Market-based Environmental Regulation and Financial Resource Allocation: Evidence from the Carbon Emissions Trading Scheme (ETS) in China
SHAN Chenyu, LI Luxi, LYU Xiaoyi
School of Finance & Dishui Lake Advanced Finance Institute, Shanghai University of Finance and Economics; Development and Planning Office, Shanghai Lixin University of Accounting and Finance; Lingnan College, Sun Yat-sen Universit
Summary:
Guiding firms toward effective emissions reduction has become an important pillar of the green transition in the process of realizing the carbon neutrality goals. The 20th National Congress of the Communist Party of China emphasized that green and low-carbon development is key to achieving high-quality growth. As a market-based policy tool with both environmental and economic benefits, the emissions trading scheme (ETS) aims to establish an effective carbon price through market mechanisms and incentivize firms to phase out outdated production capacity and pursue green transition. The effectiveness of this market-based system hinges on how efficiently financial resources are allocated to support corporate decarbonization efforts. When capital flows to firms with low abatement efficiency, firms' incentive to curb carbon emissions can be weakened and the effectiveness of the ETS can be undermined. Conversely, allocating capital to high-efficiency firms can facilitate emission reductions, ultimately strengthening the policy effect of the carbon market. Therefore, understanding how ETS participation affects corporate financing costs is essential for designing effective green finance policies, enhancing the role of financial institutions in supporting carbon markets, and achieving efficient financial resource allocation. Existing research on carbon markets mainly focuses on ETS-related risks and the impact on emission reductions, total factor productivity, innovation, and macroeconomic outcomes. Few studies examine how carbon markets affect financial resource allocation. There remains a significant gap in understanding how firms adjust their financing behavior in response to carbon policies, particularly regarding capital allocation efficiency at the firm level. For example, several key questions remain underexplored: Do firms included by the ETS receive improved financial support？ Does participation in the carbon market influence their carbon disclosure and financing costs？ Do observable and unobservable aspects of environmental performance have equal impact on financing costs and capital allocation efficiency？ And ultimately, does the ETS improve the efficiency of financial resource allocation？ To answer these questions, we manually collect and compile a list of firms that participated in China's regional carbon emissions trading markets between 2010 and 2021. We then trace these firms to their controlling listed entities and match them with listed firms on the Shanghai and Shenzhen A-share markets, thereby constructing a firm-level panel dataset. Using this dataset, we employ a difference-in-differences (DID) model to examine the impact of ETS inclusion on firms' debt financing costs. We find that firms' debt financing costs significantly decline after being included in the ETS. Further analysis shows that the reduction is driven by improvements in carbon disclosure and environmental performance. We further distinguish between observable (e.g., ESG ratings, green patents) and unobservable (e.g., carbon emission intensity, low-carbon patents) dimensions in environmental performance. The decline in financing costs is concentrated in firms that experience improvements in observable environmental performance. Regarding the unobservable dimension, we find no significant reduction in financing cost, particularly for direct and supply chain emissions. We also find significant heterogeneity in the effects of ETS participation. For instance, firms with stronger corporate governance, more efficient information transmission, and carbon allowance surpluses experience greater reductions in financing costs. This study contributes to the literature in four aspects. First, it provides firm-level evidence on the effectiveness of ETS from the perspective of financial resource allocation efficiency, expanding the literature on the interaction between market-based environmental regulation and finance. Second, we identify ETS participation at the firm level, circumventing the limitations of region-based identification, and match the sample with Trucost carbon emission data to examine the policy effects. Third, we propose and empirically test multiple channels through which ETS affects debt financing costs, focusing on the roles of information disclosure and environmental performance, and further differentiate between observable and unobservable dimensions. These findings offer novel perspectives on the financial implications of carbon pricing mechanisms. Fourth, we further contribute by using firm-level capacity utilization data to infer firms' long/short positions in carbon trading markets.
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