The main point of contention at COP26, and decades of climate negotiations, has been balancing emissions reductions with economic growth. This 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, 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 outlines the optimal climate policy nations could implement to maximize global emissions reductions and minimize economic impacts.

“When industries leave, they take their emissions with them—delivering a one-two punch of economic losses while having little impact on global climate change,” says the study’s co-author David Weisbach, Walter J. Blum Professor of Law at the University of Chicago Law School. “The best climate policy would balance trade and economic concerns while optimizing emissions reductions. Achieving that optimal policy is actually quite straightforward.”

Weisbach and his co-author Samuel Kortum from Yale University test what makes an optimal policy. 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 policy 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 for producing low-carbon goods, and even expands 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. Moreover, relatively simple policies built on the underlying principles of the optimal policy also significantly outperform conventional policies. In particular, 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) performs nearly as well as the optimal policy.

“This optimal climate policy, or conventional approaches that behave similarly, in effect encourage trading partners to take similar steps to reduce the trade of fossil fuels and to reduce the energy content of the products they trade,” says Kortum, the James Burrows Moffatt Professor of Economics at Yale University. “This could have a domino effect on climate policies globally.”

Areas of Focus: Energy Markets
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Energy Markets
Well-functioning markets are essential for providing access to reliable, affordable energy. EPIC research is uncovering the policies, prices and information needed to help energy markets work efficiently.
Fossil Fuels
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Fossil Fuels
Under current policies, fossil fuels will play an important role in the energy system for the foreseeable future. EPIC research is exploring the costs and benefits of these fuels as...
Climate Change
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Climate Change
Climate change is an urgent global challenge. EPIC research is helping to assess its impacts, quantify its costs, and identify an efficient set of policies to reduce emissions and adapt...
Climate Law & Policy
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Climate Law & Policy
As countries around the world implement policies to confront climate change, EPIC research is calculating which policies will have the most impact for the least cost.
A Solution to the Leakage Problem
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A Solution to the Leakage Problem
A simple, clearly legal, and more effective alternative to border tax adjustments could be to tax domestic extraction along with border adjustments on imports and exports of energy.