New research analyses role of border tax adjustments in climate change mitigation

A provision of the Kyoto Protocol is that signatories take on legally binding restrictions on their carbon emissions if they belong to ‘Annex 1’ of the protocol (high income and transition economies), while those that belong to non-Annex 1 countries (developing countries) do not take on such restrictions. The potential implication of this, for those countries that impose carbon emission restrictions, while the others do not, is loss in trade competitiveness and carbon leakage meaning the shift of energy intensive industries to countries without emissions restrictions. The reason for this is that any emissions reduction, caused either by taxing carbon or capping their level, may put the emissions-intensive sectors at a disadvantage by raising the effective cost of production relative to producers in countries that do not take similar actions. To offset the loss in trade competitiveness and carbon leakage — it is argued — countries who take actions against emissions may consider taxing the carbon content of imports from countries without such restrictions to ‘level the playing field’. Such taxation appropriately adjusts the differential prices of imported goods that are driven by differences in the underlying domestic carbon prices.

Such proposals have recently gained impetus in policy discussions both in EU and elsewhere (and in particular US and Australia). Indeed, provision of this kind — and in the context of the EU Emissions Trading System — is provided in an EU Directive (2009/29/EC). Similarly, the Waxman-Markey and Boxer-Kerry bills that recently went before the US Congress both aimed to institute a system of cap-and-trade for climate policy in the US and, notably, both proposals included border tax adjustment as a key provision.

To date, however, this issue although it has received considerable attention in policy discussions has not been thoroughly investigated in the academic literature. The new research concludes that if there are countries that do not set carbon taxes in line with what is optimal from a global perspective, then a purposive role for tariff policy emerges.  Such tariff policy does indeed take the form of a ‘border tax adjustment’ (BTA) for difference in carbon taxes resulting in a charge on imports (rebate on exports) equal to the carbon tax not paid abroad. In a special case this BTA has the simple structure envisaged in practical policy discussions. The research also stresses the point that the case for BTA depends critically on whether climate policies are pursued by carbon taxation or by cap-and-trade restrictions.  While there has been some discussion of the practical differences between implementing BTAs under carbon taxes and cap-and-trade, the underlying economic case is entirely different in the two cases. In the cap-and-trade case, implementation of a BTA might not deliver efficiency gains. 

A full version of the paper ‘Coordinating climate and trade policies: Pareto efficiency and the role of border tax adjustments’ can be found on the Business School website.