Optimization and Coordination of Carbon Emission Reduction Investment Under Various Emission Regulations

ABSTRACT Motivated by the imperative of industrial decarbonization, this study investigates how different regulatory frameworks—Carbon Cap, Carbon Tax, and Cap‐and‐Trade—impact a manufacturer's carbon abatement investment and supply chain coordination. Distinct from prior literature assuming frictionless markets, we explicitly model the “bid‐ask spread” in permit trading and introduce endogenous contract negotiation to resolve vertical investment inefficiencies. Our analysis yields five critical findings. First, under cap‐and‐trade policies with asymmetric trading prices and moderate quotas, the manufacturer optimally exhausts its allocated permits without engaging in trading, effectively treating the policy as a rigid cap. Second, we identify a unique optimal abatement level that maximizes manufacturer profit; notably, the retailer derives no incremental benefit from increases in the manufacturer's permit allocation. Third, contrary to standard intuition, we demonstrate that in markets with environmentally conscious consumers, increasing regulatory stringency can inadvertently suppress the manufacturer's emission reduction efforts. Fourth, comparing instruments reveals that cap‐and‐trade policies induce higher abatement levels than carbon taxes when both tax rates and assigned quotas are at their respective extremes (either very low or very high). Finally, regarding coordination, we show that perfect supply chain coordination is achievable under specific regulatory conditions if the manufacturer commits to an emission reduction level prior to negotiating order quantities and wholesale prices. These findings highlight the critical role of market frictions and bargaining power in designing effective carbon policies and operational strategies.