The most worthless climate policy is one that generates a lot of public debate, imposes serious costs on consumers and businesses, but ultimately, doesn’t put a dent in global emissions.

A great example is the Paris Agreement of 2015. World leaders got together and decided (again) that, yes, we should do something about climate change. Based on the science, we should not exceed 2 degrees of global warming above pre-industrial levels. OK. So what did they do? All participating nations drew up non-binding, “nationally determined contributions”, which are basically emissions reductions goals by a certain year. And if certain nations don’t meet their goals? They should be “named and shamed” by the rest of the world. In summary, the media made a big deal about an expensive and publicly-funded government summit while oil and gas companies continued their assault on the atmosphere.¬†There wasn’t even any agreed upon policy. Ultimately, the US (historically the most egregious polluter) dropped out of the deal less than two years later. See what I mean by worthless?

The only way climate policy can be effective is with border carbon adjustments, and this post explains why.

The status quo is cheaper

Ultimately, the issue with climate change is the collective action problem. Suppose one country (let’s call it Greenia) decides to curb climate emissions by imposing a carbon tax. The carbon tax makes energy consumption and consumption of carbon-intensive goods more expensive in Greenia. For this reason, other countries (let’s call one of them Pollutia) don’t impose such restrictions, and their citizens are richer for it. Politicians generally have an incentive to implement policies that enrich their constituencies. As a result, the people in Greenia end up paying more for energy, only to fall victim to climate change in the end anyway due to the polluting behavior of the Pollutia.

It gets worse: polluters just pollute somewhere else

Unfortunately, the problem isn’t constrained to the borders of Pollutia. Specifically, the polluting producers in Greenia sell their product to a certain group of consumers, both in Greenia and abroad. After the new emissions restrictions are imposed, their production costs go up. In order to continue serving their customers, they might minimize their costs by relocating production to Pollutia, where there is no carbon tax. As a result, the well-intended climate policy in Greenia not only caused emissions to increase elsewhere, but it also cost Greenia jobs and investment capital. 

In short, Greenia didn’t achieve its goal of reducing carbon emissions, and it made life harder for its citizens. Talk about shooting yourself in the foot.

Local climate policies affect global markets

What I described above is known as carbon leakage: a climate policy that aims to decrease carbon emissions ends up increasing emissions elsewhere. So far, I’ve only described one aspect of carbon leakage: polluting firms have an incentive to pick up and move their production to more climate-lenient jurisdictions.

If you can believe it, the story gets even worse. Firms don’t even have to move to Pollutia for emissions to increase. Rather, the policy introduced in Greenia lowers global market prices for fossil fuels, making it cheaper to use them elsewhere.

We can think of this graphically: start with a global market for coal, where Greenia and Pollutia are the only two countries in the world. The price is $50 per metric ton, and global consumption is 5 million metrics tons per year.

Then, Greenia introduces a carbon tax. This makes products that use coal as inputs more expensive in Greenia. Therefore, demand decreases by 1 million metric tons in Greenia. Assuming Greenia is a large country, let’s say the decreased demand in Greenia decreases global demand significantly (a move from D(G) to D1(G) in the graph below). Once this happens, the global price of coal decreases (in our example, from $50 to $40). In our example, global coal consumption has decreased from 5 million to 4 million tons. 

The carbon tax increases coal consumption

Now, the global price of coal has dropped (although it has actually risen in Greenia due to the tax). What do you do when the price of something you consume drops? Consume more of it! This is exactly what ends up happening with coal. Firms in Pollutia take advantage of cheaper coal and lower the price of their products. Consumers see the lower price and increase their consumption, thereby increasing the amount of coal that is ultimately burned. This is represented on the graph below by a move from D1(G) to D2(G):

In the end, while local coal consumption decreased by 1 million metric tons, Greenia’s carbon tax caused coal consumption in Pollutia to increase by 500,000 metric tons. Those 500,000 metric tons represent the amount of carbon leakage caused by Greenia’s intervention.

The unintended consequences of climate policy

Carbon leakage can be summarized by one or more of the following unintended consequences, which I’ve discussed above:

  • Climate policy makes domestic investments less profitable; this drives capital flows to jurisdictions with lax climate policy. I explained how firms in Greenia are incentivized to relocate to Pollutia.

  • Decreased demand for fossil fuels drives down their price, making their use more attractive in jurisdictions with lower taxes on fossil fuels. Above, I showed graphically how a carbon tax in Greenia drove down coal prices, ultimately increasing demand for coal in Pollutia.

  • Differences in production cost cause substitution of goods/inputs from jurisdictions with strict climate policy.

As long as countries that implement climate policy are integrated into the global economy, market behavior will increase carbon emissions in countries with less strict environmental regulations.

Border carbon adjustments get rid of unintended consequences

Ultimately, Greenia cannot dictate what lawmakers in Pollutia decide. However, it can mitigate some of the unintended consequences of its carbon tax by introducing border carbon adjustments.

Border carbon adjustments attempt to level the playing field by including imports in, or exempting exports from, the carbon tax. In our example, let’s say Greenia imposed a tax on domestically produced products that used coal in their production. In that case, consumers in Greenia could save money by simply buying foreign products that weren’t subject to the tax. A border carbon adjustment would impose a tariff on these products in line with the tax rate charged to domestic producers. 

Greenia could also exempt coal-intensive exports from the carbon tax. This would allow domestic companies to remain competitive in the global market, which solves one of the unintended consequences. The export exemption would not affect global demand assuming a competitive market.

Great idea. Let’s implement it!

The trouble with border carbon adjustments is that no country has ever actually implemented one. Climate Strategies has an outline of several proposals here, but so far, only California has introduced anything close to an actual border carbon adjustment. Even California’s policy only applies to electricity imports from neighbouring states.

There has also been a flurry of carbon tax proposals in the US lately, and the Columbia Center on Global Energy Policy covers those here. While the proposals vary in their coverage and proposed tax rate, all of them include border carbon adjustments. This is encouraging, but it could be a while before a tariff on carbon-intensive imports is actually implemented anywhere. I tend to doubt that the US will be a pioneer in climate policy.

Another issue is the scope of border carbon adjustments. They only apply to firms and consumers within a certain jurisdiction. This means that foreign firms and consumers are free to pollute all they want, as long as their behavior doesn’t affect domestic markets. But the key with climate change is capping the total amount of global carbon emissions. Pollution in one place affects all consumers and firms everywhere. While border carbon adjustments solve part of this problem, it remains the primary difficulty in climate policy.

An interesting example of jurisdictional restrictions to climate policy is described in this Climate Strategies report. One proposed version of the European Emissions Trading Scheme required foreign airlines to purchase certificates to cover their emissions in international airspace for flights entering the EU. Ultimately, the proposal was shot down due to concerns about WTO infringements (and, probably, because it would have had a negative impact on tourism in Europe).

The takeaway: border carbon adjustments are great, but not enough

I would summarize the takeaways from this post as the following:

  • As long as countries remain globally integrated, climate policy will cause some degree of carbon leakage.
  • Countries with existing carbon taxes should implement border carbon adjustments in their widest possible application, immediately.
  • Although not discussed in this post, the revenues from border carbon adjustments should be paid out as a dividend to taxpayers or invested in green technology research.¬†The dividend would mitigate the regressive effects of a carbon tax, while investments in clean tech would move the market toward a state with fewer emissions and less government intervention (i.e. cheap, clean energy usage). I wrote about one potential emerging technology here.

So far, climate policy has been largely pointless. Border carbon adjustments, while not a panacea, at least move the needle in the right direction.