Regulating Carbon in a Small Open Economy

California has embarked on a bold experiment in trying to reduce carbon emissions without causing undue harm to the state’s economy. The goal is made more difficult by the State’s inability to erect protective tariffs to restrict imports from states and countries without costly carbon regulations. Without coordinated international action to reduce greenhouse gas emissions, this is the same problem faced by many countries, even the US: how to balance the dual goals of carbon reduction and industrial competitiveness. After reviewing the literature on this issue, this paper sets up a simple theoretical model and examines how carbon taxes or tradeable permit systems should be modified to account for the surplus loss from regulation due to carbon leakage. Several cases are considered, including a single instrument (carbon tax or permits), an emission regulation coupled with an output subsidy (as in outputbased rebating), and the case where leakage also generates damage from increased carbon emissions outside the jurisdiction. *Stanford University. Email: [email protected]. Earlier versions of this paper were presented at the Catholic University of Chile, FEEM (Venice) and CESifo (Munich).