Environmental Regulation, Heterogeneous Firms, and Industry Performance

How does environmental regulation affect firm behavior, industry performance, and welfare? We develop and estimate a structural model of production with endogenous emissions and costly abatement under heterogeneous regulation, using firm-level data that report net emissions but not abatement expenditures. The model recovers productivity, the shadow price of emissions, and the implicit output subsidy induced by intensity regulation. Applying the model to China’s non-metallic mineral products industry over 1998–2007, we show that ignoring emissions conflates firm performance with compliance effort and disproportionately understates the productivity of less productive firms. Counterfactual analysis yields two main results. First, under emissions-intensity standards, welfare costs rise convexly as reduction targets tighten, with endogenous production responses accounting for up to 17% of the costs. Second, replacing intensity standards with an emissions trading system substantially lowers welfare costs of regulation, allowing emissions to fall by 44% without reducing total surplus.