Carbon Tariffs: Impacts on Technology Choice, Regional Competitiveness, and Global Emissions

by David F. Drake

Overview — Under current emissions regulation such as the European Union Emissions Trading Scheme (EU-ETS) and the Regional Greenhouse Gas Initiative (RGGI) in the Northeast US, imports entering the region fall outside the regulatory regime and incur no carbon costs. As a result, imports can compete within the carbon-regulated region with a new-found advantage, potentially altering the competitive balance between emissions-regulated and -unregulated firms. While implementing carbon tariffs—border adjustments— may appear to be a straightforward solution to this asymmetry, the potential for such a measure to be interpreted as a trade barrier, and thereby initiate a reciprocal tariff, has thus far stymied debate on the issue. This paper explores the impact of such border adjustments on firms' technology choice, regional competitiveness, and global emissions. The analysis shows that border adjustments (or lack thereof) play a vital role in determining firms' technology and production choices, both of which are fundamental operations management decisions that ultimately determine economic and environmental performance. Results have implications for each of the primary stakeholders: regulators making the policy decision regarding border adjustments; firms interested in understanding their competitiveness and location strategies under a border adjustment; and technology producers interested in assessing the potential impact of border adjustments on demand for cleaner technologies. Key concepts include:

  • Border adjustments means tariffs on the carbon content of imported goods that would incur carbon costs if produced domestically.
  • Emissions regulation in effect today is not currently supported by border adjustment mechanisms. This allows goods produced offshore to compete within the emissions-regulated market without incurring the carbon costs associated with local production.
  • Emissions regulation without border adjustment limits the legislation's ability to impact global emissions.
  • The border adjustment policy decision and firms' technology choices interact to fundamentally determine the nature of regional competitiveness, the risk of carbon leakage, and the potential for carbon regulation to achieve a reduction in global emissions.
  • This paper raises important implications related to the role and feasibility of border adjustments in mitigating leakage effects that can result from current, uncoordinated emissions abatement efforts.
  • While technology choice plays a minor role without a border adjustment, it fundamentally defines the nature of competitiveness when border adjustments are implemented.

Author Abstract

Carbon regulation is intended to reduce global emissions, but there is growing concern that such regulation may simply shift production to unregulated regions, potentially increasing overall carbon emissions in the process. Carbon tariffs have emerged as a possible mechanism to address this concern by imposing carbon costs on imports at the regulated region's border. Advocates claim that such a mechanism would level the playing field whereas opponents argue that such a tariff is anti-competitive. This paper analyzes how carbon tariffs affect technology choice, regional competitiveness, and global emissions through a model of imperfect competition between "domestic" (i.e., carbon-regulated) firms and "foreign" (i.e., unregulated) firms, where domestic firms have the option to offshore production and the number of foreign entrants is endogenous. Under a carbon tariff, results indicate that foreign firms would adopt clean technology at a lower emissions price than domestic producers, with the number of foreign entrants increasing in emissions price only over intervals where foreign firms hold this technology advantage. Further, domestic firms would only offshore production under a carbon tariff to adopt technology strictly cleaner than technology utilized domestically. As a consequence, under a carbon tariff, foreign market share is non-monotonic in emissions price, and global emissions conditionally decrease. Without a carbon tariff, foreign share monotonically increases in emissions price, and a shift to offshore production results in a strict increase in global emissions.

Paper Information