Consumption-Based Approaches in International Climate Policy

This chapter introduces a number of basic concepts needed to analyze consumption-oriented approaches in international climate policy. First, the exact difference between production-based and consumption-based emission accounting is explained. Two methods to determine a country’s consumption-based emissions inventory are presented—the bottom-up approach and the top-down approach relying on environmentally extended input-output analysis. Then the question how a country’s consumption-based emissions inventory can be used as a base for climate policy is examined. It is argued that it is crucial to distinguish between the base to which emission reduction targets refer and the base to which the policy instrument is applied. Two options are introduced by which the policy base can in practical terms be changed from production to consumption—border carbon adjustments and a “carbon-added” scheme. Finally, various criteria for assessing different climate policy variants are discussed: economic efficiency, cost-effectiveness, environmental effectiveness, carbon leakage, welfare, and competitiveness. This discussion shows that one of the most common policy effectiveness indicators—carbon leakage—in its standard definition is actually tailored only to a production-based policy. An alternative definition is presented that allows leakage to be determined in a meaningful way also for consumption-oriented policies.

The idea of switching to a consumption-orientation in international climate policy is politically controversial and might contravene some regulations of international trade law. The debate on these issues is typically framed in terms of “border carbon adjustments”—the best-known method of introducing consumption-based policies. This chapter first presents the various motivations for advocating border adjustments: to preserve the competitiveness of industry in abating countries, to increase the global environmental effectiveness of unilateral abatement measures, to sanction countries not participating in an international abatement regime, and to prevent an increase of what has become known as “weak” carbon leakage. Then the international political debate on border carbon adjustments is summarized: in the U.S., this debate focuses on competitiveness concerns, whereas in the EU generally environmental motives are emphasized. Most developing and emerging economies, on the other hand, see border measures as unfair protectionism. As regards international trade law, border carbon measures tread legally uncharted territory. In particular border measures extending to exports, measures that differentiate between goods according to the amount of “embodied” carbon, and measures used to sanction other countries or to preserve a country’s competitiveness instead of furthering purely environmental objectives are deemed problematic. Border adjustments can be designed such as to minimize the risk of a legal challenge; such designs are however typically environmentally less effective.

This chapter briefly reviews a number of research results from the theoretical economic literature that help us understand the consequences of introducing consumption-based approaches in international climate policy. In the 1970s, economists started to compare the economic efficiency of different systems of environmental taxation in unilaterally correcting a global externality. They found that, to be efficient, unilateral policies should neither solely rely on production taxes, nor solely on consumption taxes, but on a combination of these two taxes or a combination of either of these taxes with “less than full” border adjustments. With the signing of the Kyoto Protocol, the research focus shifted to a specific form of inefficiency of unilateral climate policies—to carbon leakage. The most important economic “mechanisms” generating leakage were categorized as leakage channels. This study examines four such channels: the competitiveness, the energy market, the income, and the technology spillovers channel. Various counter-measures against leakage were suggested; one of them being border carbon adjustments. Recently, some authors have drawn attention to macroeconomic effects of such countermeasures that are not depicted in standard models. One such effect is that countries targeted by border carbon taxes might react with import substitution, which might lead to an increase instead of a reduction of emissions.

This chapter critically reviews the findings of the “literature on emissions embodied in trade” on the desirability and consequences of adopting consumption-based approaches in international climate policy. This literature strand has established that emissions transfers via international trade from emerging to industrialized countries are large and increasing. In the last decades, industrialized countries have managed to stabilize their production-based, but not their consumption-based emissions. Some authors deem this worrying for the environment and they suggest that a switch to a consumption-orientation in climate policy might serve as a remedy: it would bring a larger share of global emissions into the scope of the policy, would reduce “weak” carbon leakage, and could further the diffusion of “clean” technologies. This study points out that although these arguments have their merits, they cannot guarantee that consumption-based policies are environmentally more effective than production-based ones. Another central argument of the literature on emissions embodied in trade is that consumption-based policies may be “fairer”, as not only producers, but also consumers are “responsible” for emissions. In this study it is however argued that our assessment of “responsibility” should not determine the choice between production- and consumption-based policies; rather, in order to promote justice, we should look at the distributional effects of each of the policy variants.

This study employs an analytical partial equilibrium model to compare the effectiveness of production-based approaches in international climate policy with that of consumption-based approaches. This chapter introduces the model and lays out the exact objectives of the model-based analysis. These are to establish in which way the relative effectiveness of the two policy variants depends on demand and production parameters, the size of the abating coalition, and the exact design of the policy instrument employed. The model developed for this analysis comprises two regions and four final goods markets. It is characterized by two features that distinguish it from models used in other studies: First, in addition to the final goods markets, a global fossil fuel market is also included. This allows an examination of the interplay of goods and fuel markets and the study of carbon leakage through the energy market channel. Second, firms can employ different production technologies for exports and for goods intended for the domestic market. They can thus react rationally to differences in the carbon taxation in these markets, which are a distinctive characteristic of consumption-based policies. This setting allows the examination of one of the central research questions of this study—whether a switch to a consumption-oriented policy furthers the “greening” of production technologies in emerging economies.

This chapter uses the analytical model introduced in Chap. 7 to study those economic and environmental effects of different variants of international climate policy that are transmitted via non-energy markets. A production-based policy is compared with a consumption-based one and with a policy that combines production- and consumption-based approaches by targeting both imports and exports of the abating coalition. Environmental effectiveness, carbon leakage, a simple measure of cost-effectiveness, competitiveness, and the impacts on the international income distribution are used as criteria in assessing the different policy variants. A central result of the comparison is that with an equal carbon tax rate across policy variants, neither the production-based nor the consumption-based policy is environmentally more effective in all possible settings; rather the relative effectiveness of the two policy variants depends on the size of the abating coalition, demand and production parameters, and on the design of the policy instrument used. However, a policy combining the two approaches is always more effective than the two “pure” variants. Competiveness of the abating coalition is best protected by a consumption-based policy. This policy variant also involves the least carbon leakage. As regards climate policy costs, the abating coalition however fares best under a production-based policy. Finally, the effectiveness of a consumption-based policy is reduced if a switch to “green” production technologies in emerging economies is impossible or is not incentivized by the policy instrument, which would be the case if carbon embodied in traded goods were assessed using benchmarks.

This chapter continues the theoretical comparison of consumption-based and production-based variants of international climate policy. It concentrates on those policy effects that are transmitted through the energy market, income, and technological spillovers channels. Additionally, the impact of climate policy on the international distribution of income is discussed—as well as the possible limitations of an analysis employing a two-region partial equilibrium model. Regarding the effects of the energy-market channel, this chapter finds that this channel does not change the ranking of different policy variants in terms of environmental effectiveness as determined by policy transmission in non-energy markets—it just reduces the effectiveness of both production- and consumption-based policies by the same percentage. Regarding technological spillovers, these may be larger under a consumption-based policy; but doubts remain whether a consumption-orientation also enhances the development of “green” technology. The question whether a production- or a consumption-based policy reduces the welfare of developing and emerging economies by a larger amount cannot be decided in general: it depends on the relative ability of industrialized and emerging economies to pass on the costs imposed by climate policy and on the amount of carbon embodied in the exports of the two groups of countries. Finally, two-region partial equilibrium studies may assess consumption-based policies overly optimistically, as they take into account neither the possibility of import substitution in emerging economies that triggers carbon leakage nor tax-avoidance strategies that rely on a rerouting of international trade flows.

Whereas most of this study concentrated on policy effectiveness, this chapter discusses additional criteria that a consumption-based climate policy—typically introduced by means of border carbon adjustments—must meet to prove politically feasible in a “real world” setting and also reviews proposals for the practical design of border measures. Many economists consider the adoption of consumption-oriented policies as legitimate only if these policies further environmental objectives. Additionally, it is often recommended to compensate developing countries for possible welfare losses that the introduction of such policies may bring—either by channeling the revenues from border taxes to these countries or by letting them levy an export tax instead of a carbon import tariff imposed by industrialized countries. Also, border measures should be introduced in a transparent fashion and only after consultations with the countries targeted by the measures. A review of four border adjustment design proposals shows that most authors recommend applying the adjustments not to all goods but only to a few carbon-intensive basic commodities. Also, most economists favor relying on carbon benchmarks instead of establishing the carbon content of each good separately. Some economists, however, criticize this approach as it would mean that much of the efficiency and incentive effects of the border scheme could be lost.

Based on the results of the literature review and the model-based analysis, this chapter develops proposals for the practical design of consumption-based approaches in international climate policy. First, a number of criteria are proposed that a unilateral consumption-orientated policy should meet: it should promote environmental effectiveness or cost-effectiveness, should not impose additional economic burdens on developing and emerging economies, should be perceived as fair, should stand a chance of conforming to WTO rules, and its implementation should be practicable. From these criteria recommendations for practical policy design are deduced: border tax revenues should be allocated to developing and emerging economies; “green” technology transfer to this group of countries should be fostered; the application of export rebates in addition to import tariffs is an option, but it does not have large effects on policy effectiveness; and the adoption of “green” technologies by developing and emerging economies should be incentivized. This chapter argues that the last of these recommendations is extremely important for the environmental effectiveness of the policy; this recommendation will however be difficult to implement if the policy—as typically recommended for reasons of practicability—is based on carbon benchmarks or if at least a certain measure of cooperation by the countries affected by the policy cannot be guaranteed.

This concluding chapter summarizes the main results of this study. The view of some authors that industrialized countries can easily and quickly improve the environmental effectiveness of unilateral climate policies by introducing consumption-based approaches is challenged. This study has found that none of the arguments typically presented in support of consumption-based policies can, in fact, guarantee their effectiveness. Rather, whether a production-based or a consumption-based climate policy is environmentally more effective or more cost-effective depends on the size of the abating coalition, demand, production, and trade parameters, and the exact design of the policy instrument used. In particular, the effectiveness of consumption-based approaches depends crucially on whether they incentivize a “greening” of production technology in developing and emerging economies. It is argued that in the short run—when using border adjustments as a policy instrument—the desirable incentive effects can be secured only if it is possible to achieve at least a certain level of cooperation with the countries affected by the border measures. In the long run, a “carbon-added” scheme could be introduced instead of border adjustments—this would further policy effectiveness, but require an even higher level of international cooperation. Thus, consumption-based approaches should best be discussed not as an additional “tool” of unilateral climate policy, but rather as a possible intermediate step on the way to a fully multilateral abatement strategy.