Disparate environmental regulations across nations have created challenges in meeting climate change goals set forth by international agreements such as Kyoto Protocol and the Paris Agreement. Based on the data from 1990-2020, the amount of carbon embedded in trade has a clear regional distribution, with Asia becoming a net exporter versus North America and Europe becoming net importers of carbon embedded in trade. Moreover, high-income nations are net importers of carbon and middle-income nations are net exporters of carbon via trade. Therefore, any efforts in limiting imported carbon via carbon tariff will meet with fair criticism and push back from countries at different developing stages. Hence, any efforts in reducing carbon leakage should be carefully designed to accommodate any development obstacles that developing nations might face. Revenue recycling and revenue transfers have been proposed as remedies to overcome any setbacks developing nations might face due to carbon border taxes. Such remedies are possible if nations band together, such as in ‘climate clubs’ prosed by Nordhaus in 2015.
This paper presents a General Equilibrium model which focuses on carbon leakage and transboundary pollution, along with a simulation exercise which studies the response of a carbon tariff in exporting industries in nations. Such responses could be in two ways. First, by reducing carbon intensity of the export sector of the nation. Second, by shifting production from one sector to another as result of the changes in comparative advantage due to the cost of carbon tariffs. The European Union recently proposed implementing a carbon border adjustment mechanism in the form of a carbon tariff on imports by 2026, in Energy Intensive Trade Exposed (EITE) industries, with a transitional phase from 2023-25. Therefore, this paper focuses in EITE industries in the simulation exercise for a selected sample of countries representing North America, Europe, and Asia.