Emissions trading and firm innovation: Evidence from a natural experiment in China

•We explore the impact of China's SO2 ETS pilot policy on firm innovation.•The China's SO2 ETS leads to a significant increase in patents and environmental patents among regulated firms.•The China's SO2 ETS performs better in areas with high levels of environmental enforcement.•The China's SO2 ETS simultaneously reduce SO2 emissions and promote industrial growth in the pilot areas. This study investigates the causal impact of market-based environmental regulation on firm innovation by examining a large-scale market-based regulatory attempt in a developing country, namely, China's sulfur dioxide (SO2) emissions trading program. Based on the panel data of China's publicly traded firms from 2004 to 2015, we adopt the difference-in-differences (DID) model to examine the innovation effects of the SO2 emissions trading pilot policy. The results show that the program leads to a significant increase in patents and environmental patents among regulated firms. And the innovation effects of the policy perform better in areas with a high level of environmental enforcement. In further analysis, we find that the program decreases SO2 emissions and promotes industrial growth in pilot areas. These evidences imply that the market-based emissions trading policy indeed promotes firm innovation and environmental innovation even in the context of a developing country, which is conductive to a win-win situation in both environmental protection and economic growth.