Global Externalities, Local Policies, and Firm Selection

How to fight global problems with local tools? When only firms know what externality-producing activities can be relocated, policies shape the location distribution of firm types with different social values. We find that, because of this selection effect, the optimal local policies confront firms’ mobility with elevated corrective externality prices, in contrast with the common remedies for the relocation risk. Our mechanism incentivizes also moving firms to limit the externality, and it influences strategically the distribution of moving firms that comply with policies elsewhere. The magnitude of these effects is illustrated by a quantification for the key sectors in the EU emissions trading system.