Market failure, tradable discharge permit, and pollution reduction: Evidence from industrial firms in China

Abstract

Several features of an imperfect market, such as transaction costs and market power, and strategic behaviors of firms may adversely affect the performance and efficiency of tradable discharge permit systems. However, empirical studies regarding this subject are few. To address this research gap, this study investigated the impact of market failure and strategic behaviors of firms on pollution reduction using China's sulfur dioxide (SO2) emissions trading policy as a quasi-natural experiment. Based on the micro-data matching the Chinese Industrial Firm and the Chinese Industrial Firm Pollution Emission databases, the difference-in-difference-in-differences method was employed to determine if the implementation of the policy can promote emission reduction and identify its specific influencing mechanism. The benchmark regression results indicated that the tradable discharge permit policy significantly reduced SO2 emissions in regions with high degrees of marketization. Furthermore, the mechanism analysis showed that firms would take strategic behaviors to deal with the emission reduction requirements of environmental policies under an imperfect market environment. Moreover, the heterogeneity analysis revealed that the discharge permit policy exhibited a distinct emission reduction effect due to market failure and strategic behaviors of firms. This study suggests that the Chinese government should establish systematic permit trading laws and regulations, actively build a permit trading platform, formulate a clear trading mechanism, and strengthen information disclosure.