Greenhouse-gas Emission Controls and International Carbon Leakage through Trade Liberalization

Transcription

1 Greenhouse-gs Emission Controls nd Interntionl Crbon Lekge through Trde Liberliztion Jot Ishikw (Hitotsubshi University nd RIETI) α Toshihiro Okubo (Kobe University) β October 2008 ABTRACT. This pper studies greenhouse-gs (GHG) emission controls in the presence of crbon lekge through interntionl firm reloction. The Kyoto Protocol requires developed countries to reduce GHG emissions by certin mount. Compring emission quots with emission txes, we show tht txes coupled with lower trde costs fcilitte more firm reloctions thn quots do, cusing more interntionl crbon lekge. Thus, if country is concerned bout globl emissions, emission quots would be dopted to mitigte the crbon lekge. Firm reloction entils trde-off between trde liberliztion nd emission regultions. Emission regultions my be hmpered by trde liberliztion, nd vice vers. JEL: F8, Q54 Keywords: trde liberliztion, globl wrming, Kyoto Protocol, emission tx, emission quot, crbon lekge We re grteful to seminr prticipnts t Ngoy University nd ttendees t the Hitotsubshi COE/RE Conference on Interntionl Trde & FDI 2007, the APT 2008 ydney, nd the ETG 2008 Wrsw for helpful comments nd suggestions. Any remining errors re our own responsibility. We cknowledge finncil support from the Ministry of Eduction, Culture, ports, cience nd Technology of Jpn under the COE Projects. α jot@econ.hit-u.c.jp β okubo@rieb.kobe-u.c.jp

2 . INTRODUCTION Globl environmentl problems hve recently ttrcted considerble worldwide ttention. In prticulr, globl wrming cused by greenhouse-gs (GHG) emissions hs been the centrl issue mong the problems. To cope with globl wrming, n interntionl environmentl trety, the United Ntions Frmework Convention on Climte Chnge (UNFCCC), ws mde t the Erth ummit held in Rio de Jneiro in 992. Then the Kyoto Protocol ws dopted t the third session of the Conference of Prties to the UNFCCC (COP3) in December 997. In the protocol, the industrilized countries clled Annex I Prties mde commitment to decrese their GHG emissions by 5.2% compred to their 990 bseline levels over the 2008 to 202 period. However, the United ttes, which is signtory to the protocol, hs not rtified the protocol. Moreover, developing countries including Chin nd Indi hve no obligtion to the reduction. There is no doubt tht the Kyoto Protocol is significnt step towrds the reduction of GHG emissions. Obviously, however, the prtil prticiption of certin countries in the frmework of GHG emission reduction is vitl drwbck. In prticulr, the United ttes nd Chin re the lrgest GHG emitters in the world. 2 Moreover, with prtil prticiption, serious concern is interntionl crbon lekge. Tht is, the reduction of GHG emissions in some countries increses those in other countries. As result, worldwide emissions my rise. Interntionl crbon lekge occurs through number of chnnels. For exmple, it my occur through fuel price chnges (Ishikw nd Kiyono, 2000; Kiyono nd Ishikw, 2004). When country dopts policies to reduce GHG emissions, its demnd for fossil fuels is likely to decrese. If their world prices fll s result, the demnd for fossil fuels rises in other countries with wek regultions. Crbon lekge my lso rise through the chnges in country s industril structures (Copelnd nd Tylor 2005; Ishikw nd Kiyono, 2006). With stringent GHG emission regultions, the comprtive dvntge of the emission-intensive industry my shift brod. This is the so-clled pollution hven hypothesis. In prticulr, in The Kyoto Protocol cme into force in Februry In 2005, the shres of world CO 2 emissions were 2.4% for the United ttes nd 8.6% for Chin, respectively. 2

3 response to environmentl policy differences cross countries, firms my relocte to countries with lx environmentl regultions (Mrkusen et l., 993, 995). Recent improvements in trnsporttion nd communictions technology s well s trde liberliztion llow firms to relocte their plnts more esily. In this pper, we compre emission txes with emission quots (including cretion of competitive emission-permit mrket) in the presence of the possibility of firm reloction. pecificlly, using new economic geogrphy (NEG) frmework, we exmine the effects of trde costs on emission txes nd quots. In our model, there re two countries (North nd outh), two sectors (griculture nd mnufcturing), nd two fctors (cpitl nd lbour). The griculturl product, which perfectly competitive firms produce from lbour lone with constnt-returns-scle (CR) technology, is freely trded interntionlly. The mnufctured products re subject to the Dixit tiglitz (977) type of monopolistic competition nd re costly to ship interntionlly. Following Mrtin nd Rogers (995), we ssume tht only cpitl is mobile cross countries nd determines plnt loction. 3 To mke our point s clerly s possible, in the benchmrk cse North s mrket is lrger thn outh s mrket nd ll firms in the mnufcturing sector re locted in North in stble equilibrium becuse of smll or intermedite trde costs. The North government unilterlly dopts n environmentl policy, either n emission tx or n emission quot. Then we consider the effects of these policies when trde costs fll nd firms re free to relocte to outh. One of our min results is s follows. If North cres only bout locl emissions, then North prefers emission txes to emission quots. On the other hnd, if North is concerned bout globl emissions, then emission quots should be dopted. This result hs interesting implictions for the Kyoto Protocol when regrding Annex I Prties s North. As mentioned bove, the trget for GHG emission reductions set by Annex I Prties in the protocol is locl one. In the presence of firm reloction from Annex I Prties to the other countries, therefore, trde liberliztion my induce Annex I Prties to dopt emission txes rther thn emission quots to chieve the 3 This model is known s the footloose cpitl model, which is the simplest model in NEG. ee Bldwin et l. (2003). 3

4 trget. From the viewpoint of worldwide emission reduction, however, emission quots re more effective. Another min result is tht when emission txes re dopted in North to ttin trget of globl emission reduction, trde costs nd tx rtes must stisfy certin conditions. Intuitively, lower trde costs coupled with tougher regultions fcilitte firm reloction, which leds to crbon lekge. Thus, free firm reloction entils trde-off between trde liberliztion nd emission regultions. Emission regultions my be hmpered by trde liberliztion, nd vice vers. There re mny ppers tht exmine the pollution hven hypothesis. In the frmework of n open economy, the first theoreticl nlysis on the hypothesis is Pethig (976). 4 Then Mrkusen et l. (993, 995) investigte the hypothesis in the presence of foreign direct investment (FDI). In Mrkusen et l. (993), two polluting firms (one is locl nd the other is foreign) choose the number of plnt nd plnt loctions when only the home country dopts emission txes. They re primrily concerned with mrket structures induced by txes. In Mrkusen et l. (995), single firm decides the plnt number nd loctions when both countries dopt environmentl policies non-coopertively. The governments hve n incentive to lower (rise) environmentl stndrds to ttrct (deter) investment if the benefit from investment is greter (less) thn the loss (i.e., the environmentl dmge). 5 Firm loctions nd trde costs re centrl issues in the NEG literture. A few NEG studies investigte environmentl policies (Pfluger, 200; Venbles, 200; Elbers nd Withgen, 2004). 6 Pfluger (200) considers Pigouvin emission txes in 4 Evidence on the pollution hven hypothesis is mixed. According to Jffe et l. (995), differences in environmentl policy hve little or no effect on trde ptterns, investment or firm loction. However, Henderson (996), Becker nd Henderson (2000), Greenstone (2002), nd List et l. (2003) find tht pollution-intensive plnts re responding to environmentl regultions. mrzynsk nd Wei (2004) discuss fctors tht my mke the evidence of the hypothesis wek. Levinson nd Tylor (2008) point out tht the pollution hven effects hve been underestimted. 5 When country dopts too lx environmentl policies in order to keep its competitive dvntge, its strtegy is sometimes clled environmentl (or ecologicl) dumping. On the other hnd, when country dopts too stringent environmentl policies in order to reduce locl pollution, this strtegy is clled Not in my bck yrd (NIMBY). There re number of studies which, following Mrkusen et l. (995), nlyse environmentl dumping nd NIMBY. ee, for exmple, Ruscher (995) nd Ulph nd Vlentini (200). 6 Venbles (200) studies the impct of tx on equilibrium in verticl linkge model. In the cse of energy txes tht re unilterlly introduced in one country, he discusses hysteresis in loction but does not investigte ny environmentl policies. Elbers nd Withgen (2004) study the impct of n emission tx on gglomertion in the presence of lbour migrtion. 4

5 NEG model similr to ours. However, his nlysis is long the line of Mrkusen et l. (995). Thus, environmentl dmges re locl nd governments cn detect emitters, estimte the dmge nd cn impose optiml emission txes. In contrst, emissions in our model re globl nd hence it is hrd to identify polluters nd estimte emissions dmge. This mkes it impossible to levy tx on ech polluter nd compenste the public through tx reimbursement. In our pper, globl wrming is n impending issue nd ech country is required to reduce totl emissions by certin mount. A key mechnism of environmentl policies is gglomertion rent, which is discussed somewht similrly in the literture of tx competition. The NEG literture hs been exploring txtion on gglomertion rent (Kind et l., 998; Ludem nd Wooton, 2000; Bldwin nd Krugmn, 2004). However, our environmentl policies re substntilly different from corporte tx competition nd gglomertion rent in spirit nd purpose: ) A reduction of emissions is n obligtion in interntionl greements. Txtion is imed t reducing emissions to certin level rther thn ffecting tx revenue. On the other hnd, corporte txtion is intended to bsorb gglomertion rent nd rise tx revenue; 2) Tx competition is not plusible in our pper. Only developed countries rtify the interntionl greements nd thus txtion is unilterl in our North outh model. The environmentl policies re mndtory cross rtified countries so s to reduce emissions to stisfy the greements. Thus, the interntionl environmentl greements leve no room for tx competition to increse government revenue, i.e., rce-to-top or rce-to-bottom in the tx rte; nd 3) Our discussion involves how to reduce globl emissions while refrining from using pollution hven under trde liberliztion. In contrst, tx competition studies show how ech government seeks to mximize tx revenue by ttrcting more firms nd widening the tx bse. Turning to the environment nd trde literture, Ishikw nd Kiyono (2006) nlyse the potentil effects of choices over emission controls in n open economy. They specificlly compre emission txes, quots nd stndrds in perfectly competitive generl equilibrium trde model. Their nlysis is somewht similr to ours in the sense tht one of two countries unilterlly imposes environmentl policies, 5

6 which genertes cross-border crbon lekge, 7 nd tht North s emission level is endogenously determined under emission txes. However, their model is bsed on trditionl trde models (i.e., both Ricrdin nd Heckscher Ohlin models) nd does not tke firm reloction into ccount. In n nlysis of globl wrming, Copelnd nd Tylor (2005) explore the reltionship between interntionl trde in goods nd emission permits using Heckscher Ohlin frmework. They lso consider prtil prticiption in the Kyoto protocol. Interestingly, they show tht unilterl emission reductions in North cn induce the unconstrined outh to reduce emissions. This implies tht, in contrst with our nlysis, interntionl crbon lekge my not be serious issue even without universl prticiption in the protocol. This contrst bsiclly stems from the presence of n income effect s well s the bsence of firm reloction in their nlysis. Here the income effect mens tht higher income reduces pollution. 8 The rest of the pper is orgnized s follows. In ection 2, we present our bsic model. Emission txes nd quots re investigted in ections 3 nd 4, respectively. Then, in ection 5, we compre emission txes with emission quots. In ection 6, we explore the reltionship between emission regultions nd trde liberliztion. ection 7 concludes the pper. 2. BAIC MODEL 2.. Two-country, 2-sector, 2-fctor model without environmentl policies We bsiclly introduce GHG emissions into the footloose cpitl (FC) model developed by Mrtin nd Rogers (995). There re two countries (North nd outh), two production fctors (lbour, L, nd physicl cpitl, K) nd two sectors (griculture, A-sector, nd mnufcturing, M-sector). North is bigger thn outh in popultion size. The griculturl product is produced from lbour lone by perfectly competitive firms under CR technology nd is trded without ny trde cost. This product serves s numérire. The mnufctured goods re subject to the Dixit 7 Kiyono nd Ishikw (2004) focus on interntionl interdependence of environmentl mngement policies in the presence of interntionl crbon lekge. 8 Evidence of the income effect is lso mixed. ee, for exmple, Brbier (997). 6

7 tiglitz type of monopolistic competition nd re trded with trde costs. Firms in M- sector in Mrtin nd Rogers (995) cn move between countries, but there is no entry nd exit. M-sector uses lbour, vrible cost, nd exclusively employs cpitl, fixed cost. pecificlly, ech firm is required to use one unit of cpitl, which represents fixed costs, nd units of lbour. The cost function for firm j is given by TC j π wx j, where π, i.e., the fixed cost prt of totl cost, represents cpitl return. M-sector emits GHGs in the process of production. pecificlly, the production of one unit of n M commodity entils one unit of GHG emissions. Trde costs, τ(> ), re iceberg type. The freeness of trde,, cn be defined s τ. This implies tht free trde, τ, cn be expressed s wheres 0 represents utrchy (τ ). Turning to the demnd side, representtive consumer hs the following qusi-liner utility function: () U µ ln M A f ( N ), M / / /( -/ ) ( nc n c ), > µ > 0, >, where M nd A stnd for consumption of M-sector vrieties nd tht of A-sector, respectively, nd µ is the intensity of preference towrds M-sector goods. n nd n re the number of differentited vrieties, nd c nd c re the quntities of consumption for ech vriety. in the CE function for differentited vrieties denotes the constnt elsticity of substitution between two vrieties. 9 The disutility is expressed s n incresingly monotonic function of GHG emissions, f( N ), where N nd re GHG emissions in North nd outh, respectively. Ech consumer hs one unit of cpitl s well s one unit of lbour nd gets income from both fctors, w π. However, the qusi-liner utility function hs no income effect nd thus ech consumer buys certin number of units of M-goods regrdless of his/her income nd M-goods prices. Lbour is mobile between sectors but immobile between countries. While cpitl is mobile between two ntions, cpitl owners re immobile nd thus cpitl 9 The equilibrium pth in the FC model with qusi-liner utility function is identicl to tht of the Cobb Dougls utility function. The qusi-liner function elimintes the income effect (ee Bldwin, et l. 2003). 7

8 rewrds re reptrited to the country of origin. Becuse cpitl endowment is initilly llocted in proportion to lbour endowment (mrket size), North s shre of initil cpitl nd lbour endowments re given by sk W K / K sl W L / L. However, fter the firm hs relocted, cpitl shre is generlly not equl to popultion shre, wheres popultion shre lwys corresponds to lbour shre, sl, nd cpitl shre is lwys identicl to firm shre, W n / N sk. This is becuse ech footloose firm needs one unit of cpitl. Becuse no income effect exists, the qusiliner utility function ensures s se sl, where North s expenditure shre is defined s se W E / E. For simplicity, totl expenditure W endowments, L nd one. Thus, n is North s shre of firms. 0 W K (thus the totl number of firms, 2.2. Initil equilibrium W E nd totl lbour nd cpitl W N ), re normlized to Becuse the A-sector good is the numérire nd is freely trded interntionlly, wge rtes in both countries re normlized to one, w w. Utility mximiztion results in the well-known CE demnd function. As result of mximiztion, locl nd export prices of the product vriety of the North-bsed M-sector firm re given by: (2) τ p, p, / / where is unit lbour requirement, equl to mrginl cost, which is exogenously given s constnt. Consumption per vriety is: µ (3) p E µ c nd np n p p E c. np n p Using (2) nd (3), pure profit for representtive firm in North is given by: µ π[ n ] E E, [ n] [ n] 0 Importntly, we use qusi-liner utility function. The income effect is eliminted. The totl number of households (popultion) is one in the world, becuse ech individul hs one unit of lbour nd cpitl. The level of demnd depends on popultion size rther thn income. 8

9 where E (E) represents the North s (outh s) expenditure, nd nd re defined s [ n ] n ( n) nd [ n ] n ( n). Becuse our model hs symmetric mrket size, E( s) > E( s), i.e., s > 0.5, pure profit of North-bsed firm is higher thn tht of outh-bsed firm with positive trde costs. Therefore, llowing for free reloction, the pure profits re equlized nd then firm shres, n re determined s loctionl equilibrium. µ ( ) s s (4) π[ n] π [ n] 0. [ n] [ n] olving (4), we obtin n ( s ). 2 2 As trde costs fll ( rise in ), n increses: more outh firms go to North, so-clled grdul gglomertion. Then, below certin trde cost, clled the sustin point ( ( s)/s ), ll firms concentrte in North, i.e., full gglomertion. Tht is, trde costs bove the sustin point (smll trde costs) crete full gglomertion in the big country s stble equilibrium. For simplicity, we first consider full gglomertion before considering ny environmentl policy. Accordingly, trde costs discussed in our pper re ssumed to be from the sustin point through free trde: ( s)/s < < Production nd GHG emissions The quntity produced by ech North-bsed firm (j) for the North mrket is given by x j µ p n p np, which is identicl to c. Turning to the export mrket, only x/ units rrive for export becuse of iceberg trde costs. While North s consumption is equl to the quntity produced in North for ech vriety, i.e., x c, j j µ Likewise, pure profits for outh-bsed firms reπ [ n ] E E. Note tht ech firm s profit is / times firm revenue. The ( /) terms cncel out in the price of vriety nd in CE composition. 9

10 0 the quntities produced for the foreign mrket need µτ τ p n np p c x j j. It follows tht the totl quntity produced by North-bsed firm, firm j, is written s:. µ µτ µ p p n np s p n np s p n np p p n np p x x j j For simplicity, we ssume tht producing one unit of goods entils one unit of GHG emissions. Thus, the mount of locl emissions in ech country corresponds to ech country s totl quntity produced. Locl emission levels in North nd outh re, respectively, defined s: s s nb x x n j j N ) ( nd s s b n x x n j j ) (, where ) / ( µ b is exogenously given nd constnt. Without loss of generlity, by n pproprite choice of units we cn normlize b. Note tht GHG emissions in North nd outh correspond to quntities produced in ech country. In sum, world emissions re s s n s s n N. Utilising these specifictions, emissions t the initil no-policy equilibrium (full gglomertion in North) cn be written s initil N initil becuse of nd. Note tht GHGs re initilly emitted only in North becuse of North s full gglomertion nd the emissions remin constnt nd re independent of trde costs. 2 Proposition : The totl mount of emissions is unffected by trde costs t full gglomertion (no environmentl policy) equilibrium. 2 More generlly, ignoring stble equilibrium pth, if ll firms hypotheticlly concentrte in one country, either North or outh, the mount of emissions cn be kept constnt. For instnce, if ll firms re forced to relocte to outh by policy, globl emissions cn be derived s s s N, which is the sme level s with North s full gglomertion. Hence, the globl level of emissions is independent of loction in the cse of full gglomertion, irrespective of stble equilibrium pth.

11 3. EMIION TAX 3.. Txtion without reloction Now we introduce environmentl policies. Becuse of interntionl environmentl greements such s the Kyoto Protocol, n industrilized country, which hs mnufcturing gglomertion, nmely North, is required to limit emissions to certin fixed level. To stisfy the upper bound of emissions, we ssume tht North introduces either n emission tx or quot. In this section, we exmine n emission tx. trting from full gglomertion, North imposes n emission tx so s to reduce emissions nd implement the interntionl greement. At this moment, reloction is prohibited (infinitive reloction costs). Becuse one unit of GHG emissions corresponds to one unit of quntity produced in our model, n emission tx needs to be levied on ech unit of production rther thn prices, pure profits or sles. Thus, the emission tx is equivlent to specific production tx, t. Then the totl costs nd prices re expressed s: TC π ( t) nd j x j t τ ( t) p ; p. / / The tx increses totl costs nd prices. 3 Thus, pure profit of North-bsed firm nd the North s emissions without reloction re given s: s (5) π ( ) ( s) µ t µ, s ( s) N, t (6) ( t) where North s full gglomertion leds to nd. Note tht txtion without reloction, i.e., without crbon lekge, results in reducing emissions from / to /( t). 3 Note tht we ssume t <.

12 3.2. Equilibrium with free reloction Next, we llow for free firm reloction. Becuse txtion decreses profits in North, firms my hve n incentive to move to the non-txed country, i.e., outh, regrdless of smll mrket size. When tx rtes re set t substntil level such tht π < π, i.e., t s < s ( ), full gglomertion is not stble ny more nd some firms relocte to outh. Firm shre, n, is determined so s to equlize pure profits between countries: µ s ( s) µ s s (7) π π ( ) 0 t, where n ( n) ( t) nd n ( n)( t). Figure plots firm shre, n, in terms of freeness of trde, Given fixed low rte of tx, the firm shre locus is hump-shped. Txtion cuses interntionl crbon lekge: firm reloction occurs from North (txed country) to outh (non-txed country). tted differently, it is necessry to hve intermedite levels of trde costs to keep full gglomertion, < <, which cn be written s: NL NU (8) NU ( t) ( t) 2 2( ) s 4s( s) 2( ), (9) NL ( t) ( t) 2 2( ) s 4s( s) 2( ). <Figure > In reverse, given fixed, low tx cn sustin full gglomertion. The condition for the low tx rte is given s: ~ 2( ) 2( ) t s s > ~ /(2( )) ( ) 4 ( ) 0 t < (4s( s)). When the tx rte is bove ~ t, North never sustins full gglomertion for ny trde cost nd insted outh is more likely to chieve full gglomertion. Figure 2 illustrtes the cse of high tx rtes without North s full gglomertion. 2

13 <Figure 2> As shown in Figures nd 2, ll firms relocte to outh with sufficiently smll trde cost, i.e., perfect crbon lekge. The criticl vlue of trde costs,, is nlyticlly given by: 2( ) 2( ) 4s( s)( t) (0). 2 ( s) As the tx rte, t, rises, the criticl vlue,, decreses nd full gglomertion in outh is more likely to occur. A sufficiently smll trde cost coupled with high tx rte ccelertes interntionl crbon lekge, relocting to the country without environmentl regultion. Note tht > NU > NL is lwys ensured. is rel 2( ) 2( ) number, becuse 4s( s)( t) > 0. We cn lso verify tht is lwys lrger thn NU. 4 Proposition 2: An emission tx my led to interntionl crbon lekge. Full gglomertion in North (txed country) cn be sustined if the tx rte is low nd/or trde costs re intermedite. However, when the tx rte is high nd/or trde costs re sufficiently smll, ll North firms move to outh (non-txed country). Note tht the stndrd FC model (without ny txtion) hs hump-shped gglomertion rents, which is net benefit from gglomertion (see Bldwin nd Krugmn, 2004): when trde costs decrese, the rents first rise nd then fll. Free trde hs no gglomertion rents. Txtion on the rents reduces the net benefit from gglomertion. Thus, lrge or smll trde costs led to negtive net gglomertion benefit, which cuses firm reloction to outh. Turning to emission levels, Figures 3 nd 4 plot them for North, outh nd the world, which re given by: 4 2( ) 2( ) This is becuse 4( s)s < for s > 0.5 nd > ( t). 3

14 s s N n ( t), s s n s, ( s) ( s s N n t n, ) where n ( n) ( t) nd n ( n)( t). <Figure 3> <Figure 4> Allowing firm reloction entils more GHG emissions thn the trget of the interntionl greements, /( t), becuse of interntionl crbon lekge when trde costs re either lrge or smll. Tht is, when trde costs re either lrge or smll, North s emissions fll nd outh s emissions rise (Figure 3). The crbon lekge decreses North s emissions, which re less thn the trget, /( t), nd outh s emissions increse by reloction, nd then rech mximum of / with outh s full s s gglomertion: n, where nd n. Note tht outh s emissions exceed North s for certin levels of. As trde costs fll, t firm reloction decreses n nd then, when n < holds, the outh s emissions 2 t exceed the North s. Lower tx rtes led to criticl n of 0.5, nd higher tx rtes increse the criticl n. This mens tht lowering tx rtes cn moderte crbon lekge. Figure 4 shows globl emissions, which re the sum of North s nd outh s emissions. Becuse smll nd lrge trde costs llow more reloction to the non-txed country, globl emissions increse. In prticulr, bove ll firms concentrte in outh nd no firms py tx, nd thus the emission level becomes /. Note tht this is 4

15 identicl to the initil no-policy level. North s emission policy is nullified nd the globl mount of emissions returns to the initil equilibrium (no environmentl policy). We cn sy tht the only impct of txtion with smll trde costs is to trnsfer GHG emissions from North to outh through the reloction of ll firms. With smll trde costs, unilterl emission txtion results in perfect crbon lekge (full gglomertion in outh) nd txtion cnnot control pollution ny more. Proposition 3: With emission txtion, the globl emission level is generlly U-shped in terms of freeness of trde. Emission txtion hs no impct on the globl emission level when trde costs re sufficiently smll. 4. EMIION QUOTA 4.. Quot without reloction Now we discuss the other policy, n emission quot. In this cse, strting from full gglomertion, North unilterlly introduces n emission quot so s to stisfy interntionl environmentl greements. To mke strict comprison of policy impct on crbon lekge in the tx cse, the quot is set so tht the emission level under the quot is the sme s tht under txtion t the initil equilibrium (North s full gglomertion), i.e., (constnt). Moreover, the quot is ssumed to be t ccompnied by cretion of competitive emission-permit mrket in North. The quot is implemented by the North government vi fee. Purchsing one unit of the permit llows one unit of production for North firm. Using (6), the level of the quot is given by: () s s q q q ( ) ( ) ( ) q t. Thus, the price of emission permit q is equl to t t full gglomertion (initil equilibrium), i.e., q t. The following should be noted. The price of permit, q, is endogenously determined by the number of firms locted in North nd trde costs so s to stisfy s ( s) North s emission-permit mrket clernce, n ( ) 0 q, 5

16 lthough tx rtes re invrint, exogenously given by interntionl greements. ( n ( n) ( q) nd n ( n)( q) ). This results in different impcts on firm loction nd emission level. Totl costs nd price re written s TC π ( q) x, j j q p nd / Firm loction is determined by profit equliztion nd the size of the quot. τ ( q) p. / 4.2. Equilibrium with free reloction At the equilibrium, n nd q re determined by pure profit equliztion s well s the emission constrint: 5 µ s ( s) µ s s (2) π π ( ) 0 q, s ( s) (3) π n ( q), where n ( n) ( q) nd n ( n)( q). Figure 5 plots firm shre, n, in terms of freeness of trde,. imilrly to txtion, smll or lrge trde costs led to firm reloction nd interntionl crbon lekge, while intermedite trde costs cn sustin full gglomertion in North. <Figure 5> Becuse we ssume tht the emission level under quot is the sme s tht under txtion with full gglomertion, q t nd trde costs tht result in full gglomertion re fully equivlent to those under txtion: 5 In our model, the quot is lwys binding nd hs positive permit price. If q is negtive or zero, then no firms hve n incentive to relocte nd full gglomertion is chieved. In ddition, the totl emission level is reduced by interntionl regultion nd thus the number of permits supplied by the government is less thn the quntities produced with full gglomertion. It follows tht q should be positive. 6

17 (4) NU ( q) ( q) 2 2( ) s 4s( s) 2( ), (5) NL ( q) ( q) 2 2( ) s 4s( s) 2( ). However, unlike the effect of n emission tx, quot does not involve outh s full gglomertion with smll trde costs. ome firms sty in North t ny trde cost. As plotted in Figure 6, q is positive for 0 < nd hump-shped. As long s ll firms re in North (full gglomertion) with intermedite trde costs, quot prices equl the vlues of t ( q ). However, when gglomertion rents fll becuse of smll trde costs, firm reloction to outh reduces q, while txtion t remins constnt. Firm reloction to outh softens the quot constrint in North. The fll of the permit price reduces the disdvntge of locting in North nd mitigtes reloction. <Figure 6> Proposition 4: With n emission quot, full gglomertion in North cn be sustined with intermedite trde costs. However, full gglomertion never occurs in outh for ny positive quot level. Emission levels re written s: (6) N s s n ( q), (constnt) t (7) (8) s s n s s N n t,. Figures 7 nd 8 plot emissions in terms of trde costs. imilrly to the tx cse, quot leds to U-shped globl emissions in terms of trde costs. More generlly, in the cse of smll/lrge trde costs, some firms relocte nd emit GHGs in outh, lthough North s emissions re kept t /( t) becuse of the emission constrint. However, unlike the effect from txtion, globl emissions never return to the no- 7

18 policy level, /, for ny positive trde costs. Becuse outh never cretes full gglomertion nd the quot is still binding in North, this diversifiction of firm loction results in less globl emissions thn the cse without ny policy nd the cse of txtion. <Figure 7> <Figure 8> Proposition 5: In the cse of n emission quot, North s GHG emissions re lwys kept t the trget level of interntionl environmentl greements, lthough outh increses emissions vi interntionl crbon lekge under trde liberliztion. 5. EMIION TAX VERU QUOTA Here, we mke comprison with two-policy effects on emissions. The only trget of the North government is to implement the interntionl environmentl greement nd reduce North s locl GHG emissions. The first finding is relted to tx rtes nd the quot price. Becuse interntionl greements llocte certin mount of GHG emissions to North,, tx rtes nd the price for the permit in the quot system re ll equl (t q ) s long s ll firms concentrte in North. For this reson, both policies hve the sme full gglomertion rnge: the sme levels of NL 8 nd NU. This implies tht firm reloction begins t the sme criticl trde costs. However, reloction to outh cused by environmentl regultions results in q being less thn t for given (i.e., t > q) (see Appendix for n nlyticl derivtion). The tx rte is fixed, but the fee for the emission permit is endogenously determined by the number of North firms. As more firms relocte to outh, the emission constrint cn be more esily ttined nd then the permit price decreses. Furthermore, when mny firms move to outh, the permit price drsticlly decreses, which hmpers firm reloction. To summrize:

19 Proposition 6: The price of the emission permit under quot is lwys lower thn the per unit emission tx rte in the presence of reloction. In other words, we cn sy tht the quot hs weker reloction effect thn tx. As is cler in Figure 9, crbon lekge is moderte under the quot. Becuse tx hs stronger reloction effect, it lwys leds to more crbon lekge nd full gglomertion in outh. <Figure 9> Turning to globl emissions, this implies tht the emission in North is lrger with quot thn with txtion for ny (see Appendix for derivtion). <Figure 0> Proposition 7: The GHG emission level in North is higher with quot thn with tx policy in the presence of reloction. Compred with txtion, quot cn mitigte interntionl crbon lekge. This suggests tht if North seeks to reduce only the locl emissions to stisfy the interntionl environmentl greements, North prefers txtion to quot with smll trde costs. While quot keeps some firms in North, txtion with trde liberliztion cn force ll firms to outh nd thus North hs no firms to emit GHGs, perfectly stisfying interntionl greements. Then, North will import mnufctured goods from the fully gglomerted outh with smll trde costs. 6 Accordingly, North will tke txtion with pro-trde liberliztion. However, from globl viewpoint such n egoistic ttitude by North my not be cceptble. Regrding globl emissions, s long s firms re llowed to relocte 6 Note tht outh still hs griculture. Becuse our model dopts qusi-liner utility function to exclude ny income effect nd we ssume tht ech consumer holds cpitl nd lbour, the expenditure on M-goods is not so high s to induce complete speciliztion in M-sector in the outh. 9

20 freely, interntionl crbon lekge could be lrger thn the reduction in GHGs in North. In prticulr, tx policy returns to the pre-greement globl emission level. For this reson, with free reloction nd smll trde costs becuse of trde liberliztion, quot is better policy scheme for reducing globl emissions. A quot hs weker impct on firm reloction. The quot system could be more effective nd mke the emission level closer to the globl trget, lthough not only tx but lso the quot results in more globl emissions thn the trget s long s some firms locte in outh nd trde liberliztion proceeds. Proposition 8: An emission quot is better policy scheme thn n emission tx in the sense of it being more stringent constrint on globl emissions under free reloction with smll trde costs. 6. GLOBAL EMIION, ENVIRONMENTAL AGREEMENT AND TRADE LIBERALIZATION Free reloction with smll trde costs mitigtes the effect of environmentl policy nd consequently the globl level of emissions is higher thn the level determined by interntionl greements. Now, we study wht sorts of policies nd greements cn properly control globl GHG emissions s expected by interntionl greements while ccommodting interntionl free reloction. One solution my be to choose the combintion of environmentl tx rtes s well s trde costs by interntionl greement. Here, we keep the sitution where only North rtifies interntionl environmentl greements. The policy stems from the outcomes so fr. Given the interntionl environmentl greement on totl emissions /( t), it is necessry to prevent firm reloction nd keep full gglomertion in North. To do so, tx rtes nd trde costs should be in the shded re in Figure : intermedite trde costs nd low tx rte. <Figure > 20

21 When ny combintion of both the tx rte nd trde costs in the shded re is set up by interntionl greements nd interntionl orgniztions, the trget level of globl emissions in interntionl environmentl greements cn be chieved. To summrize: Proposition 9: When only North rtifies environmentl greements, it needs to keep intermedite trde costs nd levy smll environmentl tx to prevent interntionl crbon lekge nd chieve the trget level of globl emissions in interntionl greements. This result yields n importnt insight tht, when the environmentl greements re rtified only by North, the degree of North s environmentl policy my be restricted by trde liberliztion nd vice vers. Free firm reloction entils trde-off between trde liberliztion nd environmentl regultion. Next, s nother possibility, we consider the sitution where both countries rtify the interntionl environmentl greements. If outh rtifies n interntionl environmentl greement, things would be much esier. When globl wrming becomes serious, outh my hve n incentive to rtify greements so s to prevent firm reloction from North. When the emission tx rtes re the sme cross countries, firms prefer to sty in the bigger mrket, North, nd no firms locte to outh. Therefore, in this cse the trget level of globl emissions cn be chieved for ny trde cost: /( t). It is necessry tht interntionl greements specify the trget level of emissions s well s the interntionlly levied tx rte. The common tx rte is the key to the implementtion. In this cse, trde liberliztion is not hmpered by environmentl policy, becuse there is no interntionl crbon lekge. If both countries rtify the greement, globl GHG emissions could be reduced below the trget, < /( t). In ddition to the given globl trget, /( t), interntionl greements stte tht tx rte, t, is lower bound nd llows for higher tx rte on the condition tht full gglomertion cn be kept in North. 7 When 7 If North imposes sufficiently high rte of environmentl tx, firms relocte to outh (lx environment country) nd emission increses becuse of the emission hven effect s discussed in previous sections. Here, we ssume tht mrginl tx rte is llowed so s to promote the reduction of locl emissions but to prevent n emission hven. 2

22 North suffers lrge dmge from globl wrming, North will hve n incentive to set tx rte higher thn t by υ (i.e., υ t). This tx rte is defined by: 2 2 /( ) ( s s)( t) s s (99) ( t ) υ υ ( t). When freeness of trde is ( s)/s or, the dditionl tx rte υ is zero. Otherwise, υ is strictly positive. υ is hump-shped with respect to freeness of trde. As shown in Figure 2, North s (equivlently globl) emission level is U-shped. With positive trde costs, the emission level could be less thn. <Figure 2> Proposition 0: If interntionl greements voluntrily impose more stringent (locl) emission tx nd if environmentl dmge in North is lrge, North hs n incentive to set higher tx rtes, which could mke GHG emissions lower thn the trget in the interntionl greements. 7. CONCLUION This pper studied the impct of environmentl policies on firm loction nd crbon lekge when interntionl greements such s the Kyoto Protocol require the rtified countries to reduce emissions by certin mount. We hve compred two environmentl policy tools, emission tx nd quot, under trde liberliztion. We hve found the following. ) When trde costs re smll, either environmentl policy leds firms to relocte to country without ny environmentl regultion, which cuses interntionl crbon lekge. Thus, either environmentl policy cuses crbon lekge with free trde nd free reloctions. 2) An emission tx results in more firm reloction thn quot. Thus, n emission tx cuses more crbon lekge, incresing globl emissions. If North is concerned with only locl emissions, tx is dopted to ttin the reduction trget. On the other hnd, if North is concerned with globl emissions, quot is preferred. Thus, quot is better policy 22

23 tool to cope with globl wrming. 3) Trde liberliztion nd environmentl policies re trde-off when environmentl greements re unilterl. Trde liberliztion my hmper interntionl environmentl greements. Under certin combintions of tx rtes nd trde costs, trget reduction in globl GHG emissions cn be ttined. Our pper is the first step in exploring the reltionship between trde liberliztion nd environmentl policies in the presence of firm reloction. This pper hs some limittions. For exmple, the policy trget in this pper is to reduce GHG emissions to highlight the different policy effects of tx nd quot. Of course, it is plusible to think tht governments mximize socil welfre. Welfre nlysis nd socilly optiml policies re subject for future reserch. Becuse our model ssumes one unit of emission per unit of quntity produced, production nd emissions re subject to perfect trde-off: more production (consumption) positively ffects welfre but simultneously hs negtive effect through incresed emissions. There might exist n optiml level of emissions nd production, which hinges on the specifiction of socil welfre function. To conduct welfre nlysis formlly, we hve to specify disutility in the utility function more rigorously, tking into ccount trns-boundry/locl emissions nd ccumultion of emissions over time. Furthermore, it might be worthwhile considering the negtive impct of emissions on A-sector productivity. A-sector might be subject to decresing returns to scle by serious emissions. Future reserch should conduct more rigorous nlysis on the interntionl environmentl greements nd negotition in ection 6 by using gme theory. Moreover, we hve ssumed qusi-liner utility function tht excludes n income effect. The totl demnd for mnufctured goods remins constnt even if firms relocte nd prices chnge through the bsence of txtion or quot in outh. The constnt totl demnd implies constnt totl production nd hence the globl emission level without ny environmentl policy is independent of trde costs. This hs the dvntge of highlighting the different effects of the two policies. We cn get nlyticl solutions llowing us to esily compre the reloction effects of tx nd quot. Furthermore, even if we tke into ccount tx/quot revenue reimbursement, 23

24 becuse we cn ignore its impct, we cn focus on the effects of ech policy scheme just on firm loction nd crbon lekge. 8 APPENDIX: QUOTA PRICE AND TAX RATE Here, we mthemticlly show the reltionship between tx nd quot policies using nlyticl solutions. North s emissions without reloction, which re the trget of interntionl greements, re denoted s: (A) t s s initil N ( t), where ( t) nd. As mentioned in the min text, this trget level of emissions lwys corresponds to tht of the quot cse, regrdless of reloction: Q N initil N. Note tht t n initil equilibrium (full t q gglomertion without llowing for reloction), q is equl to t ( q t ). Next, llowing for reloction, North s emissions under tx policy cn be written s: (A2) s s T N n ( t), where tx rte t is fixed. We compre (A) nd (A2): n ( t) ( t) n n n ( t) ( t) n n,. 8 However, it is certinly worthwhile exmining the robustness of our results in the presence of n income effect. The presence of n income effect cused by reloction my cuse complete speciliztion in mnufcturing (griculture) in outh (North), though it is n extreme nd unrelistic cse. Agriculture is not the numérire ny more nd fctor prices re determined by the trde blnce nd fctor mrkets. In this cse, mrket size nd fctor prices my determine emission levels. 24

25 Therefore, North s emission level under quot is higher thn under tx for ny trde costs,. Q N T N Turning to q, becuse North s emissions re lwys identicl to the trget in the interntionl greements, by keeping constnt emission level through djusting quot prices, North s emissions under free reloction re binding (3). N s s n ( q) t The quot mrket clernce condition cn be rewritten s: s t ( n) ( q) n( q) s ( n) ( q) n( q) 0. To stisfy the condition, we need ( n) q t becuse 0 n( q) nd ( n) n( q) 0. Therefore, we show tht n endogenously determined quot price is lwys less thn the tx rte, given the sme emission trget in North. REFERENCE Bldwin, R. nd R. Forslid, P. Mrtin, G. Ottvino nd F. Robert-Nicoud (2003) Economic Geogrphy nd Public Policy, Princeton University Press, Princeton. Bldwin, R.E. nd P. Krugmn (2004) Agglomertion, Integrtion nd Tx Hrmonistion, Europen Economic Review 48 (), pp 23. Brbier, E.B. (997) An Introduction to the Environmentl Kuznets Curve pecil Issue, Environment nd Economic Development 2, Becker, R. nd V. Henderson (2000) Effects of Air Qulity Regultions on Polluting Industries, Journl of Politicl Economy 08, Copelnd, B. nd M.. Tylor (2005) Free Trde nd Globl Wrming: Trde Theory View of the Kyoto Protocol, Journl of Environmentl Economics nd Mngement 49, Dixit, A.K. nd J.E. tiglitz (977) Monopolistic competition nd optimum product diversity, Americn Economic Review 67,

26 Elbers, C. nd C. Withgen (2004) Environmentl Policy, Popultion Dynmics nd Agglomertion, Contributions to Economic Anlysis & Policy, 3 (2) Article 3. Greenstone, M., (2002) The Impcts of Environmentl Regultions on Industril Activity: Evidence from the 970 nd 977 Clen Air Act Amendments nd the Census of Mnufctures, Journl of Politicl Economy 0, Henderson, J. V., (996) Effects of Air Qulity Regultion, Americn Economic Review 86, Ishikw, J. nd K. Kiyono (2000) Interntionl Trde nd Globl Wrming, CIRJE Discussion Pper eries, CIRJE-F-78, Fculty of Economics, University of Tokyo. Ishikw, J. nd K. Kiyono (2006) Greenhouse-gs Emission Controls in n Open Economy, Interntionl Economic Review 47, Jffe, A.B.,.R. Peterson, P.R. Portney nd R.N. tvins (995) Environmentl Regultions nd the Competitiveness of U.. Mnufcturing: Wht does the Evidence Tell Us? Journl of Economic Literture 33 (), Kind, H., K. Midelfrt-Knrvik nd G. chjelderup (998) Industril gglomertion nd cpitl txtion. Norwegin chool of Economics, Deprtment of Economics, Discussion Pper 7/98. Kiyono, K. nd J. Ishikw (2004) trtegic Emission Tx-quot Non-equivlence under Interntionl Crbon Lekge, in H. Ursprung nd. Ktym (eds.) Interntionl Economic Policies in Globlized World, pringer Verlg, List, J. A., D. L. Millimet, P. G. Fredriksson, nd W. W. McHone (2003) Effects of Environmentl Regultions on Mnufcturing Plnt Births: Evidence from A Propensity core Mtching Estimtor, Review of Economics nd ttistics 85, Levinson, A. nd M.. Tylor (2008) Unmsking the Pollution Hven Effect, forthcoming Interntionl Economic Review 49, Ludem, R. nd I. Wooton (2000) Economic geogrphy nd the fiscl effects of regionl integrtion, Journl of Interntionl Economics 52 (2), pp Mrkusen, J.R., E.R. Morey nd N.D. Olewiler (993) Environmentl policy when mrket structure nd plnt loctions re endogenous, Journl of Environmentl Economics nd Mngement 24, Mrkusen, J, E. Morey nd N. Olewiler (995) Competition in regionl environmentl policies when plnt loctions re endogenous, Journl of Public Economics 56, Mrtin, P. nd C.A. Rogers (995) Industril loction nd public infrstructure, Journl of Interntionl Economics 39, Pfluger, M. (200) Ecologicl dumping under monopolistic competition, cndinvin Journl of Economics 03, Pethig, R. (976) Pollution, welfre, nd environmentl policy in the theory of Comprtive Advntge, Journl of Environmentl Economics nd Mngement 2,

27 Ruscher, M. (995) Environmentl regultion nd the loction of polluting industries, Interntionl Tx nd Public Finnce 2, mrzynsk J, B. nd. Wei (2004) Pollution Hvens nd Foreign Direct Investment: Dirty ecret or Populr Myth? Contributions to Economic Anlysis & Policy 3 (2), Article 8. Ulph, A. nd L. Vlentini (200) Is environmentl dumping greter when plnts re footloose? cndinvin Journl of Economics 03, Venbles, A.J. (200) Economic Policy nd the Mnufcturing bse: hysteresis in loction, in A. Ulph (ed.), Environmentl Policy, Interntionl Agreements, nd Interntionl Trde, OUP. 27

28 n Full Agglomertion in North Full Agglomertion in outh n0 NL NU (-s)/s Figure : Tx nd Firm hre 28

29 n n0 (-s)/s Figure 2: Tx nd Firm hre (high tx rtes) 29

30 N, Full gglomertion in south / North south t 0 NL NU (-s)/s Full gglomertion in north Figure 3: Locl Emission levels 30

31 Full Agglomertion in south / t tx Full Agglomertion in north 0 NL NU (-s)/s Figure 4: Globl Emissions (Tx) 3

32 n Full Agglomertion in North n0 (-s)/s NL NU Figure 5: Quot nd Firm hre 32

33 q0 q q (-s)/s NL N Figure 6: Quot prices Full gglomertion in north 33

34 N, Full gglomertion in north / North outh q (-s)/s Figure 7: Locl Emission Levels (quot) 34

35 / Non-restriction q Quot Full gglomertion (north) 0 (-s)/s NL NU Figure 8: Globl Emissions (quot) 35

36 n Full Agglomertion in North quot Tx Full gglomertion in outh n0 (-s)/s NL NU Figure 9: Firm hre (Tx nd Quot) 36

37 tx Full gglomertion in south / t q Quot NL NU (-s)/s Full gglomertion in north Figure 0: Globl Emissions with tx nd quot 37

38 The set of policy vribles t NL NU (-s)/s Figure : Trde Liberlistion nd Tx 38

39 t (-s)/s Figure 2: Emissions nd Voluntry Tx 39