On the Optimal Design of a Carbon Border Adjustment Mechanism
by Frank Stähler, Martin Richardson, and Murat Yildiz
Abstract: We identify a simple condition in a general equilibrium model of trade with tariff bindings under which a customs union (CU) can optimally design a carbon border adjustment mechanism (CBAM) against all other countries such that they will adopt a common carbon tax set by the union. Lower tariff bindings relax the constraint imposed by a CBAM and thus trade liberalization would help the CU implement its climate policies in the world. We then consider two classes of trade model with more specific assumptions. In an intra-industry oligopoly model of trade with profit shifting incentives, we first show that the optimal carbon tax is larger when the CU maximizes union welfare relative to the case where it acts as a social planner, maximizing global welfare. More importantly, the CU raises its tariffs via CBAM beyond the difference in member and non-member environmental taxes, to "level the playing field" since product market competition not only happens in the CU but also in the non-member's market. By contrast, in an inter-industry, perfectly competitive framework with competing exporters, we find the opposite results.