Carbon Leakage: The Role of Sequential Policy Setting

We analyze non-cooperative environmental policy when the only strategic interaction between countries is through bilateral transboundary pollution, i.e., countries are closed or small open economies. When countries set pollution taxes simultaneously, there is no carbon leakage. However, in the sequential-move game, the leader sets its pollution tax lower than the marginal damage from own pollution and lower than that in the simultaneous-move game, while the follower sets its tax higher than that in the simultaneous-move game. The only motive behind the leader’s underregulation of own pollution is to reduce the incidence of transboundary pollution from the follower, i.e., to reduce carbon leakage. Aggregate pollution is higher in the sequential-move game than in the simultaneous-move game if pollution is a pure global public bad. JEL classification codes: Q58, H23.