Environmental Regulatory Arbitrage by Business Groups in the Context of the European Union’s Emission Trading System (EU-ETS)

Although the EU-ETS is implemented in all member states as the cornerstone of Europe’s climate policy, there is still significant cross-country variation in the stringency of its implementation. In this chapter, we explore how these differences between home and host countries of international business groups explain carbon emissions at the affiliate level. Using an extensive dataset of business groups with facilities covered by the EU-ETS, we find evidence of intragroup regulatory arbitrage (RA) in that affiliates with foreign parent companies show significantly higher carbon emissions compared to domestically owned affiliates. Moreover, stringency of the host country’s implementation of EU-ETS only reduces affiliates’ emissions for domestically owned affiliates while stringent implementation at parent level seems to exacerbate carbon emissions at affiliate level. However, this RA-behavior is strongly influenced by the affiliate’s carbon allowances. In line with recent results on the effectiveness of the EU-ETS, affiliates with carbon allowance shortages (under-allocated) provide fewer opportunities for intragroup regulatory arbitrage. Our results therefore not only stress the importance of cross-country uniformity of EU-ETS implementation but also the allocation mechanism at firm level for the proper functioning of the cap-and-trade system.