Climate Policy and Carbon Leakage with Firm Heterogeneity

Abstract

The possibility of carbon leakage arises when there is an asymmetry in climate policies across countries. A Border Carbon Adjustment (BCA) and a Border Tax Adjustment (BTA) are considered effective instruments to tackle this leakage. Using the Melitz trade model with firm heterogeneity, we study the effects of unilateral carbon tax, BTAs, and BCAs on leakage, competitiveness, and welfare. We analyze in particular how these policies affect firms across the productivity spectrum. Following Kreickemeier & Richter (2014), we stress the importance of the correlation between productivity and emissions levels. When firm-specific emission intensity is weakly decreasing with its productivity level, we find that a carbon tax in one country reduces average profitability and increases the probability of successful entry of firms, leading paradoxically less productive firms to enter the market after the tax. We conclude that both border adjustments are effective in mitigating carbon leakage and restoring international competitiveness partially. Their efficiency however depends on the objectives of the implementing country.