Between a Rock and a Hard Place: A Trade-Theory Analysis of Leakage Under Production- and Consumption-Based Policies

Abstract

Without a comprehensive global climate agreement, carbon leakage remains a contentious issue. Consumption-based pricing of emissions—which could in practice be implemented with a full border tax adjustment (BTA)—has been forwarded as an option to increase the effectiveness of unilateral climate policy. This paper questions the economic rationale behind this approach, using a theoretical $$2 \times 2$$ trade model in which leakage occurs through terms-of-trade effects. We show analytically, first, that consumption-based pricing of emissions does not necessarily result in less leakage than production-based policies. Second, the sign of the optimal unilateral carbon tariff depends on the carbon-intensity differential between the foreign country’s exporting and non-exporting sectors, and not on the differential between home’s and foreign’s exporting sectors, as implied by the full BTA approach. Third, based on empirical data for the year 2004, our model implies that full BTA applied by the European Union on e.g. imports from and exports to China would—by shifting China’s production from the export sector with a relatively low carbon-intensity towards the more carbon-intensive non-export sector—actually increase leakage.