Conference Agenda

Carbon tariffs are a widely discussed mitigation instrument for carbon leakage --- the relocation of emissions to other countries in response to more stringent unilateral environmental policies. This paper examines unilateral carbon pricing, specifically firm-specific carbon tariffs combined with a domestic emission tax, in a theoretical two-country, two-sector trade model. With increasing returns to scale, firm heterogeneity, and an optional fixed-cost investment to upgrade to an emission-free technology, the carbon tariff is found to reduce emissions in two ways other than leakage mitigation. First, exporters in the unregulated foreign country are incentivized to adopt the clean technology, thereby decarbonizing their domestic supply as well. Second, the carbon tariff enables a negative leakage effect: raising the carbon tax in the regulating home country expands the profits of foreign exporters. As a result, resources are reallocated from less productive, dirty non-exporters to highly productive exporting firms. If a large share of foreign exporters is clean due to the existence of the carbon tariff, an increase in the carbon tax may lead to a decrease in emissions from foreign consumption. However, the foreign gain in competitiveness also increases the number of active foreign firms, which might offset the emission decline. Finally, I show that the negative leakage effect is likely to be more pronounced in the later or `final' stages of the environmental policy, when the carbon price is high.