Climate Change Policy in the International Context: Solving the Carbon Leakage Problem

Under the Paris Agreement, nations set their own emissions goals and policies. As a result, climate policies vary widely across countries, with some countries imposing stringent emissions policies and others doing very little. A key problem when carbon policies vary across countries is that energy-intensive industries can relocate to places with few or no emissions restriction. Relocated industries would continue to pollute but would be operating in a less desirable location. Moreover, the countries that imposed strict emissions reductions lose the benefit of having those industries located domestically. This problem, known as leakage, is one of the key reasons the United States has failed to enact substantial climate change policies. Without a solution to leakage, it may be much more difficult to prevent catastrophic climate change. The most commonly proposed response to leakage is to impose border adjustments—tariffs on imports based on the emissions from the production of the imported good, and rebates for exports of prior taxes or other prices imposed on emissions. Border adjustments ensure that the same price is paid regardless of the location of production. Border adjustments, however, are complex to impose and potentially incompatible with the WTO. Moreover, numerous studies show that border adjustments do not significantly improve the effectiveness of regional carbon policies. We propose a better solution to the leakage problem. Our solution, the extraction/production tax or the EPT, combines a tax on domestic extraction with a conventional tax on emissions from domestic production. The core intuition behind this hybrid tax is that shifts in location due to carbon prices arise because of their effects on the price of energy seen by foreign actors. By reducing demand for fossil fuels, taxes on emissions from domestic production lower the global price of energy. In response, foreign actors increase their energy use, generating leakage. Border adjustments do not change this effect: carbon taxes on production with border adjustments also reduce the price of energy and increase energy use abroad. A tax on domestic extraction, however, raises the global price of energy because it reduces supply. A higher price of energy causes foreign users of energy to reduce their energy use, reducing leakage. Foreign extractors of energy, however, increase their supply. By combining a tax on the supply of energy and a tax on the demand for energy, the EPT sets these two forces against each other. A tax on the supply side of the market allows a lower tax on the demand side, with the two taxes set to minimize distortions in non-taxing regions. The EPT not only better solves the economic problem of leakage than conventional approaches; it is also much simpler to implement. The EPT can be implemented by imposing a nominal tax on domestic extraction and border adjustments only on energy (but not goods in general) at a lower rate than the nominal extraction tax. Both an extraction tax and border adjustments on energy are easy to impose, which means that the EPT can greatly simplify the administration of carbon taxes. Finally, the EPT reduces concerns with WTO legality raised by traditional approaches. The EPT is a practical solution to the leakage problem and, therefore, can be a key piece to solving the global climate change problem