LAUSR

Abstract Unlike the previous literature focusing only on the direct effect of the European Union Emissions Trading Scheme (EU ETS) on the international competitiveness of a regulated industry, this study tackles both the direct and indirect effects. We designed an interactive item between the EU ETS dummy and the number of patent applications to represent the EU ETS's indirect effect. Then, based on the panel data of 42 countries' pulp-and-paper industry from 1998 to 2013, we conducted the test by using the system generalized method of moments to address the endogeneity problem. The results show that the EU ETS's direct effect is insignificant, while its indirect effect is significantly positive. That is, the EU ETS can bring positive effect by stimulating the pulp-and-paper making enterprises toward technological innovation. Our analysis further finds that this indirect effect changes from being insignificant in Phase I to be significantly positive in Phase II and Phase III as well as gradually become larger, suggesting that the ETS-induced innovation gradually became more prominent. The above findings provide convincing new evidence that the ETS's “innovative compensation effect” is greater than its cost-effect.