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1 econtor Make Your Publication Viible A Service of Wirtchaft Centre zbwleibniz-informationzentrum Economic Böhringer, Chritoph; Bye, Brita; æhn, Taran; oendahl, Knut Einar Working Paper Output-baed rebating of carbon tae in the neighbor' backyard Oldenburg Dicuion Paper in Economic, No. V Provided in Cooperation with: Univerity of Oldenburg, Department of Economic Suggeted Citation: Böhringer, Chritoph; Bye, Brita; æhn, Taran; oendahl, Knut Einar (2015) : Output-baed rebating of carbon tae in the neighbor' backyard, Oldenburg Dicuion Paper in Economic, No. V Thi Verion i available at: Standard-Nutzungbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wienchaftlichen Zwecken und zum Privatgebrauch gepeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich autellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfaer die Dokumente unter Open-Content-Lizenzen (inbeondere CC-Lizenzen) zur Verfügung getellt haben ollten, gelten abweichend von dieen Nutzungbedingungen die in der dort genannten Lizenz gewährten Nutzungrechte. Term of ue: Document in EconStor may be aved and copied for your peronal and cholarly purpoe. You are not to copy document for public or commercial purpoe, to ehibit the document publicly, to make them publicly available on the internet, or to ditribute or otherwie ue the document in public. If the document have been made available under an Open Content Licence (epecially Creative Common Licence), you may eercie further uage right a pecified in the indicated licence.

2 Oldenburg Dicuion Paper in Economic Output-baed rebating of carbon tae in the neighbor backyard Chritoph Böhringer Brita Bye Taran æhn Knut Einar oendahl V June 2014 Department of Economic Univerity of Oldenburg, D Oldenburg

3 Chritoph Böhringer, Brita Bye, Taran æhn, and Knut Einar oendahl Output-baed rebating of carbon tae in the neighbor backyard Competitivene, leakage and welfare Abtract: We invetigate how carbon tae combined with output-baed rebating (OB) in an open economy perform in interaction with the carbon policie of a large neighboring trading partner. Analytical reult ugget that whether the purpoe of the OB policy i to compenate firm for carbon ta burden or to maimize welfare (accounting for global emiion reduction), the econd-bet OB rate hould be poitive in mot cae. urther, it hould fall with the introduction of carbon taation in the neighboring country, particularly if the neighbor refrain from OB. Numerical imulation for Canada with the US a the neighboring trading partner, indicate that the impact of US policie on the econd-bet OB rate will depend crucially on the purpoe of the dometic OB policie. If the aim i to retore the competitivene of dometic emiion-intenive, trade epoed (EITE) firm at the ame level a before the introduction of it own carbon taation for a given US carbon policy, we find that the dometic optimal OB rate are relatively inenitive to the foreign carbon policie. If the aim i to compenate the firm for action taken by the US following a Canadian carbon ta, the neceary dometic OB rate will be lower if alo the US regulate it emiion, particularly if the US refrain from OB. If the goal i rather to increae the efficiency of Canadian policie in an economy-wide ene by accounting for carbon leakage, the US policie have but a minor reducing impact on dometic optimal OB rate. Keyword: carbon leakage, econd-bet optimal carbon policie, output-baed rebate JEL claification: Q43, Q54, 2, D61 Acknowledgement: While carrying out thi reearch, all the author have been aociated with CEE - Olo Centre for eearch on Environmentally friendly Energy. The CEE Centre acknowledge financial upport from The eearch Council of Norway, Univerity of Olo and uer partner. inancial upport from the European Community Seventh ramework Programme (P7/ ) under grant agreement No and from Stiftung Mercator (ZentraClim) i alo acknowledged. Addre: Chritoph Böhringer, Department of Economic, Univerity of Oldenburg, Germany. chritoph.boehringer@uni-oldenburg.de Brita Bye, Statitic Norway, eearch Department. brita.bye@b.no Taran æhn, Statitic Norway, eearch Department. taran.faehn@b.no 1

4 Knut Einar oendahl, Norwegian Univerity of Life Science, School of Economic and Buine. 2

5 Sammendrag Vi analyerer hvor effektivt produkjonubidier (Output-Baed ebating, OB) til peielt utatte ektorer kan kompenere for de negative effektene innenlandke karbonkatter har på konkurraneevne, karbonlekkajer og velferd. Speielt underøker vi hvordan karbonpolitikken ho viktige handelpartnere virker inn på effektiviteten til den innenlandke OB-politikken. Vi utleder analytike reultater i en global, partiell markedmodell for energiinteniv, konkurraneutatt indutriprodukjon. Deretter underøker vi ved hjelp av en numerik global likevektmodell hvilken betydning klimapolitikken til USA, om den viktige handelpartneren, har for OB-politikken til Canada. Den numerike modellen tar henyn til flere effekter og mekanimer enn den analytike. Konekvenene av viktige handelpartnere karbonpolitikk på OB-politikken til et mindre land, vil avhenge av formålet med OB-politikken. Derom målet er å motvirke konkurraneevnefallet om følge av egen karbonpolitikk, finner vi at den nødvendige innenlandke OB-raten i Canada tilfelle er lite enitiv for USA karbonpolitikk. På den annen ide, derom formålet med OB-politikken er å kompenere for totaleffekten av både nabolandet og egen politikk, vil innføring av karbonpolitikk i USA reduere behovet for drive egen OB-politikk, ærlig derom USA avtår fra OB-politikk. Om formålet med den innenlandke OB-politikken narere er å makimere den totale velferden for landet, vil myndighetene måtte veie kotnader og gevinter ved OB-politikken opp mot hverandre. Den viktigte kotnaden vil normalt knytte eg til OB-ubidien privridende effekt i markedene for energiintenive, konkurraneutatte varer. Den viktigte gevinten for et lite land om ønker å oppnå globale utlippredukjoner, vil være at karbonlekkajene blir mindre. I tillegg kan det opptå bytteforholdeffekter derom landet er tort nok til å påvirke verdenmarkedpriene. Die vil normalt være negative iden ekportpriene faller om følge av OB-politikk. De kan imidlertid bli poitive, derom landet er av en vi tørrele og importerer mye energiintenive varer om faller i pri. De Statitic Norway Abtract with downloadable Dicuion Paper in PD are available on the Internet: ISSN X (electronic) 3

6 teoretike reultatene vier at den innenlandke OB-raten vanligvi vil være poitiv, men falle derom nabolandet innfører karbonkatt og dermed får lavere utlippintenitet. Dette finner vi ogå numerik, men fallet er neglijerbart. Velferdeffekter er i det hele tatt ikke ut til å være et viktig henyn i valget av OB-politikk for Canada. 4

7 1. Introduction In the abence of effective world-wide cooperation to curb global warming, ome countrie have introduced national or regional climate policie uch a unilateral carbon emiion pricing. owever, a the climate problem i global, unilateral action lead to carbon leakage, i.e., the relocation of emiion to countrie with no or more lenient emiion regulation. Carbon leakage counteract the mitigating impact on climate change. A ingle country cannot directly regulate emiion outide it territory, but can alleviate the welfare cot of leakage by econd-bet policie. Theory ugget border carbon meaure that impoe tariff on the carbon embodied in import and ta rebate for the carbon embodied in eport (Markuen, 1975; oel, 1996). owever, uch countermeaure are controverial from the free trade perpective and may not comply with the WTO law ee Böhringer et al. (2012) for a dicuion. Another unilateral countermeaure i to rebate emiion-intenive firm for their ta payment in proportion to their output, o-called Output-Baed ebating (OB) (Bernard et al., 2007). OB rule alo raie trade regulation iue and may be harmful according to WTO, but to a leer degree than border carbon meaure (icher and o, 2012; Branger and Quirion, 2013). owever, they are alo likely to be le effective againt carbon leakage (Böhringer et al., 2014). icher and o (2012) conclude that OB for elected energy-intenive indutrie can neverthele be a legally feaible and relatively effective ubtitute for the more controverial border meaure. rom an economy-wide perpective the optimal choice of OB rate will depend on the achievement in term of global abatement, i.e. when accounting for carbon leakage. or the cae of emiion trading intead of carbon taation Böhringer and Lange (2005) and Monjon and Quirion (2011) ugget o-called outputbaed allocation (OBA) of free quota. OBA will function quite imilarly to OB in the cae of carbon taation. The other concern for government apiring to conduct unilateral policie i the potential competitivene lo for dometic energy-intenive and trade-epoed indutrie. iver (2010) compare competitivene policie and ugget OBA of carbon quota for energy-intenive tradable to be a better option than other meaure in the cae of carbon pricing in Canada. Goulder (2001) find that rebating jut a maller fraction of emiion quota ignificantly alleviate the competitivene preure that originate from carbon pricing. Moreover, he conclude that the economy-wide welfare cot of the carbon policie become minor. Diou (2006) challenge thi concluion and argue that 5

8 when heterogeneity among carbon-intenive indutrie i accounted for competitivene concern are more eriou and countermeaure le effective. Thi paper contribute to the eiting literature by focuing on how carbon tae combined with OB in an open economy perform dependent on the carbon policie of a larger trading partner. We combine theoretical analyi with numerical imulation uing a global, regionalized computable general equilibrium (CGE) model with detailed repreentation of emiion-intenive, trade epoed (EITE) indutrie and energy upply ector. We look for econd-bet optimal OB-rate under different climate policie of the foreign trading partner, given that global emiion are of concern to the home country. urthermore, there may be trade-off between efficiency and competitivene concern that are important for policy deciion. ence, we alo take the perpective of individual indutrie, and eamine which OB-rate are required to utain competitivene in the form of utained initial output level, given different policie by the foreign trading partner. Our numerical eample i carbon pricing and OB in Canada and imilar policie in Canada large trading partner, the US. Competitivene concern have been on the forefront of the climate policy debate in Canada. A Peter and ertwich (2008) how, Canada trade i more emiion-intenive than the US. Canada high energy intenity, limited fuel-witch poibilitie and ignificant epoure to international market make climate policy a hot topic. Canada ha decided upon a climate action plan, called Turning the corner 1, for the current and forthcoming decade. It include intenity-baed policy regulation of emiion-intenive indutrie, i.e., indutry target for unit rather than total emiion. If tradable, uch unit emiion permit give imilar incentive to thoe of a combined emiion pricing and output-baed rebating ytem; ee iver and Jaccard (2010). Our finding can be readily tranferred to other, imilar policy regime and region that eit or are under conideration. Mot prominently, the EU Emiion Trading Sytem (EU ETS) ha practiced free allocation of emiion allowance for everal year, conditioned on the intallation output capacitie combined with the ector trade epoure and emiion payment. Similar cheme for EITE indutrie, but baed on output rather than intalled capacity, are under conideration in the US and Autralia and have been propoed in Japan or further reading about meaure dealing with carbon leakage and competitivene and propoed cheme in different region, ee, e.g., eilmayr and Bradbury (2011), Zhang (2012), and allegatte et al. (2013). 6

9 When evaluating the economy-wide welfare impact of OB policie, and to what etent competitivene and welfare concern overlap, there are everal factor to account for. In general, the econd-bet optimal rebate level will differ acro ector, a illutrated by Bernard et al. (2007). They how that ector that are highly epoed to leakage due to high degree of ubtitutability hould typically have a higher rebate rate, wherea ector with lower degree of ubtitutability hould have lower rate. They alo find that even if ome rebating i optimal, 100% rebating can be more cotly in term of the ocial planner welfare loe than no rebating. Other factor affecting optimal rate are term-of-trade effect and initial (ditorting) tae. Lenno and Nieuwkoop (2010) find ta interaction effect in the New Zealand economy that call for rate between zero and 100%, but in principle both term-of-trade and ta-interaction effect could drive the optimal OB rate above 100% or below zero. Alo, higher emiion intenitie abroad than dometically or (un-rebated) carbon ta pathrough from electricity or other emiion-intenive input will drive optimal rebate rate of the indutry upward, poibly above 100%. 3 Our theoretical analyi eplain how thee mechanim influence what OB rate to chooe by ingle economie in a partial equilibrium etting, where dometic firm interact with competitor abroad. The normative concluion depend on the policy objective purued by the dometic government. Competitivene concern tend to call for poitive, differentiated OB rate to compenate firm for carbon ta-induced profit loe, unle large offetting effect occur through reduced foreign price or increaed marginal production or abatement cot. With imilar reervation, dometic competitivene tend to benefit from a carbon ta while uffer from OB conducted by trading partner. If the political aim i, rather, to increae the efficiency of dometic policie, we till find that dometic OB rate hould be poitive when global abatement i poitively evaluated, unle termof-trade loe are ignificant. urther, we would epect the optimal OB rate to decreae with the carbon ta of influential neighbor, while their OB policy will normally have an ambiguou, but negligible effect. Our CGE imulation upplement the theoretical analyi with realitic parameter for different indutrie and account for comprehenive and comple price-reponive input-output tranmiion abent in the theoretical etting, a well a the interaction effect among the climate policie and eiting ditortion of the economy. Contrary to mot previou tudie, which conider 100% rebating (i.e., all ta payment paid by the indutrie i rebated back to the indutrie), we invetigate a broader range of OB rate. We find that neceary OB rate to compenate for competitivene loe due 3 The EU allow the member tate to compenate their EITE indutrie for higher electricity price triggered by the EU ETS. 7

10 to Canadian carbon policie differ ignificantly among the EITE indutrie, in accordance with the finding in Diou (2006). The key factor i the degree of ubtitutability between imported and dometic product. The impact of the foreign trading partner US policie will depend on the target of competitivene policie. If the aim i to retore the competitivene of dometic EITE firm at the ame level a before the introduction of it own carbon taation for a given US carbon policy, we find that more or le the ame Canadian OB ytem will be required irrepective of the US carbon policy regime. On the other hand, if the aim i to compenate the firm for action taken by the US following a Canadian carbon ta, the neceary dometic OB rate will be lower if the US regulate it emiion, particularly if the US refrain from OB. The numerical finding on Canadian carbon leakage and welfare-optimal OB rate motly confirm the reult from the analytical partial model. When the US introduce carbon taation Canadian carbon leakage drop. So doe it optimal OB rate, though only very lightly. Moreover, US OB policie have hardly any effect on the Canadian carbon leakage, nor on it optimal OB rate. An important finding i that welfare cot of deviating from the econd-bet optimal rate are found to be minor and are therefore of little guidance to practical OB policie. Even more importantly, enitivity analye reveal that the optimum rate i highly enitive to central parameter value, mot prominently, what i aumed about EITE product heterogeneity acro countrie (i.e. the highly uncertain Armington elatiicitie aigned to the EITE product). 2. Theoretical background Conider a home region, a foreign region and the ret of the world. The home region produce the good, the foreign region produce the good, and the ret of the world produce the good. The three good are aumed to be imperfect ubtitute. There i trade, and region j (j=,,) conume, j are p, p and p. j and j, o that j j j + + =. The international price of good, and j Cot of producing in region j are C j ( j,e j ), where e j i the emiion intenity (total emiion divided by total production). The cot function i aumed to be conve and increaing in j, while decreaing in e j. 8

11 9 We aume that the home region introduce a fied emiion ta σ, et equal to the marginal damage cot of emiion. 4 urthermore, we aume that the home region conider rebating (part of) the emiion payment through an output-baed rebate (ubidy). 2.1 Effect on home production of home and foreign carbon policie irm in the home region maimize profit, π : (1) e e C p σ π + = ), ( w.r.t. and e : irt order condition are a follow: (2) e C p + = σ / (3) e C σ = / Eq. (2) tate that optimal production enure that the price cover marginal production cot plu net marginal payment to the regulator (emiion payment minu the ubidy). Eq. (3) tate that the marginal cot of reducing the emiion intenity hould equalize the marginal gain of reduced emiion payment, i.e., the carbon price multiplied with output. Market equilibrium for the home product i given by: (4) ( ) ( ) ( ) p p p p p p p p p,,,,,, + + =. Let u firt conider the effect on home production of introducing dometic carbon policie, coniting of a carbon ta σ >0 and an output-baed rebate >0. We differentiate eq. (4) and rearrange: (5) ) )( ( ) )( ( ) )( ( ' ' ' ' ' ' ' ' ' d p d p d p d p d p d p d = σ σ σ σ σ σ 4 ere we mean the marginal damage cot of emiion, a perceived by the home region.

12 where ' ji j i = p, (j,i=,,) denote the direct and cro price effect on demand. The firt term in eq. (5) contain in it firt bracket the direct price derivative that are all negative. To eamine it econd bracket we ue the derivative of the firt order condition in eq. (2): (6) p C e = + σ + e σ σ σ and p C e (7) = + σ 1, where C C =. In eq. (6), the lat term repreent the direct effect on the home price of introducing a carbon ta. It i poitive and more o the higher i the emiion intenity. In mot realitic cae, the ign of eq. (6) will be poitive, a thi price-increaing effect i likely to dominate the two other indirect, and probably counteracting, effect: The econd term capture the fact that the emiion intenity i likely to fall with the carbon ta, thu modifying emiion payment. The firt term depend on the cale elaticity. With decreaing return, marginal cot will increae with the output cale. Eq. (7) epree the home price effect of introducing an output ubidy in home (OB). The direct effect of uch an output ubidy i of coure negative (lat term). Again, the two remaining effect are likely to modify but not offet the direct effect. They both depend on the cale economie. With increaing marginal cot, the firt term reflect increaed cot a output increae, and the econd reflect increaed emiion intenity that alo relate to increaing marginal cot. The econd and third term in eq. (5) are the cro price effect on dometic demand through change in price abroad. In thee two term, the firt bracket epree the poitive effect on the demand for the home good within all three market of higher price of the and product, repectively. The econd bracket of the econd and third term capture the price change, which tend to move in the ame direction a the dometic price. Thu, the indirect effect (captured by the econd and third term) will modify the direct price effect on output of the home product. The indirect effect will be tronger the cloer ubtitute the product of and are to the dometic product. owever, for ufficiently mall home countrie dometic carbon policie will not be able to affect foreign price, i.e., p p p p = = = = 0. σ σ 10

13 We can now conclude that the direct effect of carbon taation reduce output by increaing the cot of d emiion, and it i tronger the larger i the emiion intenity: < 0 dσ. Introducing OB ha a d direct favorable output effect: > 0. Additional effect do, however, occur through d a) foreign price change in the ame direction a for home price if the good are ubtitute and the home country i ufficiently large, b) marginal cot adjutment in the ame direction a output cale if there are decreaing return, c) abatement and, thu, lower emiion payment a a reult of the carbon ta. Net, we invetigate how dometic production depend on the carbon policie in the foreign region. 5 We conider both a ole introduction of a carbon ta, σ, which may or may not equal the home ta, σ, and the upplementation with an OB rate,. Similar firt order condition and market equilibrium a in eq. (2)-(4) for the home product carry over to the foreign product. We can then epre the total effect of both home and foreign carbon tae and OB (auming no carbon policie in ret of the world) by totally differentiating equation (4). To implify the dicuion we aume that both countrie are ufficiently mall to diregard price effect on the other product. earranging, we get: d = ' + ' + ' p d p + dσ p p + (8) ( ) ( ) σ σ + ' + ' + ' d dσ The firt term in equation (8) and the firt bracket in the econd term are recognizable from equation (5). The lat bracket repreent the price effect on good of the carbon policie in region. The price effect in the foreign region of foreign policie will have analogou channel and ign a the p correponding price effect in the home country, i.e., the likely net effect are > 0 and σ p < 0. 5 So far we have aumed that emiion intenitie in region and are eogenou given that thee countrie do not adopt emiion control policie. Thi aumption i relaed now for region undertaking dometic emiion regulation. 11

14 It then follow that introducing a carbon ta in the foreign country ha a poitive, direct effect on the output of the home product, and more o the higher the emiion intenity in and the larger i the enitivity of the demand for the dometic good to the price of the foreign good. The direct contribution of OB in the foreign region i to reduce the home output. Thee direct mechanim d dominate o that > 0 dσ ee a) to c) above. d and < 0, but imilar additional effect a for dometic policie apply; d Though the ign of the variou partial and net effect are not urpriing, the relative trength of the variou factor will vary from indutry to indutry depending on the indutry-pecific characteritic. The dicuion above will therefore be helpful for undertanding the variation acro heterogeneou indutrie in our numerical analyi; ee ection Second-bet optimal OB policie with no foreign carbon policie We now earch for the optimal level of in the home region, auming firt that there i no climate policy in the two other region and. The firm behavior in region i given by (1) to (3) above. Welfare in the home region i given by: (9) W = U (,, ) C (, e ) p p + p + p σ ( e + e + e ) where U denote conumption utility in the home region. Note that we aume the home region to alo care about global emiion valued at the carbon ta σ. We now maimize W with repect to, noting that all variable are function of. After rearranging, we then get: (10) W / = p ( C / ) σ e ( / ) ( C / e ) + σ ( e / ) ( ) ( p / ) ( p / ) + ( p / ) + σ e ( / ) + e ( / ) = 0 j j where we ue (4) and the relationhip U / = p, j=,,. Uing eq. (2) the firt quare bracket equal - and uing eq. (3) the econd quare bracket equal zero. We then get the following epreion for the econd-bet optimal dometic ubidy rate: 12

15 / / p / p / p / (11) σ e e = + ( ) + + / / / / / The three lat term in eq. (11) are term-of-trade effect. If thee are negligible, we ee that the optimal home ubidy rate hould equal the value of the avoided emiion abroad (with unit value σ ) when dometic production increae marginally. Note that a poible rie in the dometic emiion intenity caued by OB i not of importance to the optimal OB rate, becaue on the margin the ubequent rie in abatement cot will be eactly offet by the reduction in emiion payment (ee eq. (3)). The decreae in foreign emiion depend on the emiion intenitie in region and, a well a the enitivity of production in thee two region with repect to change in home production, which again depend on how well they ubtitute the home product in demand. The change in dometic, foreign and ret-of-the-world output a a conequence of change in in the home ubidy rate are determined by the ame factor a dicued in Section 2.1. We notice that in the pecial cae where emiion intenitie are the ame in all region (e = e = e ), and production decreae in and equal the production increae at home ( / = / / ), the optimal ubidy rate would be = σ e. That i, the emiion payment are fully rebated to the firm (in aggregate) through the ubidy payment thi i often referred to a full or 100% rebating. 100% rebating i the tandard way of modeling outputbaed rebate (OB) and we will refer to thi a the ubidy rate *. The ubtitution effect, i.e., the fraction j / / (j=,), will typically be poitive but jointly lower than one, both becaue the three good are imperfect ubtitute and becaue marginal cot will tend to be increaing. On the other hand, if the emiion intenitie are lower in the home region than in the foreign and ret-of-the-world region, the optimal ubidy rate increae. A long a we conider climate policy in the home region only, emiion intenitie abroad will tend to eceed intenitie at home. ence, we cannot rule out the poibility that may eceed *. What about the term-of-trade effect? A dicued in Section 2.1, the ubidy will increae output of the home good, and a the three good are ubtitute, all price will fall. Thu, the two firt term-oftrade term are poitive (lower import cot), while the lat term i negative (lower eport revenue). The price fall of the dometic good will tend to be larger than the price fall of the product from abroad (ince the latter price are only indirectly affected), in which cae the overall term-of-trade 13

16 effect become negative. owever, if the home region i a net importer of the three good (in aggregate) the compoite term-of-trade effect may be poitive. The cloer ubtitute the good are, the more will import price drop which contribute poitively to dometic welfare. In other word, term-of-trade effect can imply optimal OB rate that are either negative or larger than 100%. or a mall-ized open economy, the term-of-trade effect will tend to be inferior relative to the emiion effect (i.e., the firt term of eq. (11)). To implify our epoition, we will hence diregard term-oftrade effect in the remaining analyi of thi ection. 2.3 Second-bet optimal dometic OB rate in preence of foreign carbon policie When eploring the enitivity of the optimal ubidy rate with repect to the carbon policie in the foreign region, we conider two alternative: i) The foreign region introduce a carbon ta σ, which may or may not equal the emiion ta at home, σ. ii) The carbon ta σ i upplemented with rebating through an output ubidy. j We differentiate eq. (11) with repect to σ and j. We implify the epreion by denoting =, j=,,. A before, we aume that > 0,, < 0 and ( + ) <. Note that the emiion intenitie e and e now are endogenou, while e i till eogenou. We then get (after inerting for from eq. (11)): σ e d = σ (12) σ e + e e σ e e σ + e + e + e + e σ d dσ Let u firt conider only a carbon ta in region, dσ >0 and d =0. The term in front of the quare bracket i clearly poitive. Moving to the firt term inide the (firt) quare bracket, it i clear from Section 2.1 that the emiion intenity in a region decreae with the emiion price in that region. The term i therefore negative, meaning that the emiion reduction in region of uing diminihe. The three lat term in the quare bracket capture cale effect on the enitivity of output in the three region with repect to. A larger output cale i going to increae the output enitivity to. Since the negative impact of carbon pricing in i tronger on the output of than it poitive ubtitution effect on the two other good (ee Section 2.1), it i reaonable to epect that the 14

17 enitivity of with repect to drop more than the joint increae in the enitivity of and, i.e., σ < 0, while > 0 and > 0, where the firt effect i the larger. inally, we know from σ σ the dicuion of eq. (11) that < 0 for i=,, i.e., the dometic OB policy increae dometic i production at the epene of reduced production abroad. ence, we can conclude that the econd term i poitive and the two lat term are negative, but all three are dominated by the firt negative term. In um, carbon pricing in region will mot probably reduce the optimal ubidy in the home region. Aume, net, that region alo impoe an output ubidy, in addition to the carbon ta. Thi will only affect e to the degree that a firm optimal emiion intenity varie with output. In mot realitic cae, thi effect will be mall and poitive; ee Section 2.1. The effect of on (j=,,) will tend to be oppoite of the effect of σ dicued above, a we get a hift back to, from and. Still they will be of little ignificance. Overall, the effect on the optimal dometic OB rate of introducing OB in i ambiguou, but probably cloe to zero for realitic level of the foreign OB rate. j 3. Numerical model and data 3.1. Computable general equilibrium model or our quantitative economic impact analyi of OB rate we ue a three-region (USA, Canada, ret-of-the-world (ow)), multi-ector CGE model of global trade and energy etablihed for the analyi of greenhoue ga emiion control trategie (ee, e.g., Böhringer et al., 2010, for a detailed algebraic decription). CGE model build upon general equilibrium theory that combine behavioral aumption on rational economic agent with the analyi of equilibrium condition. They provide counterfactual e-ante comparion, aeing the outcome with a reform in place with what would have happened had it not been undertaken. The main virtue of the CGE approach i it comprehenive micro-conitent repreentation of price-dependent market interaction in a etting with variou, eiting public intervention. The imultaneou eplanation of the origin and pending of the agent' income make it poible to addre both economy-wide efficiency a well a ditributional impact of policy reform. 15

18 Our model feature a repreentative agent in each region that receive income from three primary factor: labor, capital, and foil fuel reource. Labor and capital are interectorally mobile within a region but immobile between region. oil-fuel reource are pecific to foil fuel production ector in each region. Production of commoditie other than primary foil fuel i captured by threelevel contant elaticity of ubtitution (CES) cot function decribing the price-dependent ue of capital, labor, energy and material (KLEM). At the top level, a CES compoite of intermediate material demand trade off with an aggregate of energy, capital, and labor ubject to a contant elaticity of ubtitution. At the econd level, a CES function decribe the ubtitution poibilitie between intermediate demand for the energy aggregate and a value-added compoite of labor and capital. At the third level, capital and labor ubtitution poibilitie within the value-added compoite are captured by a CES function wherea different energy input (coal, ga, oil, and electricity) enter the energy compoite ubject to a contant elaticity of ubtitution. In the production of foil fuel, all input, ecept for the ector-pecific foil fuel reource, are aggregated in fied proportion. Thi aggregate trade off with the ector-pecific foil fuel reource at a contant elaticity of ubtitution. inal conumption demand in each region i determined by the repreentative agent who maimize welfare ubject to a budget contraint with fied invetment (i.e., a given demand for aving) and eogenou government proviion of public good and ervice. Total income of the repreentative agent conit of net factor income and ta revenue. Conumption demand of the repreentative agent i given a a CES compoite that combine conumption of compoite energy and an aggregate of other (non-energy) conumption good. Subtitution pattern within the energy bundle a well a within the non-energy compoite are reflected by mean of CES function. Bilateral trade i pecified following the Armington differentiated good approach, where dometic and foreign good are ditinguihed by origin (Armington, 1969). All good ued on the dometic market in intermediate and final demand correpond to a CES compoite that combine the dometically produced good and the imported good from other region. A balance of payment contraint incorporate the bae-year trade deficit or urplu for each region. CO 2 emiion are linked in fied proportion to the ue of foil fuel, with CO 2 coefficient differentiated by the pecific carbon content of fuel. etriction to the ue of CO 2 emiion in production and conumption are implemented through eogenou emiion contraint or (equivalently) CO 2 tae. CO 2 emiion abatement take place by fuel witching (interfuel 16

19 ubtitution) or energy aving (either by fuel-non-fuel ubtitution or by a cale reduction of production and final conumption activitie) Data Our CGE analyi of econd-bet optimal rebate rate i baed on the mot recent verion of the Global Trade, Aitance and Production (GTAP) databae which include detailed national account on production and conumption (input output table) together with bilateral trade flow and CO 2 emiion for the year 2007 (verion 8 of GTAP ee Narayanan et al., 2012). GTAP can be fleibly aggregated toward a compoite dataet that account for the pecific requirement of the policy iue under invetigation. A to regional diaggregation we contrain ourelve to three region: Canada, USA and a compoite of all other region (ret of the world OW). A to ectoral diaggregation our compoite dataet include all major primary and econdary energy carrier: coal, crude oil, natural ga, refined oil product (OIL), and electricity. Thi diaggregation i eential in order to ditinguih energy good by CO 2 intenity and the degree of ubtitutability. In addition, we eparate the main emiion-intenive and trade-epoed (EITE) ector: chemical product (CP), non-metallic mineral (NMM), iron and teel product (I_S), and non-ferrou metal (NM), a they will be potentially mot affected by emiion control policie and therefore are the prime candidate for compenatory meaure uch a OB. 6 The remaining indutrie covered in our dataet include tranport ector, fihing, agriculture, paper, pulp and print, a well a a compoite ector of all remaining manufacturer and ervice. or model parameterization, we follow the tandard calibration procedure in applied general equilibrium analyi: the bae-year input-output data determine the free parameter of the functional form (cot and ependiture function) uch that the economic flow repreented in the data are conitent with the optimizing behavior of the model agent. The repone of agent to price change are determined by a et of eogenou elaticitie taken from the pertinent econometric literature. Elaticitie in international trade (Armington elaticitie) indicate the ubtitutability between varietie of each good between the three region, which i a key characteritic in the analyi. Thee Armington elaticitie are motly taken from the GTAP databae. 7 The GTAP databae alo provide ubtitution 6 Note that refined oil product (oil) alo claifie a EITE indutry. 7 We have increaed the Armington elaticity between dometic and foreign good from 2.1 to 4.0 for refined oil (OIL). Balitreri et al. (2010) etimate even higher elaticitie for a range of oil product, o our choice i a compromie between the GTAP number and Balitreri et al. (2010) finding. A i evident below, the Armington elaticitie for the EITE ector are crucial for the optimal OB-rate (Armington elaticitie for the other EITE ector are between 3.0 and 4.2). In addition, the elaticity for natural ga ha been reduced from 11.9 to 2.0, due to the importance of infratructure for tranporting thi energy good. 17

20 poibilitie in production (between primary factor input). The elaticitie of ubtitution in foil fuel ector are calibrated to match eogenou etimate of foil-fuel upply elaticitie (Graham et al., 1999; Krichene, 2002). 4. Numerical imulation We conider the effect of implementing carbon tae, combined with OB to the EITE indutrie in Canada. The OB cheme rebate EITE ector a percentage rate of each ector emiion payment. The rebate to a pecific firm i proportional to the firm output level. Note that an OB rate of 100% i the ame a * ection 2. We eamine different OB rate ( / * ) and are intereted in how the effect of OB may change if Canada mot important trading partner USA alo implement carbon tae with OB. We quantify effect on competitivene of individual EITE indutrie, carbon leakage, and welfare. In order to derive conitent welfare impact we need to put a value (price) on change in global emiion, cf. the theoretical analyi in ection 2. We aume that Canada value global emiion change by the carbon price it impoe. In our main cenario, thi ta rate i aumed to be 30 USD per ton of CO 2. 8 Note that in our graphical epoition of reult below we refer to Canadian climate policy along the - ai, i.e., the entry BaU indicate no climate policy regulation in Canada, wherea the entry 0 indicate an emiion ta of 30 USD per ton of CO 2 with a zero OB rate. A we move to the right on the -ai we adopt increaingly higher OB rate for dometic (Canadian) EITE indutrie. We meaure the impact of variation in the Canadian climate policy deign for three alternative policy cenario in the USA: i) BaU (no carbon policy), ii) carbon ta of 30 USD per ton of CO 2 without OB, and iii) carbon ta of 30 USD per ton of CO 2 with 100% OB. Along the y-ai we meaure the effect relative to the cenario where both Canada and the US have no carbon policy (BaU-BaU). 4.1 Effect on the competitivene of EITE-indutrie irt, we look at how output of the EITE indutrie a a proy for competitivene i affected by dometic and foreign policie. Competitivene of dometic EITE ector i of major concern to 8 Thi value i in line with global marginal cot etimate for 2020 of meeting the two degree target of the 2010 Cancun UNCCC agreement in, e.g., IEA (2012) and Nordhau (2010), but fall in the lower range of the interval reported by WGIII report of IPCC (2014). 18

21 countrie contemplating unilateral climate policy. Output and employment loe in influential EITE indutrie may be critical for the political feaibility of unilateral action. igure 1. Output effect for Canadian EITE indutrie (in % from BaU) under different dometic OB rate and three alternative aumption about US climate policy % US: BaU US: Ta & No OB US: Ta & 100% OB BaU OB-rate Canada (%) igure 1 how that if Canada unilaterally implement a carbon ta without any OB, it EITE output drop by 3.6%. urther, while upplementing the carbon ta with OB lead to le EITE reduction, we ee that a 100% OB doe not retore competitivene, in term of reaching the initial output level. Thi hold acro all the US policy regime. The compenatory effectivene for Canada of OB i approimately the ame in all the US regime depicted by the three curve in igure 1. owever, thi doe not imply that US policy i irrelevant for Canada OB deciion. Compared to a benchmark with no policy in either country, retoring Canadian output by mean of OB will be le trenuou if the US alo introduce a carbon ta, a the output fall i reduced by 1.2 percentage point. Thi relief will, however, be halved if the US imultaneouly add a 100% OB. The numerical CGE analyi allow u to invetigate output impact at a more diaggregate level and thereby identify thoe pecific indutrie that might be in particular adverely affected in competitivene. igure 2a and 2b how the output effect for the five different EITE indutrie. irt, we notice that the output effect of a unilateral carbon ta in Canada vary quite ubtantially acro the EITE ector, in accordance with the reult of Diou (2006). Our imulation how that output of 19

22 refined oil (OIL) and non-ferrou metal (NM) drop by 6.7% and 4.5%, repectively, wherea the remaining EITE indutrie face more moderate contraction, the mallet een for non-metal mineral (NMM) with a decline of merely 0.7%. A predicted by the theory model, the main eplanation i to be found in their different emiion intenitie. The numerical model alo account for input-output effect, which tend to increae the competitivene loe for many of the EITE indutrie. OIL i hit on the output ide by a fall in demand for tranportation and heating activitie. On the input ide, higher electricity price affect everal EITE indutrie markedly; moreover, ome EITE indutrie ue ubtantial amount of other EITE good a intermediate input. Conitent with the theory model foreign price, particularly thoe in the US, increae along with Canada (effect a) in 2.1). A oppoed to the theory model, however, the foreign price effect do not only dampen dometic output reduction, a the EITE indutrie ue import, which now become more epenive, a input. We find that the effect of rebating carbon ta payment are alo quite different acro ector. While iron and teel (I_S), chemical (CP) and non-metallic mineral (NMM) all return more or le to their BaU ouput level when rebating i 100%, thi i far from the cae for OIL and NM. Again the eplanation lie in the input-ouput relationhip. Both the latter indutrie face increaed input price, of crude oil and electricity, repectively. Thee effect are found in the cae when the US conduct BaU policie, and they alo hold under alternative aumption about US policie: The neceary OB rate to retore output effect at the indutry-pecific Canadian BaU level are not noteworthily affected by the US regime for thee indutrie. owever, compared to a benchmark where neither country ue carbon policie, the dometic output contraction in I_S and CP caued by Canada own emiion ta can be omewhat, but not fully, compenated by a imilar ta in the US. Thu, additional compenation by dometic OB policie will be le needed. The effect of US policie vary coniderably from indutry to indutry, a epected from the variety of effect identified in the theoretical analye in Section 2. The different US impact on Canadian indutrie are eplained by the US indutry-pecific, input-output-corrected emiion intenitie, the degree of heterogeneity between Canadian and foreign good, a well a by how dominant the US i a a trading partner. The mot marked eample i een for the NMM indutry, where introduction of a US ta rate equal to the Canadian ha tronger effect on Canadian NMM output than ha the Canadian ta, i.e. US taation more than compenate for the competitivene lo. Thi i driven by a much higher emiion intenity for thi indutry in the US than in Canada. OIL, on the other hand, i very little compenated by a US ta. Thi reflect that upply of refined oil product mainly come from dometic producer, and the US i not a particularly important trade partner. or the 20

23 remaining EITE indutrie the US ta roughly biect the output drop caued by the unilateral Canadian ta. We alo ee that when the US combine the carbon ta with full OB thi ubtantially counteract the US ta effect for Canadian NMM producer, while it ha relatively little impact on Canadian NM producer. Thi mirror the oberved counteracting effect of Canadian OB policie, and again, a reaon i that OB doe not compenate well for the indirect taation via the input-output effect. A for all indutrie, the direct effect of Canadian OB and US OB on the Canadian OIL indutry are in oppoite direction, however, they alo affect the global crude oil price, and thi effect i poitive irrepective of whether Canadian or US demand i timulated by OB policie. Thi indirectly dampen the poitive output effect of Canadian OB, while reinforce the negative effect of US OB. igure 2a. Output effect (in % change from BaU) in Canadian refined oil product (OIL) and non-ferrou metal (NM) under different dometic OB rate and three alternative aumption about US climate policy 21

24 igure 2b. Output effect (in % change from BaU) for Canadian chemical product (CP), nonmetallic mineral (NMM) and iron and teel (I_S) under different dometic OB rate and three alternative aumption about US climate policy 4.2 Effect on carbon leakage igure 3 how that carbon leakage repond markedly to change in dometic (Canadian) OB rate and alternative etting for foreign climate policy regulation in the US. 9 When climate policie in the US i abent, the carbon leakage from a Canadian carbon ta correpond to a rate of 13.9%. Thi i gradually reduced to 11.8% a Canada raie it OB rate toward full OB. When the US ha a carbon ta, leakage due to Canadian climate policie fall by percentage point, compared to the ame Canadian policy in the US no-policy (BaU) regime. Canadian taation now caue larger cut in dometic emiion, a reduction take place from larger initital output and emiion cale (i.e. a cale effect a identified in effect b) in Section 2.1). Emiion increae abroad alo decline, becaue emiion intenitie in the US are lower and reduced leakage to the US i not fully offet by increaed leakage to the ow. igure 3 alo reveal that Canadian carbon policie in preence of a combined ta and full OB policy in the US caue virtually the ame leakage rate a under a US ta regime without OB. Emiion in all three region are only indirectly and 9 The Canadian leakage rate i meaured a the emiion increae abroad (US and ow) over the emiion reduction in Canada. 22

25 inignificantly affected, a eplained in ection 2.1. In particular, leakage to the US doe not repond to US OB policy, becaue US emiion intenitie tay fairly unaffected. Scale effect in all three region are alo weak. igure 3. Carbon leakage due to Canadian climate policie under different dometic OB rate and three alternative aumption about US climate policy 14.0 % US: BaU US: Ta & No OB US: Ta & 100% OB 13.5 % 13.0 % 12.5 % 12.0 % 11.5 % 11.0 % OB-rate Canada (%) 4.3 Welfare impact of dometic OB policie Welfare effect of Canadian and US carbon policie are depicted in igure 4. Welfare i meaured in term of the ickian equivalent variation in income, denoting the amount which i neceary to add to (or deduct from) the benchmark houehold income to retore the benchmark utility level on the bai of e-ante relative price. The monetary value of reduced global emiion i then added. 10 irt, we notice that introducing a Canadian carbon ta equal to it perceived marginal value of global abatement (here: 30 USD per ton of CO 2) increae dometic welfare. Thi i not urpriing a average cot of reducing emiion typically are lower than marginal cot (i.e., the carbon ta). Net, we ee that the OB rate to EITE production that maimize welfare amount to 92% when Canada act 10 We add the value of the global emiion reduction from BaU (welfare i additive in global emiion) in order to aure a coherent cro-comparion of cenario where global emiion differ. The fully integrated approach would be to model conumer utility of global emiion reduction, but thi would call for a major etenion toward an integrated aement framework. We ue 30 USD per ton of CO2, i.e., the carbon ta rate implemented, a the perceived marginal climate cot of carbon. 23

26 unilaterally. owever, we alo notice that welfare i virtually unaffected by the OB rate within the depicted range. Welfare conideration eem to be of little relevance to the choice of OB rate. Thi concluion alo hold if we diregard the value of reduced global emiion ince global emiion are only marginally affected by the OB rate. 11 One policy implication to draw from thi i that rebating policie at leat to ome degree can be determined out of other concern than aggregate welfare effect, uch a competitivene for trade-epoed indutrie. A poitive optimal OB rate i in line with our theoretical analyi cf. eq. (11). Output-baed rebate increae dometic EITE production at the epene of production abroad which lead to a reduction in leakage. The benefit of lower emiion abroad, however, mut be traded off againt the cot of ditortionary output ubidie. The latter cot alo include potentially advere term-of-trade effect for the dometic economy. Canada i a net eporter of EITE good, and rebating will tend to decreae the price of the rebated product. ence, eport revenue will decline. igure 4. Welfare change (in % change from BaU) in Canada under different dometic OB rate and three alternative aumption about US climate policy % US: BaU US: Ta & No OB US: Ta & 100% OB 83% % % OB-rate Canada (%) 11 Wherea global emiion are reduced by 0.255% in the No OB cenario for Canada, the reduction i 0.254% in the 100% OB cenario (auming here US BaU policy). 24

27 Turning to the effect of US policie, we firt oberve in igure 4 that US carbon taation ha a net poitive economic welfare impact on Canada that far outize the poitive impact of own OB policie. The welfare gain i moderated a abatement cot are tranmitted from the US to the Canadian economy, indicating the trong link between the two economie. igure 4 how that the optimal OB rate decline when the US introduce the carbon ta, though the numerical change i mall from 92% to 83%. A decline i epected from the theoretical dicuion of eq. (12) in Section 2.3, where the main identified eplanation wa a drop in the emiion intenity in the foreign country caued by the ta. The numerical OB reult i alo conitent with the carbon leakage impact een above: US taation lead to le carbon leakage triggered by Canadian climate policy a a reult of reduced emiion intenitie in the US. The theoretical dicuion in Section 2.3 concluded ambiguouly on the impact of US rebating on the Canadian optimal OB-rate. We find a light increae in the optimal Canadian OB rate to 87% when the US rebate 100% of it emiion ta payment to own EITE indutrie. The relatively modet reaction in optimal OB rate to change in US policie ugget that Canadian rebating policie can be determined quite independently of it large neighbor. Thi concluion i trengthened by the obervation above that the welfare impact for Canada are fairly inenitive to the dometic OB rate. A we will ee from the enitivity analyi below, other eternal factor than the US climate policie are of much more importance to the optimal Canadian OB policie. irt of all, we oberve a trong enitivity of the econd-bet optimal OB rate to the aumption about EITE product heterogeneity acro countrie, i.e. choice of Armington elaticitie. 4.4 Senitivity analyi The central parameter in our numerical analyi i the trade reponivene, captured by the Armington elaticitie of ubtitution between dometic and foreign product. If we aume that EITE product in different region ubtitute le eaily, we hould epect the optimal OB rate for Canada to decreae for two reaon a evident from eq. (11): irt, the emiion abroad would repond le to the OB policy of the home country and, econd, the term of trade would not improve a much due to le accentuated drop in foreign price. Thi i confirmed by the imulation if we decreae the ubtitution elaticity for OIL (one of the five EITE good) by 50% compared to our benchmark choice of 4.0, the optimal rebate rate drop to zero, irrepective of climate policy in the US. (In thi tet the elaticity of OIL i et to the default level for OIL in the GTAP databae; cf. footnote 7). 25