Regulatory Stringency and Emission Leakage Mitigation

We construct a two-country trade model where emissions are an input in production and generate cross-border pollution. We examine the strategic incentives of an active regulator who sets a binding level of emissions in production. We show that, in the presence of terms of trade and emission leakage strategic motives, tighter regulation can mitigate emission leakage, reduce global pollution, and improve a country’s welfare. This result and the corresponding policy implications depend on the relative magnitude of emissions intensities of goods between sectors and on their relationship in production and consumption.