Carbon Tariffs and Macroeconomic Adjustment in Emerging Markets: The Role of Exchange Rate Regimes

Unilateral carbon tariffs pose severe macroeconomic challenges to emerging market economies. We develop a repeated game-theoretic model featuring multidimensional policy strategies and macro-financial constraints governed by exchange rate regimes to study how emerging markets respond to foreign carbon tariffs. Our theoretical model demonstrates that exchange rate regimes critically shape these strategic incentives. In corner solutions, fixed regimes incentivize the unilateral adoption of domestic carbon pricing and weaken the credibility of trade retaliation, whereas floating regimes undermine standalone domestic carbon pricing but strengthen complementarities between carbon pricing and carbon-based retaliation. In repeated interactions, climate policy cooperation is easier to sustain under floating regimes and more fragile under fixed regimes due to structural shock-absorption and credible retaliation mechanisms that prevent deviations. To test these theoretical insights, we construct a novel continuous trade-weighted index capturing regulatory exposure to the CBAM shock across a panel of 25 emerging markets from 2010 to 2024. This indicator is embedded within a regime-dependent Double Machine Learning Local Projections (DML-LP) framework for nonlinear causal inference. Our empirical estimations reveal a severe, delayed real effective exchange rate depreciation following a carbon tariff shock under fixed regimes, whereas floating regimes smoothly absorb the shock, strongly aligning with our game-theoretic assertions.