Emissions Reductions vs. Cost for Optimal Policy Compared to Traditional Policies

Source: Optimal Unilateral Carbon Policy, BFI Working Paper, November 2021

International climate negotiators have been meeting for decades to respond to climate change. The main point of contention has been how to balance emissions reductions with economic growth—and this year was no different. The tension has created a gap between some countries that are willing to set ambitious climate policies and other countries not willing or able to make the sacrifice. As a result, industries, and their emissions, may move to countries with less stringent policies. To confront this challenge, the European Union is considering carbon border adjustments—taxes on imports and rebates on exports. Every major carbon price proposal in the United States includes a similar mechanism. But are these tweaks effective?

A new analysis by UChicago Law’s David Weisbach and Yale University’s Samuel Kortum outlines the optimal climate policy nations could implement to maximize global emissions reductions and minimize economic impacts. They find that such a policy is one that combines taxes on the supply and demand for fossil fuels to control the price of energy in regions without strong policies. This is important because if the price of energy swings low, the cost to produce goods abroad is cheaper, and if it swings high, countries with less stringent policies would be inclined to extract more energy because they would make more money doing so. Combining taxes on the supply and demand allows the effects on the global energy price to be offset. With little impact on the price of energy, trade can continue uninterrupted.

To implement this optimal policy (gray line) would involve 1) imposing a tax on domestic extraction (supply) and 2) combining that with production and consumption taxes (demand) through border adjustments on fossil fuels—taxes on fossil fuel imports and rebates on fossil fuel exports—as well as border adjustments on other imports (according to their energy content). The border adjustments would be at a lower rate than the extraction tax rate. This feature shifts a portion of the tax downstream to production and consumption, but because it is at a lower rate, maintains a portion of the extraction tax. Further, the optimal policy would include a 3) subsidy for exports to ensure that there is still the incentive to produce low-carbon goods, and expanding the export of such goods.

The study goes on to compare the optimal policy to more conventional policies, such as taxes on emissions from domestic production or those taxes combined with border adjustments. The optimal policy can achieve two to three times the emissions reductions for the same cost as the conventional policies, like a typical carbon tax (a production tax, blue line). Moreover, relatively simple policies built on the underlying principles of the optimal policy also significantly outperform conventional policies. A tax on domestic extraction combined with border adjustments on imports and exports of fossil fuels (but not other imports and leaving out the subsidy for exports) at a lower rate than the extraction tax rate performs nearly as well as the optimal policy (red line).

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