Environmental Regulation, Firm Heterogeneity and Macroeconomic Volatility

This paper investigates how firm heterogeneity affects the transmission of macroeconomic shocks and the volatility of key macroeconomic variables under environmental regulation. To address this question, we compare a representative-agent (Rep) benchmark to a heterogeneous-firm (Het) model subject to the same aggregate shocks and operate under the same cap-and-trade regime. The findings are as follows. First, macroeconomic volatility is higher in the presence of firm heterogeneity relative to a representative-agent counterpart. This result holds regardless of the origin of the macroeconomic shock considered. Second, the investment decisions of the heterogeneous firms are nonlinear and exhibit stronger reactions to shocks, particularly for smaller firms with lower capital and less efficiency in abatement activities. Third, a carbon pricing shock causes a more significant decline in investment and a rapid increase in abatement costs due to higher marginal emissions costs than the analogous Rep counterpart. The key micro-parameters are estimated consistently with data of regulated firms under the EU Emissions Trading System (EU ETS).