Free-riding, carbon treaties, and trade wars: the role of domestic environmental policies

Abstract

This paper uses a calibrated general-equilibrium model of North–South trade with carbon emissions to explore the strategic, open-economy implications of price- and quantity-based instruments for CO 2 emission reduction. We compute non-cooperative environmental and trade policy equilibria and Nash bargaining outcomes in environmental policies with side payments of cash. Results show that quotas can lead to higher internalization levels in a non-cooperative zero-tariff equilibrium in comparison with emission fees. If tariffs are also chosen non-cooperatively, the form of policy instrument used affects equilibrium tariffs, with quotas leading to lower trade barriers, particularly under a regional carbon treaty.