Environmental regulation and pollution abatement under incremental innovation

We propose a simple framework for modeling abatement decisions by regulated polluters in a carbon pricing regime, when firms can reduce emissions both by controlling product output and by adopting new environmental technologies incrementally. Previous literature only focuses on output control with all-or-nothing innovation, thereby overlooking the strategic decision of the optimal amount of innovation that must be adopted to minimize abatement costs. In this paper, we allow for regulated firms nesting incremental innovation steps into the abatement process. We show that, in equilibrium, for the firm it is optimal to mix innovation and output control, abating more by means of the strategy that is more cost effective. Since the marginal cost of abating via output control increases with technological deepening, over time firms deal with carbon pricing by abating disproportionately more by means of innovation. Increased carbon pricing may amplify this pattern, thereby widening technological asymmetries between firms and countries. Econometric analysis on a large sample of firms under the EU-ETS provides empirical evidence consistent with the main implications of the model. • New framework models abatement decisions of polluters in a carbon pricing regime. • Firms can reduce emissions by output control and incremental environmental innovation. • Firms increasingly rely on innovation over output control as carbon pricing rises. • Carbon pricing may induce technological divergence across polluting firms.