Agriculture, Land Use and Optimal Second-Best Environmental and Climate Policy with Greenhouse Gas Leakage

Despite being a major source of greenhouse gas (GHG) emissions, agriculture remains one of the least regulated sectors in climate policy. Designing climate policy for agriculture is challenging due to the interaction between GHG emissions, emissions of other pollutants such as ammonia and nitrate, competing land uses, and the risk of GHG leakage. Within a general equilibrium framework, we analyze cost-effective climate policy for the entire economy with a focus on agriculture, assuming a national GHG emissions target and a target for limiting GHG leakage. The first-best policy requires a large set of tax and subsidy instruments to mitigate GHG leakage from all possible channels. We argue that this set of instruments is unlikely to be implemented in practice. We therefore focus on an implementable second-best policy. We show that accounting for all externalities and leakage effects, it is second-best optimal to differentiate GHG taxes across sectors and to allow taxes on other emissions to deviate from their Pigouvian level. To quantify the second-best policy, we simulate a calibrated version of our theoretical model, with leakage coefficients computed using a large-scale global general equilibrium model. Simulations indicate that the domestic environmental co-benefits of GHG reductions may be sufficiently large to ensure that overall household welfare improves even when disregarding global warming effects. However, the government faces a trade-off: if it wishes to limit GHG leakage, it will have to sacrifice the benefits to the domestic environment that could otherwise be gained from the second-best optimal unilateral climate policy.