Strategic Climate Policies with Endogenous Plant Location: The Role of Border Carbon Adjustments

Carbon leakage and the relocation of rms is one of the main concerns of governments when choosing their climate policy. In a strategic trade model with endogenous plant location, we study the effect of border carbon adjustments (BCAs) on equilibrium emission taxes in a non-cooperative policy game between two asymmetric countries. To this end, we compare a No-BCA regime with a BCA regime for two scenarios: a simultaneous and a sequential game. Without BCAs, a “race to the bottom” is the only Nash equilibrium. In a Stackelberg equilibrium, a second less negative outcome may emerge, which constitutes a Pareto-improvement to all governments. In this “wise chicken equilibrium”, the Stackelberg leader gives in, letting his/her firms relocate in order to avoid the race-to-the-bottom equilibrium. With BCAs, the race-to-the-bottom in carbon taxes can be avoided in the Nash equilibrium and also in Stackelberg equilibria global emissions are reduced. We show that the country imposing BCAs is always better off, global welfare usually increases with BCAs, even though the country on which BCAs are imposed may be better worse off. We characterize those conditions.