Strategic Trade Policy with Border Carbon Adjustments

Abstract

This article further develops a framework of Brander and Spencer (1984) by adding Border Carbon Adjustments (BCA) to compensate for cost differences caused by emissions reduction among countries. On a level playing field, BCA is one-directional in that only a country with a more stringent carbon tax can impose BCA on its imports. In a two-stage game with a reciprocal market model, governments move first by choosing domestic carbon tax rate on their own firms. The level of BCA is determined by both home and foreign carbon taxes. Firms take taxes and BCA as a given and compete by choosing either output levels or prices. The right to impose BCA makes two countries unequal in that a country with the right can extend the influence range of its domestic carbon tax on imports while the other cannot. Besides equalizing carbon costs across countries, BCA changes the incentive structure regarding governments’ domestic climate policy choices, as governments try to maximize their countries’ welfare. Our findings are robust whether the competition is Cournot or Bertrand because the effect by BCA dominates the mode of competition.