August 07, 2021

Under the Cap-and-Trade program, a maximum (cap) is set on the total amount of greenhouse gases that can be emitted by all participating installations. Allowances for emissions are then auctioned off or allocated for free and can subsequently be traded. Installations must monitor and report their CO2 emissions. If emission exceeds what is permitted by its allowances, an installation must purchase allowances from others. Conversely, if an installation has performed well at reducing its emissions, it can sell its leftover credits. This allows the system to find the most cost-effective ways of reducing emissions without significant government intervention. Those well versed in the theory of rent seeking behavior worry about some special interest groups hijacking the allocation process to their benefits. If no safeguards are enacted, the rent seekers could easily corrupt the process. The Cap-and-Trade is just an example of this type of solution that can accommodate alternative way sofa singing the property rights. But as we already mentioned this solution is optimal for a closed economy. An import tax offers the possibility of eliminating or at the very least reducing the leakages already mentioned. Our discussion suggests that carbon prices could be a cost-effective way to fight climate change—but for them to work properly, emissions must be priced everywhere. A carbon border tax could help prevent the free riding issue. Unfortunately, this will not lead to a global optimal solution. If factories all over the world that wanted to sell steel, cement, aluminum, or fertilizer to the E.U. they will pay the EU a surcharge for the pollution they emit. To this end, they will have incentive to clean up their act. If it makes sense economically, they will do so. A carbon import tax would also stop European firms from responding to the carbon price by moving production to parts of the world where they can pollute without penalty. The tax would shield EU companies from being undercut by rivals from such places and to encourage foreign firms who want to sell to Europe to go green. Even if the previously mentioned perilous steps can be avoided, the carbon import tax plan is at most what economist call a “second best” solution. Yes, the carbon tariff internalizes the external effects associated with the exports of goods produced in countries with lax environmental standard. But they need to be reminded that this only applies to exports to the EU that does not directly affect any production that is consumed at home or traded with countries that are not part of the CO2 reduction compact.

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