The Role of Firm Heterogeneity and Intermediate Inputs in Carbon Leakage

How effective are climate policies in reducing emissions? Although this issue is becoming more pressing, standard models largely ignore the role of heterogeneity in firms’ responses. Using administrative German firm data, I show that two determinants of carbon leakage, the emission intensity of production and the import intensity of intermediates, vary significantly across firms. I incorporate this heterogeneity into a model of heterogeneous firms to introduce two new adjustment channels to carbon pricing: the reallocation of production towards firms with a lower emission intensity or a higher import intensity. I calibrate the model to the German manufacturing sector and simulate an increase in the domestic carbon price. A model with firm heterogeneity predicts greater emission reductions, smaller welfare losses, and a higher leakage rate. Production reallocation towards less emission-intensive firms offsets increased emissions from offshoring. Combining a domestic carbon price with a carbon tariff would further reduce leakage and welfare losses. However, it would not yield additional emission reductions since it limits the reallocation of domestic production towards clean firms. These results suggest that optimal carbon taxes and tariffs derived from models without firm heterogeneity may be set at an excessively high level to achieve a specified emission target.