Trade and the emissions trading system in a small open economy

Abstract

To control greenhouse gas emissions efficiently, we should regulate all pollution emission sources in the economy equally. However, in the real world, environmental regulations differ by sector. Using a small open economy model, this paper examines how the enforcement of an economy-wide emissions trading system (ETS) (i.e., uniform environmental regulation) affects welfare under a trade policy, where the government initially implements different environmental regulations across sectors. It is important to consider this relation between environmental regulations and trade policy because countries tend to impose weak environmental regulations in sectors facing global competition often protected by import tariffs. We find that an economy-wide ETS may harm a small open economy even under a low import tariff rate as long as the environmental regulation in the exporting industry is weaker than in the importing industry. To avoid welfare deterioration, the government should then decrease the import tariff rate in line with mitigation of the sectoral differences in environmental regulation.