives to invest in greening will be muted. Even in advanced economies, the impact of environmental policies on innovation is not impressive and favored the adoption of off-the-shelf abatement technologies. It is not easy to change the historical patterns of innovation in clean technologies among firms; there is significant path dependence.

Climate policies are not benign: Consider firm-level distributional consequences

The most vulnerable firms have neither the means to protect against changes in climate policies nor to recover from climate change.  In Indonesia, energy prices increased the probability of exits for energy-dependent plants. Smaller plants in Indonesia substituted labor for emissions-intensive machinery instead of undertaking more efficient measures. In the OECD countries, most productive firms gained in productivity at the expense of other firms. In China, firms with better management quality moderated responses to climate policy through low-carbon innovation, while others lagged behind. A better understanding of how existing inequalities interact with the risks posed by climate policies is needed because firms’ ability to navigate will depend on initial capabilities such as management practices.

Making climate policies work for firms: Complement with firm-level support, horizontal policies and enhanced institutional capabilities

Today, most climate policies do not adequately address the micro-level market failures preventing firms from adopting green management practices or technology.  Decarbonization will require massive upgrading of firm capabilities, yet such opportunities are weaker in developing countries. The Dutch climate policy package illustrates the strength of an approach that combines a strong commitment to raising carbon prices with ambitious firm-level support. From a political perspective, such policy-induced changes in firm competitiveness may also enhance the acceptability of environmental policies if a portion of carbon-tax or auctioned-permit revenues are earmarked for supporting firm capabilities.

Ultimately, transitioning to net-zero emissions will entail structural transformation that goes beyond the climate policy toolbox. Horizontal policies that foster competition, reduce distortions in factor and product markets, encourage innovation, and firm growth will ease the transition to net-zero. It will reduce the societal burden to subsidize the adoption of green management practices and low-carbon technologies. The effectiveness of policies for decarbonization will rest heavily on the capabilities of governments to implement these policies, maintain competitive neutrality and enact complementary reforms and targeted firm-level support.


Arti Grover

Principal Economist and Regional Program Leader, World Bank Group

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