Smart hedging against carbon leakage

All three authors are affiliated with the Oslo Centre for Research on Environmentally friendly Energy (CREE) and appreciate financial support from the Research Council of Norway through CREE.Unilateral climate policy induces carbon leakage through the relocation of emission-intensive and trade-exposed industries to regions with no or more lenient emission regulation. Both analytical and numerical studies suggest that emission pricing combined with border carbon adjustment is a second-best instrument, and more cost-effective than output-based rebating, in which case domestic output is indirectly subsidized. No country has so far imposed border carbon adjustment, while variants of output-based rebating have been implemented. In this paper we show that combining output-based rebating for emission-intensive and trade-exposed goods with a consumption tax on the same goods can be equivalent with border carbon adjustment. Moreover, we demonstrate that it is welfare improving for a region which has already implemented emission pricing along with outputbased rebating to also introduce such a consumption tax. We conclude that supplementing outputbased rebating with a consumption tax constitutes smart hedging against carbon leakage: Compared to output-based rebating stand-alone it constitutes a robust strategy for improving cost-effectiveness of unilateral climate policy; compared to border carbon adjustment it limits the risks of potentially detrimental trade disputes.publishedVersio