When the cat is away the mice will not play: The political economy of carbon emission trading systems

Abstract

We examine how carbon emission trading systems (ETS) address both government and market failures in the Cat and Mouse game of controlling emissions. We investigate how Chinese cities responded to two natural experiments: unannounced inspections by the central government and turnovers of senior local government officials. Using both theoretical and empirical analysis, we show that cities tend to rein in their emissions when inspection teams are in town because "the cat is around." And they are less stringent on emission controls when local political powers change hands because "the cat is away". However, cities with ETS exchanges will be less responsive to these political events than those without, as the ETS system regulates firms' behaviour and consequently reduces both the incentives and opportunities for gaming the system. Our theoretical model indicates an efficient Carbon Market condition when the price is high enough. And empirical works confirms the essentiality of the condition. The findings remain robust when alternative event windows and estimation methods are employed. We conclude that ETS is an effective way to address government and market failures in carbon emission control. When the cat is away, the mice will not play because there is a system in place to discourage such behaviour. Our findings provide additional support for the development of ETS in China and beyond.

Keywords: Carbon emission control, Pilot ETS in China, political risk, climate policy, global warming, cap-and-trade, government failure and market failure

JEL Classification: C32, E44, G12, O13, P28