Technology choice under the cap-and-trade policy: The impact of emission cap and technology efficiency

Abstract

This paper studies how competing firms make technology choices and production decisions under the cap-and-trade policy when they engage in both product and emission trading markets. Using a two-stage game theoretical model, we analyze firms’ responses to stricter emission caps and efficiency improvements of clean technology. Interestingly, we identify a “reverse trading” phenomenon where the firm with traditional technology and hence higher emission intensity sells emission allowances to the firm with clean technology because the latter operates with a higher profit margin and can afford a higher premium for allowances. Furthermore, stricter regulations incentivize firms to adopt clean technology only if the technology efficiency exceeds a certain level. Otherwise, no matter how low the emission cap is, neither firm will adopt it due to higher production costs. Additionally, cleaner technology does not necessarily provide firms greater incentives to adopt it. The efficiency of clean technology has a non-monotonic effect on firms’ adoption incentives because it not only affects the adopting firm but also has a positive spillover effect on the firm using traditional technology through emission trading. From a regulatory perspective, we propose setting a moderate emission cap to maximize social welfare, and as clean technology becomes more efficient, the optimal cap should be further tightened when the technology is already highly efficient. These findings provide practical insights for policymakers in designing the cap-and-trade policy tailored to different levels of technology improvements.