Carbon Tax and Carbon Leakage:

Policy Options

Carolyn FischerResources for the Future

October, 2011

Why might a carbon price alone

not be enough?• Pre-existing taxes distort labor (and capital) markets

– Higher prices from regulation lower real wage, reducing

labor supply and tax revenue: “Tax Interaction”

– It matters how we use the revenues

• Incomplete regulatory coverage

– Higher product prices can cause substitution towards

unregulated goods or imports: “Carbon leakage”

– It matters how we treat energy-intensive trade-exposed

(EITE) sectors

• Other market failures

– Imperfect competition, technology spillovers, barriers…

Fischer-Fox Emissions and Trade

Model

• CGE model based on GTAPinGAMS-EG

– Static, 2004 base year

• Key features

– Labor-leisure tradeoff

– Improved emissions data: process emissions, feedstocks, and baseline calibrated to EIA

– Calibrated global fuel supply elasticities

• Crude oil is slightly inelastic, while coal and now gas are elastic

• Compare scenarios for unilateral U.S. policies with equivalent global emissions outcomes

The Importance of Revenue

Recycling

-90,000

-80,000

-70,000

-60,000

-50,000

-40,000

-30,000

-20,000

-10,000

0

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

U.S

. wel

fare

co

st o

f re

du

ctio

ns

(mil

lio

ns

of

$2

00

4)

Percentage reduction in U.S. emissions (net of leakage)

Recycle

Transfer

% Change in Production, of which Change in Net

Exports (20% Reduction Target, 100% Recycling)

Options for Coping with Leakage

• Making the carbon tax global (best)

• Effects of other options can depend on how the

remaining revenues are being used!

Option (1): Output-based rebating

• Could be implemented by requiring compliance

payments above a (refundable) performance

standard

– Still like a subsidy

• Mitigates product price increase, which dampens

leakage but also conservation incentives

– Best applied narrowly to EITE sectors

• Also dampens tax interaction, but less effectively

than a broad-based tax cut

– Rebates in electricity more costly than recycling, but may

be better than transfers

Option (2) : Border Carbon Adjustment

• Taxing imports based on a measure of their carbon

content (and refunding for exports)

• Ensures consumers pay carbon-inclusive price,

regardless of origin

– Dampens leakage but maintains conservation incentives

• Costly if implemented too broadly

– But can improve cost-effectiveness if applied narrowly to

EITE sectors most vulnerable to leakage

– Controversial, but BTA may be more likely to pass WTO

muster in combination with a carbon tax than tradable

permits

Stylized policy scenarios

Abbrev-

iation

Scenario Description

A0 (G0) 100% recycling (transfers)

A1 (G1)OBR to EITE (direct+indirect emissions for each sector),

remaining 85% of revenues recycled (transferred)

A2 (G2)OBR to EITE+ELE (direct emissions for each sector),

remaining 50% of revenues recycled (transferred)

A3 (G3)BCA for EITE+ELE imports (direct+indirect emissions for each

sector), 100% of revenues recycled (transferred)

• Unilateral U.S. policy

• Coverage: 1) Comprehensive 2) Energy intensive only

-30,000

-25,000

-20,000

-15,000

-10,000

-5,000

0

5,000

10,000

15,000

20,000

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

A0

A1

A2

G0

G1

G2

• U.S. prefers OBR to EITE with rest recycled

– less leakage, improved terms of trade

– little effect on carbon price

• Extending OBR to ELE

– 33% higher carbon price

– less leakage than full recycling (A2 > A0)

– Less tax interaction than transfers (G2 > G0)

Sensitivity of U.S. Welfare Changes to Stringency of Emissions Reduction Target (Millions of 2004 USD)

Compared to 100% recycling

-30,000

-25,000

-20,000

-15,000

-10,000

-5,000

0

5,000

10,000

15,000

20,000

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

A0

A1

A3

G0

G1

G3

• U.S. prefers OBR to BCA for EITE sectors

Sensitivity of U.S. Welfare Changes to Stringency of Emissions Reduction Target (Millions of 2004 USD)

Compared to 100% recycling

-30,000

-25,000

-20,000

-15,000

-10,000

-5,000

0

5,000

10,000

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

A0

A1

A3

G0

G1

G3

Sensitivity of Global Net Welfare Changes to Stringency of Emissions Reduction Target (Millions of 2004 USD)

Compared to 100% recycling

• Global welfare highest with BCA + recycling,

while recycling generally preferred to OBR

• If revenues are transferred,

OBR and BCA both preferred to

no treatment of EITE sectors

Conclusions and Caveats

• OBR and BCA have potential to improve efficiency

and reduce leakage from unilateral climate policy

– If appropriately circumscribed

– Must phase out OBR as more trade partners regulate CO2

• Not recycling the revenue is costly

• Serious practical challenges for both OBR and BCA

– defining appropriate metrics for eligibility, consistent

units of production, benchmarks that do not mute the

effectiveness of the carbon price, embodied carbon calcs

• Most models (like ours) lack sufficient sectoral detail

to capture these issues.

Thanks!

• Fischer, C. and A.K. Fox. 2010. “On the Scope for Output-Based Rebating in Climate Policy: When Revenue Recycling Isn’t Enough (or Isn’t Possible)” RFF DP 10-69.

• Funding from the ENTWINED Program of the Mistra Foundation gratefully acknowledged.