Threshold-based-exemption in environmental regulation and firms dynamics (JMP)

Threshold-based exemption in environmental regulation involves excluding emitters with emissions below a specified threshold. I study the long-term implication of such a policy on aggregate output, Total Factor Productivity (TFP), and emissions. Analyzing pollution data from various establishments, I find that 40% of firms benefit from exemption, exhibiting clustering around the threshold, primarily influenced by new entrant firms. Utilizing an industry dynamic model featuring heterogeneous firms and a carbon pricing system allowing for threshold-specific exemption, I calibrate the model to California’s Cap-and-Trade and show that removing the exemption leads to a 0.05% output gain due to resource reallocation toward more productive firms. The model also explores the implications of an alternative policy, “partial-exemption”, where firms only pay for additional emissions above the threshold. To gauge the misallocation induced by the exemption policy, I quantify the dispersion of firm-level Total Factor Productivity Revenue-based (TFPR) through the lens of the model. The analysis reveals that overall TFPR volatility is explained by the dispersion between firm categories, determined by their relative emission to the exemption threshold. Firms with intermediate productivity clustering around the exemption threshold exhibit a much higher average and dispersion of TFPR compared to large productive firms that bear emission costs.