Carbon Tariffs, Emissions Leakage, and Production Relocation

We study whether carbon tariffs can prevent emissions leakage which occurs when firms relocate production across countries. We extend a segmented market model of international trade to a North-South setting with polluting firms. A northern firm may relocate its plant to the South to avoid the higher carbon costs imposed on its domestic production relative to those on its offshored production. To prevent emissions leakage through the firm's relocation, the North can adopt a carbon tariff and an export rebate that can offset its gap in carbon taxes with the South. We find that the North’s carbon tariff and export rebate prevent emissions leakage, which causes an increase in global emissions, if the northern firm uses less emissions-intensive technology relative to the southern firm and its emissions intensity exceeds fifty percent of that of the southern firm. However, if the northern firm’s emissions intensity is less than fifty percent of that of the southern firm, the North’s carbon tariff fails to prevent emissions leakage even with its export rebate. We also find that the North’s optimal carbon tax regime includes its carbon tariff and export rebate. Furthermore, we show that the North's optimal carbon tax regime actually benefits the South through a reduction in global emissions.