The Regional Economic Effects of a Reduction in Carbon Emissions and An Evaluation of Offsetting Policies in China

China has promised to cut CO2 emissions per unit of GDP 40-50% by 2020. It is almost certain that the reduction in emissions will have negative effects on the economy; moreover, the effects are likely to differ across regions, given that there is considerable heterogeneity among Chinese regions. These differential regional impacts will affect regional disparities, which are already very substantial and the source of great concern at the highest policy levels. Yet, very little analysis of them has yet been carried out. We help fill this gap by building a small theoretical model involving two regions designed to capture some of the features of the Chinese economy. We incorporate the right to emit CO2 as a factor of production with the national level of permitted emissions set by the national government. The model is solved numerically based on a parameterisation using Chinese data to simulate the effects on the regions of the carbon-reduction. We find that a reduction has regionally differentiated effects on key variables such as income, welfare and output. We also explore the effects of offsetting policies that may be undertaken by governments at both regional and national levels to ameliorate the effects of the carbon reduction. We find that the effects of standard fiscal policies (both regional and national) depend crucially on whether one or both regions are targeted. Welfare changes are often in the opposite direction to output changes. Boosts to productive capacity do better in terms of output but also have “perverse” welfare effects.