Labor Market Distortions and Welfare-Decreasing International Emissions Trading

International emissions trading (IET) has been widely recognized as a preferred approach for tackling the climate change because it would equalize total abatement costs and generates gains for all participants. However, this argument is heavily premised on the notion of partial equilibrium and ignores general equilibrium effects of IET. Using a multi-region, multi-sector CGE model, this paper analyzes effects of IET with focus on labor market distortions. We construct four separate models with several different labor market specifications: i) a model without labor market distortions (i.e. where the labor supply is determined exogenously and wages are flexible); ii) a model with tax-interaction effects in the labor market (i.e. where the labor supply is endogenously determined and a labor tax exists); iii) a model with a minimum wage; and iv) the final model is one in which a wage curve determines wages. We use these models to analyze how the effects of IET change according to model specification. The main results from the analysis are as follows. First, we found that IET generates gains for all participants in the model without labor market distortions. Second, even in the models with labor market distortions, importers of emissions permits are highly likely to benefit. Conversely, we show that the possibility of a welfare loss from IET is not as small for exporters of permits. In particular, in the minimum wage and wage curve models, we found that the exporters of emissions permits are likely to be disadvantaged. However, this also depends on the region in question. For example, China is likely to suffer under IET, whereas Russia, also an exporter, is likely to benefit. We also make clear that if policies are employed to correct (i.e. reduce) labor market distortions when emissions regulation is introduced, all participants will benefit from IET in almost all cases. It is generally recognized that IET is a desirable policy that benefits all participating regions. However, we show that an analysis that does not take account of such labor market distortions will likely overestimate the benefits of IET for permit exporters.