International spillovers from climate policy – Bank Underground

Francesca Diluiso and Aydan Dogan

To achieve the emissions reduction targets outlined in The Paris Agreement, many economies have started implementing various types of climate policies. These policies, which include subsidies for green production or investment, carbon taxes, and cap and trade schemes, are crucial for guiding the transition to a greener economy. However, by altering the cost and the emission intensity of domestically produced goods, they may have an impact on inflation, output, and international trade flows. This blog post explores the spillover effects due to the implementation of climate policy in a single country. We examine two major types of policies currently implemented and discussed worldwide: green subsidies and carbon taxes.

To illustrate, consider two prominent examples. The US introduced the Inflation Reduction Act in 2022, which offers tax incentives for domestic investments in green technologies. Meanwhile, the European Union has established a carbon pricing system and is promoting a comprehensive set of green policies. These reforms, while targeting domestic goals, are likely to create international spillovers. Since empirical evidence on these international effects is limited, we use a theoretical model to build intuition.

We borrow a Dynamic Stochastic General Equilibrium model developed in a recent paper, featuring three blocks: two advanced economies (the euro area and the US) and the rest of the world, representing emerging market economies (EMEs). The EME block produces only emission-intensive goods, while in advanced economies there are two sectors where firms produce either emission-intensive or carbon-free (‘green‘) goods. Emission-intensive goods are cheaper due to mature technologies but generate carbon emissions contributing to global warming which reduces global output. Green goods are more expensive, but do not generate emissions. Consumers have the same preferences for both types of goods and consume both domestically produced and imported goods. Investment in each sector is a mix of foreign and domestic inputs. Carbon tax revenues are redistributed to households in a lump-sum manner, while green subsidies are financed through lump-sum taxes. Monetary policy is set by central banks following a standard Taylor rule.

Dynamic transmission of carbon tax shocks and international spillovers

What happens if domestic Country D (euro area) imposes a carbon tax and foreign Country F (the US) does not?

Domestic country

A carbon tax in Country D raises production costs for emission-intensive firms, reducing their output and demand for labour and capital. This prompts a reallocation of resources towards the green sector which experiences an increase in labour, capital, and investment. Despite the boost in green production, total output in Country D decreases due to the significant contraction of the emission-intensive sector, which is, by assumption, more productive than the green one. Initially, the carbon tax raises inflation by increasing marginal costs in the emission-intensive sector, but over time, inflation declines as productivity rises in the green sector and aggregate investment decreases. Potential strong adjustments in aggregate demand due to carbon taxes have been documented in the literature (eg Diluiso et al (2021); Coenen et al (2024)). However, the size of this adjustment, relative to changes in relative prices and inflation, crucially depends on the expectations and behaviour of firms and households (Annicchiarico et al (2024)).

Foreign country

For a trading partner of similar size to Country D, the carbon tax creates a comparative advantage in the emission-intensive sector, increasing its production (and emissions). The increased productivity of this sector reduces inflation and boosts aggregate output in Country F but leads to carbon leakage, as emissions in Country F rise due to the shift in production toward the polluting sector.

Spillovers: bilateral trade dynamics

The real exchange rate of Country D appreciates, reflecting higher consumer prices relative to Country F, leading to a trade balance deterioration. However, not all sectors are affected equally. In Country D, the green sector runs a trade deficit: as demand switches from emission-intensive to green goods, there is a surge in green imports. In Country F, the expenditure share of the emission-intensive sector goes up, along with investment, leading to a slight trade surplus in Country D’s emission-intensive sector.

What happens if Country F is a small open economy?

The spillovers described above hold when D and F are both large economies, able to influence global prices. However, a carbon tax in a large economy affects small open economies (SOEs), like the UK, in a different way, since these economies are more sensitive to relative price changes abroad. In SOEs, imports are a large share of domestic demand, and exports are a large share of output. Therefore, in response to a carbon tax abroad, they might experience a trade surplus driven by an increase in the export of green goods, and an expansion in the production of emission-intensive goods. However, their overall output gradually declines as total demand from D contracts. At the same time, imports become more expensive, pushing up inflation. Consequently, the SOE country may experience a surge in inflation and a fall in output. This differs from the case of a large F economy.

Dynamic transmission of green subsidy shocks and international spillovers

What happens if domestic Country D (the US) imposes a green subsidy and foreign Country F (euro area) does not?

Domestic country

The main difference with the carbon tax case considered above lies in the reaction of output and inflation. In this case both variables increase. The subsidy reduces the cost of green goods, boosting their demand. Moreover, households are paying lump-sum taxes to finance the subsidy. The additional fiscal burden that weighs on households’ income prompt them to work more, increasing the overall labour supply in the economy and reducing wages. This lowers production costs in Country D further. Emissions decline as production relocates from emissions-intensive sectors toward green ones. Initially, inflation falls as green prices drop, but it then rises, driven by the increase in aggregate demand. Green subsidy shocks in Country D act like positive demand shocks, by stimulating green production and leading to higher overall production and demand.

Foreign country

In the carbon tax case, we observed an increase in output and a decrease in inflation in trade partners of the same size as Country D. In response to a green subsidy, instead, Country F experiences an increase in both output and inflation, following a short-lived fall due to a loss of competitiveness from an initial exchange rate depreciation. On the one hand, in response to the increased demand for green exports, Country F expands its green production, marginal costs rise, and this causes inflation in the green sector. On the other hand, domestic demand switches to emission-intensive goods, leading to an expansion of the emission-intensive sector. However, while the expansion and resource reallocation to the emission-intensive sector may lead to lower production costs and reduced inflation, this effect is milder than in the case of a carbon tax and insufficient to offset the inflationary pressures caused by the strong demand for green exports.

Spillovers: bilateral trade dynamics

The real exchange rate of Country D depreciates on impact, as green goods become cheaper. However, this effect is short-lived: as demand strongly picks up, the real exchange appreciates, making imports cheaper relative to domestic goods. Country D’s trade balance deteriorates. Similarly to the carbon tax case, this is driven by the surge of green imports. Net exports of emission-intensi=ve goods improve marginally.

What happens if Country F is a small open economy?

If the trading partner is a SOE, its bilateral real exchange rate depreciates (from the perspective of Country D). The SOE’s output increases due to the expansion of green production required to meet the higher demand for green goods from Country D, although exports displace domestic demand. Due to cheaper imports and lower domestic demand, the cumulative response is a fall in inflation.

Rest of the world

Recall that the rest of the world serves as a proxy for EMEs, which only produces emission-intensive goods. In response to both climate policy shocks, production in this block increases, leading to a rise in emissions. Since there are no climate policies in place, emitting remains costless for firms. The real exchange rate depreciates, and the overall trade balance improves.

Global emissions

Despite carbon leakage effects, global emissions decline in all scenarios, suggesting the policies are successful in reducing domestic emissions sufficiently to counteract the increase in the emissions of Country F and the rest of the world.

Conclusion

Both carbon taxes and green subsidies result in a reallocation of resources from emission-intensive sectors to green ones in the economy imposing the policy. However, carbon leaks to trading partner countries, as resources are reallocated towards more emission intensive sectors there.

Interestingly, these policies may have distinct macroeconomic impacts and lead to different international spillovers. In the country imposing the policy, carbon taxes lead to a contraction in output and a gradual fall in inflation, while green subsidies boost both output and inflation.

Spillovers on output and inflation in trading partner countries, as well as real exchange rate and trade balances dynamics, are crucially influenced by the size and openness of the economies involved.

Francesca Diluiso works in the Bank’s Structural Economics Division and Aydan Dogan works in the Bank’s Global Analysis Division.

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