In a world in which countries are linked by international trade, capital flows, and technology transfers GHG abatement by one country has welfare effects on others. In some cases these impacts, or spillovers, are positive and in others negative. Spillovers are a broad concept that has been used in relation to a number of different international inter-linkages between GHG emission reduction policies and impacts on industrial competitiveness, reallocation of industry, and a development and implementation of technologies. This section provides a short introduction to these main categories of spillovers as an introduction to Chapters 8 and 9 that include a review of economy-wide and sectoral studies on spillovers.

7.4.3.1 Industrial Competitiveness and Potential Reallocation of Industries

GHG emission reduction policies potentially will have a major impact on industrial competitiveness because sub-sectors that have relatively high GHG emission intensity or have relatively high reduction costs potentially can lose in competitive-ness.

The basic theoretical framework is that of a full employment, open economy, and no international capital mobility (Dixit and Norman, 1984). Within this model an emissions constraint shifts the production possibility frontier inwards, as long as the constraint requires some “no regret” measures to be undertaken. The spillover impact of this shift depends on whether the emissions reductions have a greater impact on the production of the export good, or on the import competing good. If it is the former, abatements turn the terms of trade in favour of the country that undertakes abatement and against the country that does not. In these circumstances the non-abating country suffers some welfare loss, while the abating country could be better or worse off, depending on the size of the shift in terms of trade relative to costs of abatement. Conversely, if emissions have a greater impact on the production of the import-competing good, the terms of trade move in favour of the non-abating country, which should have an increase in welfare. The analysis of industrial reallocation considered in the previous section becomes further complicated when international capital mobility is taken into account. Carbon constraints typically alter relative rates of return against abating and in favour of non-abating countries. A flow from the former to the latter is then likely, which shifts further inwards the production possibility frontier in the abating country. At the same time, it causes an outwards shift of the frontier in the non-abating country. Modelling capital flows is notoriously difficult, however, and no theoretical results can be obtained for the complex and empirically relevant cases. Hence the indisputable need to use simulation models and to undertake primary empirical research. The welfare impacts of changes in international capital flows are seldom reported. Progress depends on the further development of techniques such as decomposition analysis (Huff and Hertel, 1996)¹⁸ and multiple simulations in which some variables are held constant to isolate their influence on the final outcome.

Seen from a more practical perspective the theoretical arguments about competitiveness and international capital flows have at least two versions of what happens without specific developing country targets: either domestic industry relocates abroad, or the demand for domestic energy-intensive goods declines and the trade balance deteriorates; or both occur.

Consider four factors that affect location or trade effects. First, do the non-tradable sectors account for a substantial share of carbon emissions? Second, are energy costs a small or large percentage of the total costs in key manufacturing sectors? Third, is the burden of meeting an emission reduction target partially borne by non-participating countries because of changes mediated through international trade? For example, developed nations could demand fewer exports from non-participating countries. This would shift the terms of trade against these countries, and they would bear some of the costs of reducing GHGs. Fourth, how do resources shift across sectors because of carbon policy? For instance, there could be a shift from the energy-intensive sector to the domestic goods sector that is non-energy intensive. The aggregate impact could be positive or negative depending on the potential returns from the non-energy intensive sector.

First, consider the “pollution havens” hypothesis, in which firms are tempted to relocate to or to build new plants in nations with lax environmental standards (see Dean, 1992; Summers, 1992; Esty, 1994; Jaffe et al., 1994). Palmer et al. (1995) point out that the following must be considered:

• whether the cost of complying with environmental regulation is a small fraction of total cost;
  
• whether the differences between the developed nation’s environmental regulations and those of most major trading partners are small or large; and
  
• whether the firms of the developed nation build state-of-the art facilities abroad regardless of the host nation’s environmental regulations.

The evidence to date on pollution havens is not strong, although this may change in the future as international agreements on climate change come into force.

In the context of climate change, cost estimates must consider how carbon taxes affect trade flows in the short and long runs. The “leakage effect” reflects the extent to which cuts in domestic emissions are offset by shifts in production and therefore increases in emissions abroad. The empirical question is whether nations that are a net exporter in fossil fuel intensive products (e.g., steel) gain under Annex I-only carbon policies. Other developing nations might not gain because less capital will be available as the income in the developed nations drops, and it becomes more costly to import from developed nations the capital goods that promote growth (e.g., machinery and transportation equipment). See Chapters 8 and 9 for any empirical evidence on the magnitude of leakage.

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