Opening the Brown Box: Production Responses to Environmental Regulation

We study production responses to emission capping regulation on manufacturing firms. We find that firms reduced their pollution as they transitioned from self-generated to externally sourced electricity, shifted toward producing less coal-intensive products, and increased their abatement expenditures. Firms preserved profitability by increasing their production of higher-margin products. However, firms in highly polluting industries produced fewer products. In the aggregate, we document lower product variety, higher markups, an altered firm-size distribution, and lower business formation. Our findings highlight both the mechanisms behind how mandated pollution reduction can be effective and its costs, suggesting a loss in agglomeration externalities.