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The green love triangle — carbon tax, carbon leakage and the climate club

#2 of 121 articles from the Special Report: Negotiating survival
Countries attending COP27 must emerge from the conference with even stronger climate policies. Photo by shutterstock

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How can we be at our 27th COP, but haven't yet successfully implemented worldwide climate action? The rationale is simple: most of the burden rests on climate actors; countries that go forward with strong climate policies risk diminishing the competitiveness of their businesses and hurting their economies.

For example, we adopted a carbon tax in Canada because it is the cheapest way to achieve our GHG reduction target. But, unfortunately, it comes with carbon leakage; by imposing an extra burden on our Canadian businesses, the goods we produce here might "leak" to more GHG-intensive countries — increasing the total greenhouse gases released into the atmosphere despite our objective to reduce it.

To ensure our carbon tax does not damage the Canadian economy or the climate through leakage, we need to implement carbon border adjustments, or CBAs. This means taxing imports from countries that do not have a carbon pricing system.

The climate club

William Nordhaus, who won the Nobel Prize 2018 in economics for his research on the economic impact of climate change, proposes the concept of a climate club.

To ensure our carbon tax does not damage the Canadian economy or the climate through leakage, we should implement carbon border adjustments, writes @cordeau_ #CircularEconomy #COP27 #ClimateCrisis #ClimateAction #renewableenergy #ActOnClimate

Countries with reasonable carbon prices would not have to pay border taxes — since they are "club members" — whereas those without carbon pricing would see themselves being taxed proportionally to the GHG insensitivity of their grids. This would ensure that those with solid climate agendas do not pay the economic or political price of doing the right thing. On the contrary, they would benefit from doing so — ending the so-called tragedy of the commons.

Foreign corporations — not solely environmentalists — would push their governments to apply carbon pricing since they would benefit from doing so. This also means more economically minded voters would request a carbon tax, seeing better prosperity from being green.

Realistic

This proposal is realistic. It does not need international collaboration; countries with a carbon tax will implement a CBA to prevent leakage. In fact, the EU will start implementing it next year, and Canada pledged collaboration. Moreover, even without a carbon tax, the U.S. is considering applying a CBA to prevent production from being reallocated to cheaper, more GHG-intensive countries. Indeed, the Inflation Reduction Act makes it especially appealing for American firms to implement a CBA since the American grid will become greener, improving their competition.

In short, a CBA — a climate club being a logistically easily implementable form — favours climate action. In addition, it incentivizes non-members to implement climate policies, such as carbon pricing, clean electricity regulations, and/or subsidies.

It is, perhaps, the best tool we possess to reduce the world's GHGs. Even better, this measure would not hurt our economy, quite the opposite; it would support and facilitate the energy transition of Canadian businesses. They would no longer undergo unfair competition against competitors from lax environmental jurisdictions.

Equitable

Some wise voices may raise concerns. For example, "The West has polluted massively during its industrialization and now has greener grids. Wouldn't that be unfair for developing countries?"

It is.

It is worth stressing that developing countries are the most affected by climate change; this implies that they benefit the most from climate action. So, a worldwide reduction of GHGs is excellent news for them, yet these nations do not possess our wealth, and the lives of their citizens depend on their economies. Literally.

To tackle this issue, Canada should start by honouring its part (ideally more) of the $100-billion pledge from the Paris Agreement, which aimed to assist developing countries in this climate endeavour. The money could be used to implement renewable grids, foster a green transition and establish climate resilience.

The financing for this could come from the very tax we imposed on borders. That way, the money would be efficiently allocated to maximize intergenerational welfare without exacerbating inequities.

Prisoner of the wrong dilemma

The climate club proposal is rooted in the idea that climate change is a prisoner's dilemma. However, Akalin and Mildenberger (2020) have weakened the prisoner's dilemma hypothesis. Their thesis is simple: the evidence that climate change is a prisoner's dilemma is weak, whereas evidence that it is a distributive conflict is strong. But, forming a climate club is not only destined to solve the prisoner's dilemma, it is aligned with the Bergquist et al. (2020) coalition-building strategy. If implementing a climate club reduces the loser's burden — notably by ensuring fair competition with foreign countries — then climate action is eased.

Conclusion

The carbon tax is one of the best tools to reduce local GHGs. However, the existing tax gives rise to carbon leakage, potentially increasing the GHGs released by certain goods worldwide. Here is where the climate club takes root. By stopping leakage, the concept promotes itself as a realistic, efficient and equitable form of CBA.

Hugo Cordeau is a PhD student in economics at the University of Toronto.

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