The environmental economics literature has long established that, in order for environmental regulation to be cost-effective, all polluters need to be regulated so that their marginal abatement costs are equalized. The “full coverage” of polluters is more important for carbon regulation: since almost all sectors emit greenhouse gases, they should all face the same carbon price. In this paper, we make the case for “partial coverage” where only a subset of polluting industries is regulated in a general equilibrium model with monopolistically competitive firms regulated by a cap-and-trade system with auctioned permits. Environmental regulation, by moving factors of production from dirtier to cleaner industries, ameliorates the damages of imperfect competition if the cleaner industries also have higher markups (and thus lower outputs). Partial coverage dominates full coverage if and only if the correlation between industry emission intensities and markups, weighted by emission targets, is more negative under partial than full coverage. Partial coverage always dominates full coverage when the abatement target is moderate, and the covered industries might not be those with the highest emission intensities. We apply the model to carbon regulation in China and identify which industries should be covered under different abatement targets.
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