Climate Change, Border Tax Adjustments, and the Green Paradox

New paper: A major problem in coordinating international efforts in combating climate change is that some countries have incentives to free ride: they can capture the bene…fits without incurring the costs. In the context of international trade, the free riding countries enjoy an additional advantage: without imposing a carbon tax (or equivalent measures), the competitive positions of their …firms will be enhanced. Concerns over the loss of competitive advantage due to free riding behaviour of trading partners have lead economists and policymakers to contemplate proposals for various forms of “border tax adjustments” (BTA), defi…ned as differential taxation of traded goods that is motivated by differences in underlying carbon prices. In particular, they consider the possibility of setting a charge on imports equal to some notion of carbon tax ‘not paid ’abroad, and remitting tax on exports in similar fashion. BTA has been considered as a possible mechanism to combat “carbon leakage”, de…fined as the phenomenon where the effort of abating countries are offset to some extent by increasing emissions in nonabating countries. Our paper presents a model of BTA in the context of fossil fuel extraction when a backstop technology is available. We study the impact of border tax adjustments (BTA) when owners of fossil fuel stocks adjust their extraction paths to maximize their wealth, and where the rate of interest is endogenously determined. Using this framework, we investigate the possibility of a Green-Paradox outcome when BTA is implemented. The term Green Paradox was coined by Sinn (2008), in his analysis of intertemporal supply behavior of extractive fi…rms. It refers to the possibility that, due to intertemporal supply side adjustment, a policy measure intended to reduce CO2 emissions might have the opposite effect. This phenomenon has been further explored in a series of papers investigating various channels through which a Green-Paradox outcome might arise. Our paper identifi…es a new channel: a policy measure intended to reduce carbon leakage may indirectly induce a change in the equilibrium interest rate which in turn increases extraction in the near future.