Examining a cross section of seven regional Emission Trading System (ETS) and thenational ETS in China, we explore the interplay between firms and governments. We find heterogeneous adaptation among firms. Firms in regions anticipating stringentpolicies reduce emissions and invest in decarbonization technology, whereas expecta-tions of lenient policies lead to increased emissions. Meanwhile, governments set upmore stringent carbon policies when firms decarbonize more proactively. The resultsare robust to allowance allocation policies, such as cap-and-trade or tradable perfor-mance standards. Our findings underscore the importance of strategic interactionsbetween firms and governments in decarbonization.