Carbon Tariffs: Effects in Settings with Technology Choice and Foreign Comparative Advantage

Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. Carbon regulation is intended to reduce global emissions, but there is growing concern that such regulation may simply shift production to unregulated regions and increase global emissions in the process. Carbon tariffs have emerged as a possible mechanism to address these concerns by imposing carbon costs on imports at the regulated region's border. I show that, when firms choose from discrete production technologies and offshore producers hold a comparative cost advantage, carbon leakage can result despite the implementation of a carbon tariff. In such a setting, foreign firms adopt clean technology at a lower emissions price than firms operating in the regulated region, with foreign entry increasing only over emissions price intervals within which foreign firms hold this technology advantage. Further, domestic firms are shown to conditionally offshore production despite the implementation of a carbon tariff, adopting cleaner technology when they do so. As a consequence, when carbon leakage does occur under a carbon tariff, it conditionally decreases global emissions. Three sources of potential welfare improvement realized through carbon tariffs require both foreign comparative advantage and endogenous technology choice, underscoring the importance of considering both in value assessments of such a policy. With carbon regulation driving projected production cost increases in excess of 40% in some industries (Drake et al. 2010, Ryan 2012), such policies endow facilities located outside the regulated region with a windfall cost advantage, altering the competitive landscape. This cost advantage enables competitors outside the regulated region (i.e., " foreign " firms) to increase their penetration into the regulated (i.e., " domestic ") region. Further, such policies can lead domestic firms to shift facilities offshore to avoid carbon-related costs. Such foreign entry and offshoring are both sources of carbon leakage – the displacement of domestic production and its associated carbon emissions to offshore locations as a result of climate change policy – which has been shown to erode emissions improvements resulting from such policy. Carbon leakage could potentially be mitigated by border adjustments – tariffs on the carbon content of imported goods that would incur carbon-costs if produced domestically. Proponents of