EU carbon border adjustment mechanism and production location

Abstract

As part of the European green deal European Union (EU) has proposed Carbon Border adjustment mechanism (CBAM). Its purpose is to compensate for emission taxes within EU to avoid carbon leakage to non-taxing countries. Among all possible options, border tariffs for products imported from non-taxing countries to EU countries are set equal to emission taxes. This appears fair, but the economies of scale effects are not considered. This paper examines the effects of realistic cost functions on the resulting production allocation. We experiment with single product, four-country, equilibrium model where three countries are potential producers, and all four countries are markets. In our model, demand and supply (producer cost) function parameter values and transportation cost are equal, and total producer profit is maximized. Our cost function is a power curve entailing economies of scale. We primarily examine the effects of producer tax and border tariff levels on production and profit. We also consider the effect of consumer tax during experimentation. The results show that the amount of economies of scale strongly affects the profit-maximizing production allocation. It appears that under economies of scale effects the EU border tariff levels are far too low to create a fair marketplace. Low border tariffs under economies of scale lead to centralized production by a non-taxed producer using polluting technology, whereas sufficiently large border tariffs decentralize production to different countries, and the amount of polluting production is reduced significantly. The effects of short-run capacity constraints and market size on the production allocation are also examined.