Christoph Böhringer, Brita Bye, Taran Fæhn, and Knut Einar Rosendahl

Transcription

1 Dicuion Paer No. 783, June 2014 Statitic Norway, eearch Deartment Chritoh Böhringer, Brita Bye, Taran æhn, and Knut Einar oendahl Outut-baed rebating of carbon tae in the neighbor backyard Cometitivene, leakage and welfare Abtract: We invetigate how carbon tae combined with outut-baed rebating (OB) in an oen economy erform in interaction with the carbon olicie of a large neighboring trading artner. Analytical reult ugget that whether the uroe of the OB olicy i to comenate firm for carbon ta burden or to maimize welfare (accounting for global emiion reduction), the econd-bet OB rate hould be oitive in mot cae. urther, it hould fall with the introduction of carbon taation in the neighboring country, articularly if the neighbor refrain from OB. Numerical imulation for Canada with the US a the neighboring trading artner, indicate that the imact of US olicie on the econd-bet OB rate will deend crucially on the uroe of the dometic OB olicie. If the aim i to retore the cometitivene of dometic emiion-intenive, trade eoed (EITE) firm at the ame level a before the introduction of it own carbon taation for a given US carbon olicy, we find that the dometic otimal OB rate are relatively inenitive to the foreign carbon olicie. If the aim i to comenate 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, articularly if the US refrain from OB. If the goal i rather to increae the efficiency of Canadian olicie in an economy-wide ene by accounting for carbon leakage, the US olicie have but a minor reducing imact on dometic otimal OB rate. Keyword: carbon leakage, econd-bet otimal carbon olicie, outut-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 uort from The eearch Council of Norway, Univerity of Olo and uer artner. inancial uort from the Euroean Community Seventh ramework Programme (P7/ ) under grant agreement No and from Stiftung Mercator (ZentraClim) i alo acknowledged. Addre: Chritoh Böhringer, Deartment of Economic, Univerity of Oldenburg, Germany. chritoh.boehringer@uni-oldenburg.de Brita Bye, Statitic Norway, eearch Deartment. brita.bye@b.no Taran æhn, Statitic Norway, eearch Deartment. taran.faehn@b.no Knut Einar oendahl, Norwegian Univerity of Life Science, School of Economic and Buine. knut.einar.roendahl@nmbu.no

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3 Sammendrag Vi analyerer hvor effektivt rodukjonubidier (Outut-Baed ebating, OB) til eielt utatte ektorer kan komenere for de negative effektene innenlandke karbonkatter har å konkurraneevne, karbonlekkajer og velferd. Seielt underøker vi hvordan karbonolitikken ho viktige handelartnere virker inn å effektiviteten til den innenlandke OB-olitikken. Vi utleder analytike reultater i en global, artiell markedmodell for energiinteniv, konkurraneutatt indutrirodukjon. Deretter underøker vi ved hjel av en numerik global likevektmodell hvilken betydning klimaolitikken til USA, om den viktige handelartneren, har for OB-olitikken til Canada. Den numerike modellen tar henyn til flere effekter og mekanimer enn den analytike. Konekvenene av viktige handelartnere karbonolitikk å OB-olitikken til et mindre land, vil avhenge av formålet med OB-olitikken. Derom målet er å motvirke konkurraneevnefallet om følge av egen karbonolitikk, finner vi at den nødvendige innenlandke OB-raten i Canada tilfelle er lite enitiv for USA karbonolitikk. På den annen ide, derom formålet med OB-olitikken er å komenere for totaleffekten av både nabolandet og egen olitikk, vil innføring av karbonolitikk i USA reduere behovet for drive egen OB-olitikk, ærlig derom USA avtår fra OB-olitikk. Om formålet med den innenlandke OB-olitikken narere er å makimere den totale velferden for landet, vil myndighetene måtte veie kotnader og gevinter ved OB-olitikken o mot hverandre. Den viktigte kotnaden vil normalt knytte eg til OB-ubidien rivridende effekt i markedene for energiintenive, konkurraneutatte varer. Den viktigte gevinten for et lite land om ønker å onå globale utliredukjoner, vil være at karbonlekkajene blir mindre. I tillegg kan det otå bytteforholdeffekter derom landet er tort nok til å åvirke verdenmarkedriene. Die vil normalt være negative iden ekortriene faller om følge av OB-olitikk. De kan imidlertid bli oitive, derom landet er av en vi tørrele og imorterer mye energiintenive varer om faller i ri. De teoretike reultatene vier at den innenlandke OB-raten vanligvi vil være oitiv, men falle derom nabolandet innfører karbonkatt og dermed får lavere utliintenitet. 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-olitikk for Canada. 3

4 1. Introduction In the abence of effective world-wide cooeration to curb global warming, ome countrie have introduced national or regional climate olicie uch a unilateral carbon emiion ricing. owever, a the climate roblem 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 imact on climate change. A ingle country cannot directly regulate emiion outide it territory, but can alleviate the welfare cot of leakage by econd-bet olicie. Theory ugget border carbon meaure that imoe tariff on the carbon embodied in imort and ta rebate for the carbon embodied in eort (Markuen, 1975; oel, 1996). owever, uch countermeaure are controverial from the free trade erective and may not comly with the WTO law ee Böhringer et al. (2012) for a dicuion. Another unilateral countermeaure i to rebate emiion-intenive firm for their ta ayment in roortion to their outut, o-called Outut-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 erective the otimal choice of OB rate will deend 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 oututbaed allocation (OBA) of free quota. OBA will function quite imilarly to OB in the cae of carbon taation. The other concern for government airing to conduct unilateral olicie i the otential cometitivene lo for dometic energy-intenive and trade-eoed indutrie. iver (2010) comare cometitivene olicie and ugget OBA of carbon quota for energy-intenive tradable to be a better otion than other meaure in the cae of carbon ricing in Canada. Goulder (2001) find that rebating jut a maller fraction of emiion quota ignificantly alleviate the cometitivene reure that originate from carbon ricing. Moreover, he conclude that the economy-wide welfare cot of the carbon olicie become minor. Diou (2006) challenge thi concluion and argue that 4

5 when heterogeneity among carbon-intenive indutrie i accounted for cometitivene concern are more eriou and countermeaure le effective. Thi aer contribute to the eiting literature by focuing on how carbon tae combined with OB in an oen economy erform deendent on the carbon olicie of a larger trading artner. We combine theoretical analyi with numerical imulation uing a global, regionalized comutable general equilibrium (CGE) model with detailed rereentation of emiion-intenive, trade eoed (EITE) indutrie and energy uly ector. We look for econd-bet otimal OB-rate under different climate olicie of the foreign trading artner, given that global emiion are of concern to the home country. urthermore, there may be trade-off between efficiency and cometitivene concern that are imortant for olicy deciion. ence, we alo take the erective of individual indutrie, and eamine which OB-rate are required to utain cometitivene in the form of utained initial outut level, given different olicie by the foreign trading artner. Our numerical eamle i carbon ricing and OB in Canada and imilar olicie in Canada large trading artner, the US. Cometitivene concern have been on the forefront of the climate olicy 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 oibilitie and ignificant eoure to international market make climate olicy a hot toic. Canada ha decided uon a climate action lan, called Turning the corner 1, for the current and forthcoming decade. It include intenity-baed olicy regulation of emiion-intenive indutrie, i.e., indutry target for unit rather than total emiion. If tradable, uch unit emiion ermit give imilar incentive to thoe of a combined emiion ricing and outut-baed rebating ytem; ee iver and Jaccard (2010). Our finding can be readily tranferred to other, imilar olicy regime and region that eit or are under conideration. Mot rominently, the EU Emiion Trading Sytem (EU ETS) ha racticed free allocation of emiion allowance for everal year, conditioned on the intallation outut caacitie combined with the ector trade eoure and emiion ayment. Similar cheme for EITE indutrie, but baed on outut rather than intalled caacity, are under conideration in the US and Autralia and have been rooed in Jaan. 2 1 htt://ublication.gc.ca/collection/collection_2009/ec/en e.df 2 or further reading about meaure dealing with carbon leakage and cometitivene and rooed cheme in different region, ee, e.g., eilmayr and Bradbury (2011), Zhang (2012), and allegatte et al. (2013). 5

6 When evaluating the economy-wide welfare imact of OB olicie, and to what etent cometitivene and welfare concern overla, there are everal factor to account for. In general, the econd-bet otimal rebate level will differ acro ector, a illutrated by Bernard et al. (2007). They how that ector that are highly eoed to leakage due to high degree of ubtitutability hould tyically 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 otimal, 100% rebating can be more cotly in term of the ocial lanner welfare loe than no rebating. Other factor affecting otimal rate are term-of-trade effect and initial (ditorting) tae. Lenno and Nieuwkoo (2010) find ta interaction effect in the New Zealand economy that call for rate between zero and 100%, but in rincile both term-of-trade and ta-interaction effect could drive the otimal OB rate above 100% or below zero. Alo, higher emiion intenitie abroad than dometically or (un-rebated) carbon ta athrough from electricity or other emiion-intenive inut will drive otimal rebate rate of the indutry uward, oibly above 100%. 3 Our theoretical analyi elain how thee mechanim influence what OB rate to chooe by ingle economie in a artial equilibrium etting, where dometic firm interact with cometitor abroad. The normative concluion deend on the olicy objective urued by the dometic government. Cometitivene concern tend to call for oitive, differentiated OB rate to comenate firm for carbon ta-induced rofit loe, unle large offetting effect occur through reduced foreign rice or increaed marginal roduction or abatement cot. With imilar reervation, dometic cometitivene tend to benefit from a carbon ta while uffer from OB conducted by trading artner. If the olitical aim i, rather, to increae the efficiency of dometic olicie, we till find that dometic OB rate hould be oitive when global abatement i oitively evaluated, unle termof-trade loe are ignificant. urther, we would eect the otimal OB rate to decreae with the carbon ta of influential neighbor, while their OB olicy will normally have an ambiguou, but negligible effect. Our CGE imulation ulement the theoretical analyi with realitic arameter for different indutrie and account for comrehenive and comle rice-reonive inut-outut tranmiion abent in the theoretical etting, a well a the interaction effect among the climate olicie and eiting ditortion of the economy. Contrary to mot reviou tudie, which conider 100% rebating (i.e., all ta ayment aid by the indutrie i rebated back to the indutrie), we invetigate a broader range of OB rate. We find that neceary OB rate to comenate for cometitivene loe due 3 The EU allow the member tate to comenate their EITE indutrie for higher electricity rice triggered by the EU ETS. 6

7 to Canadian carbon olicie differ ignificantly among the EITE indutrie, in accordance with the finding in Diou (2006). The key factor i the degree of ubtitutability between imorted and dometic roduct. The imact of the foreign trading artner US olicie will deend on the target of cometitivene olicie. If the aim i to retore the cometitivene of dometic EITE firm at the ame level a before the introduction of it own carbon taation for a given US carbon olicy, we find that more or le the ame Canadian OB ytem will be required irreective of the US carbon olicy regime. On the other hand, if the aim i to comenate 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, articularly if the US refrain from OB. The numerical finding on Canadian carbon leakage and welfare-otimal OB rate motly confirm the reult from the analytical artial model. When the US introduce carbon taation Canadian carbon leakage dro. So doe it otimal OB rate, though only very lightly. Moreover, US OB olicie have hardly any effect on the Canadian carbon leakage, nor on it otimal OB rate. An imortant finding i that welfare cot of deviating from the econd-bet otimal rate are found to be minor and are therefore of little guidance to ractical OB olicie. Even more imortantly, enitivity analye reveal that the otimum rate i highly enitive to central arameter value, mot rominently, what i aumed about EITE roduct heterogeneity acro countrie (i.e. the highly uncertain Armington elatiicitie aigned to the EITE roduct). 2. Theoretical background Conider a home region, a foreign region and the ret of the world. The home region roduce the good, the foreign region roduce the good, and the ret of the world roduce the good. The three good are aumed to be imerfect ubtitute. There i trade, and region j (j=,,) conume, j are, and. j and j, o that j j j =. The international rice of good, and j Cot of roducing in region j are C j ( j,e j ), where e j i the emiion intenity (total emiion divided by total roduction). The cot function i aumed to be conve and increaing in j, while decreaing in e j. 7

8 8 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 (art of) the emiion ayment through an outut-baed rebate (ubidy). 2.1 Effect on home roduction of home and foreign carbon olicie irm in the home region maimize rofit, π : (1) e e C σ π = ), ( w.r.t. and e : irt order condition are a follow: (2) e C = σ / (3) e C σ = / Eq. (2) tate that otimal roduction enure that the rice cover marginal roduction cot lu net marginal ayment to the regulator (emiion ayment minu the ubidy). Eq. (3) tate that the marginal cot of reducing the emiion intenity hould equalize the marginal gain of reduced emiion ayment, i.e., the carbon rice multilied with outut. Market equilibrium for the home roduct i given by: (4) ( ) ( ) ( ),,,,,, =. Let u firt conider the effect on home roduction of introducing dometic carbon olicie, coniting of a carbon ta σ >0 and an outut-baed rebate >0. We differentiate eq. (4) and rearrange: (5) ) )( ( ) )( ( ) )( ( ' ' ' ' ' ' ' ' ' d d d d d d d = σ σ σ σ σ σ 4 ere we mean the marginal damage cot of emiion, a erceived by the home region.

9 where ' ji = j i, (j,i=,,) denote the direct and cro rice effect on demand. The firt term in eq. (5) contain in it firt bracket the direct rice derivative that are all negative. To eamine it econd bracket we ue the derivative of the firt order condition in eq. (2): (6) C e = σ e σ σ σ and C e (7) = σ 1, where C C =. In eq. (6), the lat term rereent the direct effect on the home rice of introducing a carbon ta. It i oitive and more o the higher i the emiion intenity. In mot realitic cae, the ign of eq. (6) will be oitive, a thi rice-increaing effect i likely to dominate the two other indirect, and robably counteracting, effect: The econd term cature the fact that the emiion intenity i likely to fall with the carbon ta, thu modifying emiion ayment. The firt term deend on the cale elaticity. With decreaing return, marginal cot will increae with the outut cale. Eq. (7) eree the home rice effect of introducing an outut ubidy in home (OB). The direct effect of uch an outut ubidy i of coure negative (lat term). Again, the two remaining effect are likely to modify but not offet the direct effect. They both deend on the cale economie. With increaing marginal cot, the firt term reflect increaed cot a outut 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 rice effect on dometic demand through change in rice abroad. In thee two term, the firt bracket eree the oitive effect on the demand for the home good within all three market of higher rice of the and roduct, reectively. The econd bracket of the econd and third term cature the rice change, which tend to move in the ame direction a the dometic rice. Thu, the indirect effect (catured by the econd and third term) will modify the direct rice effect on outut of the home roduct. The indirect effect will be tronger the cloer ubtitute the roduct of and are to the dometic roduct. owever, for ufficiently mall home countrie dometic carbon olicie will not be able to affect foreign rice, i.e., = = = = 0. σ σ 9

10 We can now conclude that the direct effect of carbon taation reduce outut by increaing the cot of d emiion, and it i tronger the larger i the emiion intenity: < 0. Introducing OB ha a dσ d direct favorable outut effect: > 0. Additional effect do, however, occur through d a) foreign rice change in the ame direction a for home rice if the good are ubtitute and the home country i ufficiently large, b) marginal cot adjutment in the ame direction a outut cale if there are decreaing return, c) abatement and, thu, lower emiion ayment a a reult of the carbon ta. Net, we invetigate how dometic roduction deend on the carbon olicie 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 ulementation with an OB rate,. Similar firt order condition and market equilibrium a in eq. (2)-(4) for the home roduct carry over to the foreign roduct. We can then ere the total effect of both home and foreign carbon tae and OB (auming no carbon olicie in ret of the world) by totally differentiating equation (4). To imlify the dicuion we aume that both countrie are ufficiently mall to diregard rice effect on the other roduct. earranging, we get: d = ' ' ' d dσ (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 rereent the rice effect on good of the carbon olicie in region. The rice effect in the foreign region of foreign olicie will have analogou channel and ign a the correonding rice effect in the home country, i.e., the likely net effect are > 0 and σ < 0. 5 So far we have aumed that emiion intenitie in region and are eogenou given that thee countrie do not adot emiion control olicie. Thi aumtion i relaed now for region undertaking dometic emiion regulation. 10

11 It then follow that introducing a carbon ta in the foreign country ha a oitive, direct effect on the outut of the home roduct, and more o the higher the emiion intenity in and the larger i the enitivity of the demand for the dometic good to the rice of the foreign good. The direct contribution of OB in the foreign region i to reduce the home outut. Thee direct mechanim d d dominate o that > 0 and < 0, but imilar additional effect a for dometic olicie aly; dσ d ee a) to c) above. Though the ign of the variou artial and net effect are not urriing, the relative trength of the variou factor will vary from indutry to indutry deending on the indutry-ecific characteritic. The dicuion above will therefore be helful for undertanding the variation acro heterogeneou indutrie in our numerical analyi; ee ection Second-bet otimal OB olicie with no foreign carbon olicie We now earch for the otimal level of in the home region, auming firt that there i no climate olicy 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 ) σ ( e e e ) where U denote conumtion 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 reect to, noting that all variable are function of. After rearranging, we then get: (10) W / = ( C / ) σ e ( / ) ( C / e ) σ ( e / ) ( ) ( / ) ( / ) ( / ) σ e ( / ) e ( / ) = 0 j j where we ue (4) and the relationhi U / =, j=,,. Uing eq. (2) the firt quare bracket equal - and uing eq. (3) the econd quare bracket equal zero. We then get the following ereion for the econd-bet otimal dometic ubidy rate: 11

12 / / / / / (11) σ e e = ( ) / / / / / The three lat term in eq. (11) are term-of-trade effect. If thee are negligible, we ee that the otimal home ubidy rate hould equal the value of the avoided emiion abroad (with unit value σ ) when dometic roduction increae marginally. Note that a oible rie in the dometic emiion intenity caued by OB i not of imortance to the otimal OB rate, becaue on the margin the ubequent rie in abatement cot will be eactly offet by the reduction in emiion ayment (ee eq. (3)). The decreae in foreign emiion deend on the emiion intenitie in region and, a well a the enitivity of roduction in thee two region with reect to change in home roduction, which again deend on how well they ubtitute the home roduct in demand. The change in dometic, foreign and ret-of-the-world outut 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 ecial cae where emiion intenitie are the ame in all region (e = e = e ), and roduction decreae in and equal the roduction increae at home ( / = / / ), the otimal ubidy rate would be = σ e. That i, the emiion ayment are fully rebated to the firm (in aggregate) through the ubidy ayment thi i often referred to a full or 100% rebating. 100% rebating i the tandard way of modeling oututbaed rebate (OB) and we will refer to thi a the ubidy rate *. The ubtitution effect, i.e., the fraction j / / (j=,), will tyically be oitive but jointly lower than one, both becaue the three good are imerfect 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 otimal ubidy rate increae. A long a we conider climate olicy in the home region only, emiion intenitie abroad will tend to eceed intenitie at home. ence, we cannot rule out the oibility that may eceed *. What about the term-of-trade effect? A dicued in Section 2.1, the ubidy will increae outut of the home good, and a the three good are ubtitute, all rice will fall. Thu, the two firt term-oftrade term are oitive (lower imort cot), while the lat term i negative (lower eort revenue). The rice fall of the dometic good will tend to be larger than the rice fall of the roduct from abroad (ince the latter rice are only indirectly affected), in which cae the overall term-of-trade 12

13 effect become negative. owever, if the home region i a net imorter of the three good (in aggregate) the comoite term-of-trade effect may be oitive. The cloer ubtitute the good are, the more will imort rice dro which contribute oitively to dometic welfare. In other word, term-of-trade effect can imly otimal OB rate that are either negative or larger than 100%. or a mall-ized oen 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 imlify our eoition, we will hence diregard term-oftrade effect in the remaining analyi of thi ection. 2.3 Second-bet otimal dometic OB rate in reence of foreign carbon olicie When eloring the enitivity of the otimal ubidy rate with reect to the carbon olicie 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 ulemented with rebating through an outut ubidy. j We differentiate eq. (11) with reect to σ and j. We imlify the ereion 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 oitive. 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 rice 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 cature cale effect on the enitivity of outut in the three region with reect to. A larger outut cale i going to increae the outut enitivity to. Since the negative imact of carbon ricing in i tronger on the outut of than it oitive ubtitution effect on the two other good (ee Section 2.1), it i reaonable to eect that the 13

14 enitivity of with reect to dro 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 olicy increae dometic i roduction at the eene of reduced roduction abroad. ence, we can conclude that the econd term i oitive and the two lat term are negative, but all three are dominated by the firt negative term. In um, carbon ricing in region will mot robably reduce the otimal ubidy in the home region. Aume, net, that region alo imoe an outut ubidy, in addition to the carbon ta. Thi will only affect e to the degree that a firm otimal emiion intenity varie with outut. In mot realitic cae, thi effect will be mall and oitive; ee Section 2.1. The effect of on (j=,,) will tend to be ooite 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 otimal dometic OB rate of introducing OB in i ambiguou, but robably cloe to zero for realitic level of the foreign OB rate. j 3. Numerical model and data 3.1. Comutable general equilibrium model or our quantitative economic imact 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 decrition). CGE model build uon general equilibrium theory that combine behavioral aumtion on rational economic agent with the analyi of equilibrium condition. They rovide counterfactual e-ante comarion, aeing the outcome with a reform in lace with what would have haened had it not been undertaken. The main virtue of the CGE aroach i it comrehenive micro-conitent rereentation of rice-deendent market interaction in a etting with variou, eiting ublic intervention. The imultaneou elanation of the origin and ending of the agent' income make it oible to addre both economy-wide efficiency a well a ditributional imact of olicy reform. 14

15 Our model feature a rereentative agent in each region that receive income from three rimary factor: labor, caital, and foil fuel reource. Labor and caital are interectorally mobile within a region but immobile between region. oil-fuel reource are ecific to foil fuel roduction ector in each region. Production of commoditie other than rimary foil fuel i catured by threelevel contant elaticity of ubtitution (CES) cot function decribing the rice-deendent ue of caital, labor, energy and material (KLEM). At the to level, a CES comoite of intermediate material demand trade off with an aggregate of energy, caital, and labor ubject to a contant elaticity of ubtitution. At the econd level, a CES function decribe the ubtitution oibilitie between intermediate demand for the energy aggregate and a value-added comoite of labor and caital. At the third level, caital and labor ubtitution oibilitie within the value-added comoite are catured by a CES function wherea different energy inut (coal, ga, oil, and electricity) enter the energy comoite ubject to a contant elaticity of ubtitution. In the roduction of foil fuel, all inut, ecet for the ector-ecific foil fuel reource, are aggregated in fied roortion. Thi aggregate trade off with the ector-ecific foil fuel reource at a contant elaticity of ubtitution. inal conumtion demand in each region i determined by the rereentative agent who maimize welfare ubject to a budget contraint with fied invetment (i.e., a given demand for aving) and eogenou government roviion of ublic good and ervice. Total income of the rereentative agent conit of net factor income and ta revenue. Conumtion demand of the rereentative agent i given a a CES comoite that combine conumtion of comoite energy and an aggregate of other (non-energy) conumtion good. Subtitution attern within the energy bundle a well a within the non-energy comoite are reflected by mean of CES function. Bilateral trade i ecified following the Armington differentiated good aroach, where dometic and foreign good are ditinguihed by origin (Armington, 1969). All good ued on the dometic market in intermediate and final demand correond to a CES comoite that combine the dometically roduced good and the imorted good from other region. A balance of ayment contraint incororate the bae-year trade deficit or urlu for each region. CO 2 emiion are linked in fied roortion to the ue of foil fuel, with CO 2 coefficient differentiated by the ecific carbon content of fuel. etriction to the ue of CO 2 emiion in roduction and conumtion are imlemented through eogenou emiion contraint or (equivalently) CO 2 tae. CO 2 emiion abatement take lace by fuel witching (interfuel 15

16 ubtitution) or energy aving (either by fuel-non-fuel ubtitution or by a cale reduction of roduction and final conumtion activitie) Data Our CGE analyi of econd-bet otimal rebate rate i baed on the mot recent verion of the Global Trade, Aitance and Production (GTAP) databae which include detailed national account on roduction and conumtion (inut outut 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 comoite dataet that account for the ecific requirement of the olicy iue under invetigation. A to regional diaggregation we contrain ourelve to three region: Canada, USA and a comoite of all other region (ret of the world OW). A to ectoral diaggregation our comoite dataet include all major rimary and econdary energy carrier: coal, crude oil, natural ga, refined oil roduct (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 earate the main emiion-intenive and trade-eoed (EITE) ector: chemical roduct (CP), non-metallic mineral (NMM), iron and teel roduct (I_S), and non-ferrou metal (NM), a they will be otentially mot affected by emiion control olicie and therefore are the rime candidate for comenatory meaure uch a OB. 6 The remaining indutrie covered in our dataet include tranort ector, fihing, agriculture, aer, ul and rint, a well a a comoite ector of all remaining manufacturer and ervice. or model arameterization, we follow the tandard calibration rocedure in alied general equilibrium analyi: the bae-year inut-outut data determine the free arameter of the functional form (cot and eenditure function) uch that the economic flow rereented in the data are conitent with the otimizing behavior of the model agent. The reone of agent to rice change are determined by a et of eogenou elaticitie taken from the ertinent 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 rovide ubtitution 6 Note that refined oil roduct (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 roduct, o our choice i a comromie 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 otimal 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 imortance of infratructure for tranorting thi energy good. 16

17 oibilitie in roduction (between rimary factor inut). The elaticitie of ubtitution in foil fuel ector are calibrated to match eogenou etimate of foil-fuel uly elaticitie (Graham et al., 1999; Krichene, 2002). 4. Numerical imulation We conider the effect of imlementing carbon tae, combined with OB to the EITE indutrie in Canada. The OB cheme rebate EITE ector a ercentage rate of each ector emiion ayment. The rebate to a ecific firm i roortional to the firm outut 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 imortant trading artner USA alo imlement carbon tae with OB. We quantify effect on cometitivene of individual EITE indutrie, carbon leakage, and welfare. In order to derive conitent welfare imact we need to ut a value (rice) on change in global emiion, cf. the theoretical analyi in ection 2. We aume that Canada value global emiion change by the carbon rice it imoe. In our main cenario, thi ta rate i aumed to be 30 USD er ton of CO 2. 8 Note that in our grahical eoition of reult below we refer to Canadian climate olicy along the - ai, i.e., the entry BaU indicate no climate olicy regulation in Canada, wherea the entry 0 indicate an emiion ta of 30 USD er ton of CO 2 with a zero OB rate. A we move to the right on the -ai we adot increaingly higher OB rate for dometic (Canadian) EITE indutrie. We meaure the imact of variation in the Canadian climate olicy deign for three alternative olicy cenario in the USA: i) BaU (no carbon olicy), ii) carbon ta of 30 USD er ton of CO 2 without OB, and iii) carbon ta of 30 USD er 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 olicy (BaU-BaU). 4.1 Effect on the cometitivene of EITE-indutrie irt, we look at how outut of the EITE indutrie a a roy for cometitivene i affected by dometic and foreign olicie. Cometitivene 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 reorted by WGIII reort of IPCC (2014). 17

18 countrie contemlating unilateral climate olicy. Outut and emloyment loe in influential EITE indutrie may be critical for the olitical feaibility of unilateral action. igure 1. Outut effect for Canadian EITE indutrie (in % from BaU) under different dometic OB rate and three alternative aumtion about US climate olicy % US: BaU US: Ta & No OB US: Ta & 100% OB BaU OB-rate Canada (%) igure 1 how that if Canada unilaterally imlement a carbon ta without any OB, it EITE outut dro by 3.6%. urther, while ulementing the carbon ta with OB lead to le EITE reduction, we ee that a 100% OB doe not retore cometitivene, in term of reaching the initial outut level. Thi hold acro all the US olicy regime. The comenatory effectivene for Canada of OB i aroimately the ame in all the US regime deicted by the three curve in igure 1. owever, thi doe not imly that US olicy i irrelevant for Canada OB deciion. Comared to a benchmark with no olicy in either country, retoring Canadian outut by mean of OB will be le trenuou if the US alo introduce a carbon ta, a the outut fall i reduced by 1.2 ercentage oint. Thi relief will, however, be halved if the US imultaneouly add a 100% OB. The numerical CGE analyi allow u to invetigate outut imact at a more diaggregate level and thereby identify thoe ecific indutrie that might be in articular adverely affected in cometitivene. igure 2a and 2b how the outut effect for the five different EITE indutrie. irt, we notice that the outut 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 outut of 18

19 refined oil (OIL) and non-ferrou metal (NM) dro by 6.7% and 4.5%, reectively, 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 redicted by the theory model, the main elanation i to be found in their different emiion intenitie. The numerical model alo account for inut-outut effect, which tend to increae the cometitivene loe for many of the EITE indutrie. OIL i hit on the outut ide by a fall in demand for tranortation and heating activitie. On the inut ide, higher electricity rice affect everal EITE indutrie markedly; moreover, ome EITE indutrie ue ubtantial amount of other EITE good a intermediate inut. Conitent with the theory model foreign rice, articularly thoe in the US, increae along with Canada (effect a) in 2.1). A ooed to the theory model, however, the foreign rice effect do not only damen dometic outut reduction, a the EITE indutrie ue imort, which now become more eenive, a inut. We find that the effect of rebating carbon ta ayment 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 ouut level when rebating i 100%, thi i far from the cae for OIL and NM. Again the elanation lie in the inut-ouut relationhi. Both the latter indutrie face increaed inut rice, of crude oil and electricity, reectively. Thee effect are found in the cae when the US conduct BaU olicie, and they alo hold under alternative aumtion about US olicie: The neceary OB rate to retore outut effect at the indutry-ecific Canadian BaU level are not noteworthily affected by the US regime for thee indutrie. owever, comared to a benchmark where neither country ue carbon olicie, the dometic outut contraction in I_S and CP caued by Canada own emiion ta can be omewhat, but not fully, comenated by a imilar ta in the US. Thu, additional comenation by dometic OB olicie will be le needed. The effect of US olicie vary coniderably from indutry to indutry, a eected from the variety of effect identified in the theoretical analye in Section 2. The different US imact on Canadian indutrie are elained by the US indutry-ecific, inut-outut-corrected emiion intenitie, the degree of heterogeneity between Canadian and foreign good, a well a by how dominant the US i a a trading artner. The mot marked eamle i een for the NMM indutry, where introduction of a US ta rate equal to the Canadian ha tronger effect on Canadian NMM outut than ha the Canadian ta, i.e. US taation more than comenate for the cometitivene 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 comenated by a US ta. Thi reflect that uly of refined oil roduct mainly come from dometic roducer, and the US i not a articularly imortant trade artner. or the 19

20 remaining EITE indutrie the US ta roughly biect the outut dro 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 roducer, while it ha relatively little imact on Canadian NM roducer. Thi mirror the oberved counteracting effect of Canadian OB olicie, and again, a reaon i that OB doe not comenate well for the indirect taation via the inut-outut effect. A for all indutrie, the direct effect of Canadian OB and US OB on the Canadian OIL indutry are in ooite direction, however, they alo affect the global crude oil rice, and thi effect i oitive irreective of whether Canadian or US demand i timulated by OB olicie. Thi indirectly damen the oitive outut effect of Canadian OB, while reinforce the negative effect of US OB. igure 2a. Outut effect (in % change from BaU) in Canadian refined oil roduct (OIL) and non-ferrou metal (NM) under different dometic OB rate and three alternative aumtion about US climate olicy 20

21 igure 2b. Outut effect (in % change from BaU) for Canadian chemical roduct (CP), nonmetallic mineral (NMM) and iron and teel (I_S) under different dometic OB rate and three alternative aumtion about US climate olicy 4.2 Effect on carbon leakage igure 3 how that carbon leakage reond markedly to change in dometic (Canadian) OB rate and alternative etting for foreign climate olicy regulation in the US. 9 When climate olicie in the US i abent, the carbon leakage from a Canadian carbon ta correond 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 olicie fall by ercentage oint, comared to the ame Canadian olicy in the US no-olicy (BaU) regime. Canadian taation now caue larger cut in dometic emiion, a reduction take lace from larger initital outut 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 olicie in reence of a combined ta and full OB olicy 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. 21

22 inignificantly affected, a elained in ection 2.1. In articular, leakage to the US doe not reond to US OB olicy, becaue US emiion intenitie tay fairly unaffected. Scale effect in all three region are alo weak. igure 3. Carbon leakage due to Canadian climate olicie under different dometic OB rate and three alternative aumtion about US climate olicy 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 imact of dometic OB olicie Welfare effect of Canadian and US carbon olicie are deicted 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 rice. The monetary value of reduced global emiion i then added. 10 irt, we notice that introducing a Canadian carbon ta equal to it erceived marginal value of global abatement (here: 30 USD er ton of CO 2 ) increae dometic welfare. Thi i not urriing a average cot of reducing emiion tyically are lower than marginal cot (i.e., the carbon ta). Net, we ee that the OB rate to EITE roduction 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-comarion of cenario where global emiion differ. The fully integrated aroach 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 er ton of CO 2, i.e., the carbon ta rate imlemented, a the erceived marginal climate cot of carbon. 22

23 unilaterally. owever, we alo notice that welfare i virtually unaffected by the OB rate within the deicted 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 olicy imlication to draw from thi i that rebating olicie at leat to ome degree can be determined out of other concern than aggregate welfare effect, uch a cometitivene for trade-eoed indutrie. A oitive otimal OB rate i in line with our theoretical analyi cf. eq. (11). Outut-baed rebate increae dometic EITE roduction at the eene of roduction abroad which lead to a reduction in leakage. The benefit of lower emiion abroad, however, mut be traded off againt the cot of ditortionary outut ubidie. The latter cot alo include otentially advere term-of-trade effect for the dometic economy. Canada i a net eorter of EITE good, and rebating will tend to decreae the rice of the rebated roduct. ence, eort revenue will decline. igure 4. Welfare change (in % change from BaU) in Canada under different dometic OB rate and three alternative aumtion about US climate olicy % 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 olicy). 23

24 Turning to the effect of US olicie, we firt oberve in igure 4 that US carbon taation ha a net oitive economic welfare imact on Canada that far outize the oitive imact of own OB olicie. 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 otimal OB rate decline when the US introduce the carbon ta, though the numerical change i mall from 92% to 83%. A decline i eected from the theoretical dicuion of eq. (12) in Section 2.3, where the main identified elanation wa a dro in the emiion intenity in the foreign country caued by the ta. The numerical OB reult i alo conitent with the carbon leakage imact een above: US taation lead to le carbon leakage triggered by Canadian climate olicy a a reult of reduced emiion intenitie in the US. The theoretical dicuion in Section 2.3 concluded ambiguouly on the imact of US rebating on the Canadian otimal OB-rate. We find a light increae in the otimal Canadian OB rate to 87% when the US rebate 100% of it emiion ta ayment to own EITE indutrie. The relatively modet reaction in otimal OB rate to change in US olicie ugget that Canadian rebating olicie can be determined quite indeendently of it large neighbor. Thi concluion i trengthened by the obervation above that the welfare imact 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 olicie are of much more imortance to the otimal Canadian OB olicie. irt of all, we oberve a trong enitivity of the econd-bet otimal OB rate to the aumtion about EITE roduct heterogeneity acro countrie, i.e. choice of Armington elaticitie. 4.4 Senitivity analyi The central arameter in our numerical analyi i the trade reonivene, catured by the Armington elaticitie of ubtitution between dometic and foreign roduct. If we aume that EITE roduct in different region ubtitute le eaily, we hould eect the otimal OB rate for Canada to decreae for two reaon a evident from eq. (11): irt, the emiion abroad would reond le to the OB olicy of the home country and, econd, the term of trade would not imrove a much due to le accentuated dro in foreign rice. Thi i confirmed by the imulation if we decreae the ubtitution elaticity for OIL (one of the five EITE good) by 50% comared to our benchmark choice of 4.0, the otimal rebate rate dro to zero, irreective of climate olicy 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). 24

25 If we intead increae the ubtitution elaticitie for all EITE good by 50% comared to our benchmark aumtion, the otimal OB rate in Canada eceed 200%, irreective of US climate olicie. Thu, the enitivity analyi indicate that the degree of ubtitutability of EITE good i much more imortant for the otimal OB rate in Canada than the climate olicie imlemented in the US. Thi finding i alo confirmed if we imulate OB olicie toward the individual Canadian EITE ector. In the imulation above, we allowed the level of global emiion to reond to olicy change. The welfare accounting included the evaluation of thee emiion change, by auming that the Canadian carbon ta reflect it marginal value of abatement. To tet the robutne of our reult, we alo erform a enitivity tet where we kee the global emiion rather than the carbon ta rate contant acro cenario. In other word, we aume a cot-effectivene aroach. Thi deign avoid evaluating different global emiion level, becaue the emiion change are equal acro cenario. We imulate the cae of a Canadian quota market intead of a carbon ta, combined with comenation in term of outut-baed allocation of quota (OBA) intead of an outut-baed ubidy rate (OB). We let the ca on emiion in Canada be leakage-adjuted, o that global emiion remain the ame acro the different OBA rate (for a given olicy in the US). We find that the main concluion from our olicy analye carry over to thi cae. That i, the otimal OBA level for Canada decline when the US alo imlement climate olicie, but the overall welfare imact are not much affected by the etent of allocation. We alo obtain qualitatively imilar concluion when we increae the fied carbon ta from 30 to 50 USD er ton of CO 2. Tae on caital and labor may have ignificant interaction effect when the factor uly reond to climate olicy change (Parry et.al., 1999). Such ta interaction effect can alo influence on the otimal OB rate, cf. Lenno and Nieuwkoo (2010). When imulating our model with the ame Canadian climate olicie but all other tae et to zero, the otimal OB rate dro to zero. Eecially OIL i highly taed initially o in the no-tae alternative the OIL roduction in the BAU i higher and the outut reone of a carbon ta only i larger, while the ooite i the cae for the other EITE indutrie. Total leakage i maller and introducing OB ha a maller effect on EITE outut. With initial tae introducing OB work a an imlicit ubidy on the highly taed OIL indutry and a non-zero OB-rate i otimal. The ta interaction effect reent in the model 12 have a 12 Ta reone effect through labor and caital uly are abent in our model, but there are ignificant ta interaction effect of ector and good ecific ta difference that influence the allocation of reource in the economy. 25