The Copenhagen conference of parties (COP 16) was a setback in the quest for a global deal to address climate change. Instead of binding emission reduction commitments for all major industrialised and developing regions, the Copenhagen conference came up with a voluntary system of pledge-and-review. As a result, it appears that effective emission reduction will hinge for quite some time on unilateral policy initiatives of countries choosing to lead the way. A prominent example is the EU which has committed its member states to unilateral greenhouse gas emission reductions of at least 20% on average by 2020 (European Commission 2008).
One fundamental problem with unilateral climate policies is emission leakage – the phenomenon where policies meant to reduce emissions in one country cause emissions to increase in uncontrolled countries (Felder and Rutherford 1993 and Perroni and Rutherford 1993). Leakage occurs not only through the international energy markets, as the drop in demand in the abating countries lowers fossil fuel prices, but also through the markets for energy-intensive goods, as production costs in abating countries increase.
Leakage provides an efficiency argument for deviating from uniform emission pricing as the first-best strategy of emission reduction. Lower emission prices for emission-intensive and trade-exposed sectors in regulated countries can reduce leakage and thereby reduce the overall cost of global emission reduction.
More precisely, with optimal price differentiation, an increase in domestic abatement cost (due to un-equalised marginal abatement costs across domestic polluters) is offset by international efficiency gains through lower leakage. Apart from preferential emission pricing, other measures to counteract leakage include border adjustments such as climate taxes on embodied carbon in imports from unregulated trade partners or output-based allocation of emission rights for domestic energy-intensive and trade-exposed industries. All of these measures have their own pros and cons with respect to the potential cost reductions that can be achieved compared to blunt uniform emission pricing, compatibility with legal provisions or political acceptance by important interest groups. All these measures share the basic economic reasoning that preferential treatment to energy-intensive-trade-exposed sectors can be justified due to incomplete regulatory coverage of emission sources, i.e. leakage concerns.
Protectionism or optimal policy?
While preferential treatment of energy-intensive and trade-exposed sectors in regulated countries can in principle be justified as a second-best strategy to address leakage, it raises concerns on unfair or illegal exploitation of international market power through manipulating the terms of trade. The problem for an informed policy debate is that the motives for non-uniform treatment of industries are inherently intertwined.
At first glance, it is not obvious to what extent special rules for energy-intensive and trade-exposed industries can be justified on global efficiency grounds (to combat leakage), or to what extent these are simply strategic exploitation of international market power.
In order to gain insights into the relative importance of the leakage motive when compared with the terms-of-trade motive for differential regulation of industries, we have developed a decomposition method that enables us to separate the two motives.
The logical experiment which provides our decomposition is as follows.
- Choose an optimal abatement policy, subject to the constraint imposed by Articles 4.8 and 4.9 of the Kyoto Protocol.
These articles require that signatory states compensate developing countries for the impacts of response measures.
- Faced with the costs of compensation, an optimal policy selects solely on the basis of the leakage externality and excludes the beggar thy neighbour motive which otherwise affects the choice.
In a recent paper (Böhringer et al. 2010), we first prove formally that this logic is correct, and then implement the optimal tax calculation using the CONOPT (Drud 1992) constrained nonlinear optimisation code and a model based on the GTAP 7 database (Narayanan and Walmsley 2008).
With this conceptual framework and empirical implementation we can address central questions of unilateral climate policy design including.
- What is the relative importance of the leakage and the terms-of-trade motive for differential treatment of industries?
- How does non-uniform regulation affect the economy-wide cost of emission abatement?
- How large are the differences in economic cost between more sophisticated second-best regulatory strategies as compared to a simple uniform emission pricing rule which neglects international spillover effects?
We apply our technique to study the implications of leakage concerns and strategic terms-of-trade exploitation for differential emission pricing for energy-intensive, trade-exposed sectors on the one hand and the remaining economy on the other hand.
In numerical simulations of unilateral climate policies for the US and the EU economies providing a consistent level of global emission reduction we find that both motives are likely to be overstated in the ongoing policy debate on preferential treatment of energy-intensive and trade-exposed industries.
While leakage concerns may justify noticeable emission price reductions for energy-intensive and trade-exposed industries, the implications for leakage and overall economic cost are second order. Likewise, the scope for exploiting terms of trade through differential pricing of energy-intensive goods and the rest of the economy is limited.
Overlooked in the policy discussions is the insight that any terms-of-trade motive for price differentiation depends on the trade pattern. A net exporter (importer) of energy-intensive goods adopts higher (lower) emission prices on its energy-intensive production as a substitute for export tariffs (import duties). From a domestic economy-wide perspective an optimal beggar-thy-neighbour policy may imply higher emission prices – not lower – for the energy-intensive and trade-exposed sectors compared with the remaining economy – opposite to the common practice in many OECD countries currently adopting price differentiation in favour of energy-intensive industries.
We find that emission leakage and terms-of-trade effects are largely driven by decreases in international fuel prices due to global reductions in energy demand. The energy demand reductions in turn are directly linked to the targeted reduction in global emissions. Holding constant a country’s contribution to the global public good of climate protection, the international energy market responses are robust to alternative emission pricing strategies, and these dominate both the leakage and the terms-of-trade implications. Fuel importing regions receive terms-of-trade gains from the decrease in international fuel prices, fuel exporting regions face terms-of-trade losses.
The trade channel through non-energy goods which can be influenced through strategic emission pricing plays a secondary role in terms of leakage and terms-of-trade. Trade in energy-intensive (non-energy) goods accounts for a small share of overall emissions. In order to mitigate leakage through trade, price discrimination in favour of energy-intensive goods is warranted but the efficiency cost non-uniform emission pricing works in the opposite direction. In addition, leakage adjustment and terms-of-trade motives are limited through the restricted scope of differential emission pricing between two segments of the economy. In theory, price differentiation should be applied to many categories of goods.
In practice, however, the rough categorisation across two segments underlying our simulations seems to be a condition driven by pragmatic reasons. The dominant role of international energy market adjustments for terms-of-trade changes and leakage explains why non-strategic uniform emission pricing as a competitive market outcome comes very close to a second-best policy design with explicit recognition of induced leakage.
Large open economies such as the EU or the US cannot substantially reduce costs by using sophisticated tax differentiation. A simple first-best rule of uniform emission pricing is close to optimal, even in the second-best world of international spillovers.
Böhringer, C, A Lange and TF Rutherford (2010), “Optimal Emission Pricing in the Presence of International Spillovers. Decomposing Leakage and Terms-of-Trade Motives”, NBER Working Paper 15899.
Drud, AS (1992), “CONOPT - A Large-Scale GRG Code”, ORSA Journal on Computing, 6: 207- 216.
Felder, S and TF Rutherford (1993), “Unilateral Reductions and Carbon Leakage. The Effect of International Trade in Oil and Basic Materials”, Journal of Environmental Economics and Management, 25:162–176.
Narayanan BG and TL Walmsley (eds.) (2008), Global Trade, Assistance, and Production. The GTAP 7 Data Base, Centre for Global Trade Analysis, Purdue University.
Perroni, C and TF Rutherford (1993), “International trade in carbon emission rights and basic materials. general equilibrium calculations for 2020”, Scandinavian Journal of Economics, 95(3):257–278.
European Commission (2008), “The Climate Action and Renewable Energy Package, Europe's climate change opportunity”.