Strategic climate policy with endogenous plant location: The role of border carbon adjustments

• Published date: 01 December 2022
• Author: Noha Elboghdadly,Michael Finus
• Date: 01 December 2022
• DOI: http://doi.org/10.1111/jpet.12615

Received: 27 March 2021

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Accepted: 10 August 2022

DOI: 10.1111/jpet.12615

ORIGINAL ARTICLE

Strategic climate policy with endogenous

plant location: The role of border

carbon adjustments

Noha Elboghdadly

1

|Michael Finus

2,3

1

Department of Economics, Alexandria

University, Alexandria, Egypt

2

Department of Economics, University of

Graz, Graz, Austria

3

Department of Economics, University of

Bath, Bath, UK

Correspondence

Michael Finus, Department of

Economics, University of Graz,

Universitätsstraße 15, 8010 Graz, Austria.

Email: michael.finus@uni-graz.at

Funding information

Ministry of Higher Education and

Scientific Research, Egypt

Abstract

Carbon leakage and the relocation of firms is one of the

main concerns of governments when choosing their

climate policy. In a strategic trade model with endogenous

plant location, we study the effect of border carbon

adjustments (BCAs) on global welfare and emissions in an

emission tax competition game between two asymmetric

countries for two games: a simultaneous and a sequential

game. Without BCAs, a ruinous “race to the bottom”with

no relocation of firms is the only Nash equilibrium in a

simultaneous game. In a sequential game, additionally, a

“wise chicken”equilibrium may emerge where the

Stackelberg leader gives in, letting all his/her plants

relocate to avoid being stuck at the bottom. With BCAs,

equilibrium emission taxes in both countries are higher,

implying lower global emissions and usually higher global

welfareinbothgames.WithBCAs,theenvironmental

more concerned country accepts that its firm partially

relocates abroad, as it is rewarded with better control of

global emissions, tariff revenues and higher net profits

(profits minus taxes). This avoids high environmental

damages and that either net profits are zero because of

high subsidy levels in a “race to the bottom”or because all

production plants have moved abroad.

J Public Econ Theory. 2022;24:1266–1309.1266

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wileyonlinelibrary.com/journal/jpet

This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial‐NoDerivs License, which permits

use and distribution in any medium, provided the original work is properly cited, the use is non‐commercial and no modifications or

adaptations are made.

© 2022 The Authors. Journal of Public Economic Theory published by Wiley Periodicals LLC.

1|INTRODUCTION

The history of climate change negotiations suggests that it is difficult to implement measures to

reduce greenhouse gases significantly. Effective global actions are hampered by free‐rider

incentives and sub‐global actions are not effective as they are undermined by “carbon leakage.”

That is, emission reductions by some environmentally concerned countries are partly or

completely offset by higher emissions in environmentally less concerned countries. One

important channel of carbon leakage is the relocation of the production of emission‐intensive

industries to countries with laxer environmental policies. This phenomenon is known as the

“pollution haven hypothesis”(PHH). Although there is mixed empirical evidence to support

the PHH, the threat of relocation of firms, associated with the loss of jobs and investment, is an

important argument in the policy debate.

1

Recently, border carbon adjustments (BCAs) have been proposed to address carbon leakage and

the loss of competitiveness of domestic industries (Böhringer et al., 2014; Fischer & Fox, 2012;

Larch & Wanner, 2017;Stiglitz,2006;Woodersetal.,2009). For example, the EU announced a

proposal to support their ambitious climate policy under the European Green Deal through a

carbon border adjustment mechanism (CBAM) (European Commission, 2021;EuropeanUnion,

2021). Generally, BCAs may comprise an import tariff, an export rebate, or both. Even ignoring

strategic considerations by adopting a pure welfare perspective, trade measures, complementing

environmental policies, can be justified as already demonstrated by Markusen (1975). He shows

that in the absence of global action, the internalization of the externality caused by a global

pollutant requires a combination of a Pigouvian tax and import tariffs.

2

That is, BCAs correct

distortions; hence, they are not considered disguised trade barriers (D. Helm et al., 2012).

In this paper, we are interested in whether and under which conditions BCAs support the

implementation of more ambitious climate policies. Our model takes into account that firms

cannot only relocate parts of their production but even their entire production facilities abroad

(endogenous plant location) and that governments engage in a strategic emission tax

competition game (bilateral and endogenous policy choices) and may perceive global damages

from greenhouse gases differently (asymmetric countries).

We model an emission tax competition game between two governments that try to attract

the plants of two firms. Both firms produce a homogeneous emission‐intensive good and

compete in a Nash‐Cournot fashion. Governments may evaluate damages caused by global

emissions differently. The game comprises three stages: in stage 1, governments choose their

policies; in stage 2, firms choose their location and in stage 3 firms choose their output. We

solve our game under two different policy regimes. Under the No‐BCA regime, each

government imposes a carbon tax on the production of those plants which are located within its

national boundaries. Under the BCA regime, the country that sets a higher carbon tax can

additionally impose a tariff on imports from plants located abroad. C. Helm and Schmidt (2015)

show, in a different setting, that full BCAs, that is, combining carbon tariffs with export rebates,

can eliminate the incentives of firms to relocate to countries with lower carbon prices.

However, we exclude export rebates and consider BCAs on imports only in our paper for the

following reasons. First, export rebates are difficult to justify under the rules of GATT. They

1

For example, Levinson (1996) and Eskeland and Harrison (2003) find no evidence of the PHH. In contrast, Fredriksson

et al. (2003), Kellenberg (2009) and Chung (2014) report significant effects of environmental policies on the location of

firms.

2

See also Hoel (1996) and Copeland (1996) for similar results. These models assume perfect competition.

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could be considered illegal export subsidies according to the WTO's Subsidies and

Countervailing Measures (SCM) Agreement (Burke et al., 2021; Cosbey et al., 2019; Fischer

& Fox, 2012). Second, although export rebates may address the leakage effect, they do not

reduce global emissions effectively (Böhringer et al., 2014; Elliott et al., 2010). Thus, it would be

difficult to implement BCA on exports under the umbrella of Article XX of GATT for

environmental reasons.

3

Third, the CBAM proposed so far by the EU in the European Green

Deal is designed on the import side only and does not include rebates for EU exporters.

4

Therefore, BCAs only on imports are more likely to emerge in the near future.

As mentioned by Markusen et al. (1995), endogenous plant location may lead to a discontinuity of

welfare functions with respect to tax levels as firms may change their location abruptly above a

threshold. In our model, this leads to noncontinuous best‐response functions under the BCA regime,

which implies that a Nash equilibrium may not exist. Therefore, as Stackelberg equilibria always

exist, we also consider the possibility that governmentschoosetheirtaxessequentially.

5

Apart from

this technical point, a sequential policy choice also gives rise to new interesting results. Given the

policy focus of this paper, and the complications arising from modeling endogenous plant location,

we simply assume the sequence of moves and the identity of the leader to be exogenous. That is, we

do not adopt the sophisticated endogenous timing model due to Hamilton and Slutsky (1990), with

further comments in Amir (1995).

Under the No‐BCA regime, if countries choose their policies simultaneously, we end up in a

“race to the bottom”with no relocation of firms. This is the only Nash equilibrium, irrespective

of the degree of asymmetry among countries. In contrast, if governments move sequentially, the

Stackelberg leader may be able to avoid being stuck at the bottom. The leader may act as a

“wise chicken,”imposing a higher carbon tax than the follower such that all production plants

of the home firm move to the follower (total relocation of firms).

Under the BCA regime, we show that a Nash equilibrium may not exist, though it exists

when the potential gains from cooperation would be large. If the Nash equilibrium exists, a

BCA policy is an effective measure to eliminate the “race to the bottom,”resulting in higher

taxes, higher global welfare, and lower global emissions, though global welfare falls short and

global emissions exceed those in the social optimum. The location equilibrium entails partial

relocation of plants from the more to the less environmentally concerned country. Thus, BCAs

do not avoid entirely the relocation of firms but reduce a government's concern that plants will

leave its country. Tariffs on imports allow for better control of global emissions, raise revenues,

and generate higher profits, even if some production facilities have moved abroad. Moreover,

the foreign government also knows that it will never attract all plants and that the tariff

eliminates the tax differential. Hence, BCAs do not only lead to a higher tax at home but also

abroad and thus to lower global emissions. In addition, in the sequential game, BCAs do not

only avoid the “race to the bottom”but also the alternative that all production facilities move

abroad. Thus, BCAs avoid that the environmentally concerned country has only the choice

between two bad alternatives.

3

Article XX provides general exceptions for the adoption of certain policy measures which are not compatible with

WTO rules, but are necessary to protect the environment. Although these exceptions could be used to justify BCAs on

imports, there are no exceptions under the SCM Agreement.

4

https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3661.

5

The assumption of sequential policy choices is common in the tax competition literature (e.g., Baldwin & Krugman,

2004; Borck & Pflüger, 2006; Groenert & Zissimos, 2013; Wang, 1999), also for the same reasons as assumed in our

paper.

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