The Strategic Value of Embodied Carbon Tariffs

Unilateral carbon policies are inefficient due to the fact that they generally mean that abatement takes place in high-cost countries and because they are subject to carbon leakage. In this paper, we ask whether the use of carbon tariffs — tariffs on the carbon embodied in imported goods — might lower the cost of achieving a given reduction in world emissions. Specifically, we explore the role that the tariffs might play as an inducement to unregulated countries to adopt emission controls of their own. We use a computable general equilibrium model to generate the payoffs of a one-shot policy game. In the game, a coalition of countries regulates its own emissions and chooses whether or not to employ carbon tariffs against unregulated countries. Unregulated countries may respond by adopting emission regulations of their own, retaliating against the carbon tariffs by engaging in a trade war, or by pursuing no policy at all. In the unique Nash equilibrium produced by this game, the use of carbon tariffs by coalition countries is credible. China and Russia respond by adopting binding abatement targets to avoid being subjected to them. Other unregulated countries retaliate. Cooperation by China and Russia lowers the global welfare cost of acheiving a 10% reduction in global emissions by half relative to the case where coalition countries undertake all of this abatement on their own. ∗Department of Economics, University of Oldenburg †Resources for the Future; Department of Economics and Institute for Sustainable Energy, Environment and Economy, University of Calgary ‡Department of Agricultural and Applied Economics and Policy, University of Wisconsin, Madison A central preoccupation of the international climate-change debate is the question of when developing nations should accept binding targets on their carbon emissions. Developing countries argue that, in the near term, it is unfair to ask them to cut back on their emissions without compensation for the effect it would have on their prospects for economic growth. At the same time, the unilateral carbon policies currently being pursued (or contemplated) by developed countries are likely to be highly inefficient due to the fact that these countries have relatively high abatement costs. Unilateral policies are also subject to carbon leakage, offsetting increases in emissions in unregulated countries, which increases these costs even further (Hoel 1991, Felder and Rutherford 1993). In theory, a system of international emission-permit trade could deliver on the demands of the developing world and control world emissions in a cost-effective way. However, there remains considerable skepticism that such a system is practical. The monitoring and enforcement challenges as well as the large and explicit transfers of wealth that unrestricted permit trade would impart to countries with limited institutional capacities make finding the political will to implement such a scheme difficult (McKibbin and Wilcoxen 1997). Against this background, many policy analysts have noted that developed countries are large net importers of embodied carbon emissions from their developing-world trade partners. This observation has contributed to the popularity of proposals to use trade policies as tools for regulating carbon emissions in countries that currently have no domestic emission regulations of their own. These policies could work directly by stifling demand for carbon-intensive goods produced in developing countries. They could also work indirectly as an environmentallysanctioned punishment that speeds the adoption of emission controls in those countries. One popular set of proposals involves the use of embodied carbon tariffs, tariffs levied on the direct and indirect carbon emissions embodied in imported goods. They have support as a form of direct regulation from the theory of second-best environmental taxation (Markusen 1975, Hoel 1996). If foreign governments cannot regulate these emissions at the source, tariffs may be justified from a global efficiency perspective. Nevertheless, there are substantial practical and legal costs that would inevitably come with their use (Brewer 2008, Pauwelyn 2007, Howse and Eliason 2008, Charnowitz, Hufbauer and Kim 2009). Furthermore, quantitative evidence from computable general equilibrium (CGE) models suggests that the use of embodied carbon tariffs is unlikely to result in substantial reductions in the global cost of achieving emission reductions. The main effect of carbon tariffs is to shift the burden of policy to the countries subjected to them (Böhringer, Carbone and Rutherford 2011, Mattoo, Subramanian, Mensbrugghe and He 2009, Babiker and Rutherford 2005, Böhringer and Rutherford 2002). In this paper, we explore the indirect role carbon tariffs might play as an environmental sanction. Their burden-shifting effect means that they have the potential to confer substantial trade gains to the countries that use them, making them politically attractive there. They also