Strategic responses to the carbon border adjustment mechanism: When and how to implement a carbon tax

Abstract

This study investigates when and how a low-carbon-regulated country (LCRC) implements a carbon tax in response to the enforcement of a Carbon Border Adjustment Mechanism (CBAM) by a high-carbon regulation country (HCRC). In particular, we analyze the roles of carbon cost deductions and free allowances in such policies. Using free allowances as indicators of CBAM policy intensity, we develop a model representing a manufacturer in an LCRC that serves both export (HCRC) and domestic markets. Our results reveal a CBAM intensity threshold that significantly alters the manufacturer’s CBAM costs and decision-making, yielding two distinct scenarios: Scenario PA (costs incurred above the threshold) and Scenario FA (costs not incurred below the threshold). In Scenario PA, introducing a carbon tax leads to higher emission reduction levels, increased export production, and lower total carbon emissions, despite a decline in domestic sales and profits. Conversely, in Scenario FA, the carbon tax reduces emission reduction levels and export production, increasing total carbon emissions. Importantly, we reveal the dynamic relationship between CBAM policy intensity and optimal carbon tax rates, providing a clear map for how the LCRC government should adjust tax rates as CBAM intensity increases. Specifically, we recommend that the LCRC government adopt a carbon tax only when the CBAM policy intensity exceeds the threshold and progressively increase the tax rate in response to a stronger CBAM. Furthermore, carbon tax revenues should be strategically reinvested in emission reduction technologies to foster sustainable growth for domestic manufacturers.