Carbon policy and the structure of global trade

• DOI: http://doi.org/10.1111/twec.12535
• Author: Edward J. Balistreri,Christoph Böhringer,Thomas F. Rutherford
• Date: 01 January 2018
• Published date: 01 January 2018

ORIGINAL ARTICLE

Carbon policy and the structure of global trade*

Edward J. Balistreri

1

|

Christoph B€

ohringer

2

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Thomas F. Rutherford

3

1

Department of Economics, Iowa State University, Ames, IA, USA

2

University of Oldenburg, Oldenburg, Germany

3

University of Wisconsin, Madison, WI, USA

1

|

INTRODUCTION

The 21st Conference of Parties (COP21) to the United Nations Framework Convention on Climate

Change (UNFCCC) held in Paris in December 2015 concluded with the so-called Paris agreement

(UNFCCC, 2015): 196 countries agreed to the goal of limiting climate change to <2°C compared

to pre-industrial levels. Legally binding greenhouse gas emission reduction targets as previously

imposed under the Kyoto Protocol to signatory industrialised countries were replaced with volun-

tary Intended Nationally Determined Contributions (INDCs). The disparity in INDCs and the

absence of binding commitments implies potentially large asymmetries in emission pricing across

trading partners. Stringent carbon emissions pricing by a limited coalition of countries can put

energy-intensive production within the coalition at international competitive risk, as well as rais ing

concerns over relocation of emissions (carbon leakage) to countries with lax INDCs or lax enforce-

ment. Furthermore, the distribution of policy burdens established in part by the INDC process can

be significantly altered by direct international market adjustments. Thus, the global distribution of

economic adjustment costs in meeting the overall goal is another source of concern. Our perspec-

tive on how policy distortions are transmitted through international trade can have a profound

influence on the validity of these concerns and thus the appropriate design and goals of future cli-

mate policy.

In this paper, we quantify the structural sensitivity of competitive effects, environmental out-

comes (emission leakage) and the welfare implications triggered by subglobal emissions regulation.

We assess the quantitative outcomes in the context of three important alternative international trade

structures. We demonstrate that a conventional model based on regionally differentiate d goods (the

so-called Armington assumption) is at odds with the perspectives offered by a neoclassical homo-

geneous goods model and the advanced heterogeneous-firms model adopted in many contemporary

theoretic and empirical investigations in international trade. We contrast these structural sensi tivi-

ties under a standard policy scenario that includes emissions reductions by a subglobal coalition of

developed countries.

*The authors thank two anonymous referees and participants of seminars at the Colorado School of Mines, the Western

Economic Association meetings, the University of Idaho, and Washington State University for discussion and helpful com-

ments. B€

ohringer is grateful for support from Stiftung Mercator (ZentraClim). All programs used to replicate the results are

available from the authors.

DOI: 10.1111/twec.12535

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:194–221.

From an economic perspective, the efficiency rationale for international cooperation in c ontrol-

ling global environmental externalities such as CO

2

-induced global warming is straightforward—

emissions should be reduced where it is cheapest to do so. International cooperation in the provi-

sion of climate protection, however, is hindered by severe incentive problems. In recent papers, for

example, Libecap (2014) highlights the difficulty of assigning and enforcing property rights in

international environmental agreements, and Nordhaus (2015) focuses on free riding as the primary

impediment to binding international agreements on climate policy. The challenges of international

cooperation have resulted in a transition away from binding country-specific targets as outlined,

for example, in the Kyoto Protocol. A group of developed countries are still motivated, however,

to take a lead role in the battle against anthropogenic climate change with binding unilateral com-

mitments. The fear is that the voluntary INDC process leaves considerable latitude for underperfor-

mance by a large number of countries. Given the importance of international markets to

environmental and distributional spillovers associated with subglobal action, a critical assessment

of alternative perspectives on trade structures is indispensable.

The applied economic literature provides important insights into the interactions of environmen-

tal regulation and the international location of production activities. Econometric studies often

focus on identifying a causal signal, where environmental policy impacts the spatial pattern of

trade and production. There are numerous studies that test the pollution haven hypothesis, which

posits that pollution intensive production co-locates with lax environmental regulation.

1

As

explained by Millimet and Roy (2016) this literature faces significant identification challenges

because measurement of the level of environmental regulation is difficult, environmental polic y is

endogenous to economic activity, and there are geographic spillovers. Despite these challenges

(under appropriate identification strategies), many authors have concluded that a sensible signal

emerges from the data. In the search for a signal one can be somewhat agnostic about the underly-

ing theoretic structure, as many theories predict the pollution haven hypothesis. A more structured

approach is needed, however, for a quantitative analysis of large and unprecedented future emis-

sions policies.

The literature on carbon policy relies heavily on computable general equilibrium (CGE) models,

which are adept at translating large unprecedented policy shifts into economic responses based on

microeconomic theory. This structural approach, somewhat obviously, requires the researcher to

take a hard stance on the particular structure. Studies in this literature overwhelmingly adopt a par-

ticular set of structural assumptions about international trade. More specifically, countries are

assumed to produce regionally differentiated goods under perfect competition, and these imported

and domestically produced differentiated goods are combined in a constant elasticity of substitution

(CES) demand system.

The proposition to differentiate products by country of origin is often referred to as the Arming-

ton assumption, after its seminal notion and application by Armington (1969).

2

The Armington

structure has several empirical advantages, but it has been criticised for its inconsistency with

micro-level observations and questionable counterfactual implications. The Armington assumption

provides a tractable solution to various problems associated with the standard neoclassical

(Heckscher-Ohlin) perspective of trade in homogeneous goods (Whalley, 1985): (i) it

1

See for example, Brunnermeier and Levinson, (2004), Ederington, Levinson, and Minier (2005), Kellenberg (2009), Keller

and Levinson, (2002), Millimet and List (2004) and Millimet and Roy (2016).

2

The Armington assumption has also been used by theorists as a justifications for the gravity relationship observed in trade

flows (e.g., Anderson, 1979). Newer trade theories developed by Krugman (1980), Eaton and Kortum (2002), and Melitz

(2003) naturally produce the same gravity relationship.

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