How Firms Cut Carbon

Abstract

Europe’s industrial emissions fell by over 30% during the first 16 years of the EU Emissions Trading System (EU ETS), despite limited evidence of job or output losses. We investigate this decline using firm-level data and a flexible production model where carbon is a byproduct of production but firms can abate emissions by reallocating inputs toward abatement effort. We estimate the model and find that substitution elasticities between emissions and other inputs are low, suggesting limited abatement occurred via marginal input adjustments. Instead, our estimates suggest that emissions intensity declined primarily through clean factor-augmenting technology improving by over 50% from 2005 to 2021. We embed our production model within a multi-sector multi-country equilibrium model of firm competition to explore the role of within-firm reallocation, across-firm reallocation, across-sector reallocation, and improvements in clean technology. Counterfactual simulations show that, holding technology constant, carbon pricing reduced emissions by shifting output toward cleaner firms and cleaner sectors, but lowersmoutput and employment in regulated sectors. Improvements in clean technology mitigated these effects by lowering production costs, highlighting how clean technological progress can ease the short-run economic burden of carbon pricing.