Assessing the effectiveness of import duty to reduce carbon leakage under carbon-price uncertainty

Abstract

We model the behaviour of a profit-maximising producer in a region where carbon prices may be uncertain (possibly due to implementing emissions trading system (ETS)) or known deterministically (possibly due to a carbon tax). In particular, we analyse the propensity of the producer to shift a part of their operations offshore (carbon leakage) to avoid paying for emissions. Using a two-stage stochastic optimisation model, we show the striking difference in a producer’s long-term investment decisions in the presence and absence of carbon price uncertainty. When the producer knows the carbon price deterministically, she either invests in converting the existing domestic infrastructure to more sustainable ones or installs new capacity offshore, depending upon the magnitude of the carbon price, but never both. However, when the carbon price is uncertain, the producer could gain by simultaneously investing in domestic upgrades as well as an offshore plant, indicating guaranteed carbon leakage. While the behaviours could be different, we show that a carefully designed import duty could combat carbon leakage effectively, irrespective of the uncertainties. This, further indicates that, when used in combination with an import duty as a policy instrument, both carbon tax as well as ETS act as effective environmental policies.