The economic cost of carbon pricing depends on the ability and incentives of firms to switch towards cleaner fuels. Yet, many fundamental economic forces that drive firms' decisions to use different fuels are unobserved, causing significant uncertainty over the effectiveness of carbon policies. In this paper, I propose a new dynamic production model with multidimensional unobserved heterogeneity that underly technology differences and captures how firms' fuel choices respond to price changes. These differences cause heterogeneity in abatement costs, which generates heterogeneous responses to carbon pricing. Leveraging minimal assumptions about optimal input choice and the technology frontier, I quantify the model from a detailed panel of Indian steel establishments. Based on these estimates, implementing a carbon tax equivalent to 2,000 INR/ton (25 USD/ton) of carbon dioxide equivalent leads to a 70% reduction in emissions. But only 18% of this reduction comes from fuel-switching within existing firms. I find that the larger reductions come from reallocation of output across firms (58%) and costly reduction in aggregate output (24%). Substantial heterogeneity in the fuel efficiency of existing furnaces coupled with the limited geographical reach of natural gas pipelines towards high-emission firms explains the prevalence of output reallocation relative to fuel switching.

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This paper examines how plants adjust their production in response to asymmetric carbon pricing. When plants compete across areas, asymmetric regulation can lead to carbon leakage, shifting emissions from regulated to unregulated areas. I build a production model with multiple fuel inputs, imperfect competition, and region-specific carbon taxes. Using publicly available Canadian plant-level data on a wide range of air pollutants, I invert the chemical reactions from combustion to back out plants’ fuel usage. I then estimate the model by exploiting variation in the British Columbia (B.C.) and Quebec carbon taxes, which were implemented in 2008 and 2007, respectively. Findings indicate substantial emissions reductions in British Columbia, with 95 % confidence intervals ranging from 7 % to 48 %, and no reduction in Quebec. Contrary to theoretical predictions of carbon leakage, the analysis reveals no statistically significant shift in production toward unregulated provinces. A detailed decomposition reveals that the absence of leakage was primarily due to the regulated plants’ ability to absorb the tax by switching from oil to natural gas and by reallocating output from dirtier to cleaner plants within British Columbia.