A Carbon Leakage Mitigation Reform Strategy: The Role of Border Carbon Adjustments

This paper sheds light on the unidentified effects of unilateral environmental and trade actions within an international trade framework with two large open economies, transboundary pollution, and Public Pollution Abatement (PPA) activities. When private and public abatement coexists in the exporting country, stricter environmental policy by the importing one magnifies the carbon leakage effect. Pareto efficiency dictates that Border Carbon Adjustment (BCA) should account not only for the difference in carbon taxes between the two countries,
but also for the policy’s unintended consequences on PPA. More importantly, we argue that a conditional reduction of BCA, subject to stricter environmental policy by the country that exports the polluting good, decreases global pollution and increases countries’ welfare. Such reform strategy generates strong incentives for countries with laxer environmental policy to adopt a stricter one.