Trade Policy as Climate Policy: Payoffs and Tradeoffs

Reducing carbon emissions is a global public good: every country has an incentive not to reduce its own emissions and still benefit from the actions of compliant countries. We explore how import tariffs can solve this free-rider problem. We use a multi-region, multi-sector simulation model in which some countries adopt a carbon tax and compete with non-compliant countries in global markets. First, we consider the European Union (EU)’s carbon border adjustment mechanism (CBAM) in which non-compliant countries face import tariffs in selected sectors based on the carbon emitted in production. While it helps EU producers, CBAM will not reduce global emissions because exporting countries can diversify their trade to non-EU countries. Next, we consider a climate club in which members adopt a carbon tax and impose punitive tariffs against all products from non-members. In this case, tariffs can reduce global emissions by inducing non-taxing countries to join the club. However, climate clubs are fragile. When club members are strongly linked to non-club regions through integrated production relationships, in which imports complement domestic goods, they suffer trade losses, adding to the cost of club membership. Furthermore, high punitive tariffs are needed to induce all regions to join the club.